What is ‘credit score’ and how does it work?

Understanding how credit score works is crucial to knowing your credit worthiness and the rate of interest you will be charged on debts.

In today’s world, with every bank and financial institution offering loans for personal as well as professional needs, taking a loan seems like a cakewalk. However, things are not as easy as they first appear. You might have a large income from your job or business, but that alone does not guarantee that you will get a loan right away at the interest rate you desire.

To understand how the loan system works for you as the customer, it is important to first understand a concept known as ‘credit score’. This is a number derived from one’s personal credit history: the type of past credit, payment history, new credit taken, credit repaid and length of credit. These collectively determine one’s credit score, which is the single most important factor that banks and financial institutions use to determine if the applicant is a suitable candidate for mortgage loans, credit cards or personal loans.

Not just credit worthiness, the credit score can also help the lending institution determine whether the application for a mortgage loan, for example, should be approved or not. If it is approved, the lender will also deliberate on the rate of interest to be charged on that loan.

Those with a low credit score often find it difficult to get approvals for loans, and may also have to pay a higher rate of interest on the same. The key point to remember is that the credit score is considered before the credit is extended. Hence, it is a prudent move to build a better score before approaching a lender for a mortgage loan.

How to build a good credit score:

* First time applicants may not have a past loan history, but the lender will consider such factors as whether the applicant has any owned property that he or she can use as collateral.

* Those with previous loans can build a good credit score by repaying the loan faster than the loan term period. This can be done by repaying larger amounts (exceeding the EMI amount) periodically.

* Not defaulting or missing payments is key. Lenders study the pattern of defaults closely, and compare the same with financial statements of the same period. The score will be automatically lowered if the lender observes sufficient income but payment defaults, or large borrowings from private sources at the same time that the loan is active.

* Repaying credit card bills on time is crucial. Lenders study how many credit cards the applicant has, what is the repayment pattern like, how much monthly spending takes place on each, etc.

* Another key area of scrutiny is whether the applicant is embroiled in any cheating and/or forgery cases, or whether there are bankruptcies or foreclosures against the applicant’s name.

* Even such payment records as utility bill payment records are closely monitored.