Your credit score and credit report can make or break your chances of securing a loan. As a potential borrower, you need to understand how your credit score impacts your ability to secure a loan.
Whether you’re looking for a personal loan, home loan, car loan, business loan, or any other type of loan, the first factor that lenders look for is your creditworthiness. The credit score plays a crucial role in helping banks and other financial institutions assess your ability to repay the loan.
In this article, we walk you through the basics of your credit score and credit history, helping you understand the vital role of these two factors in determining your loan application’s outcome.
First things first,
What is a credit score?
In the simplest of terms, a credit score is a numerical number that represents a borrower’s creditworthiness.
- It reflects the ability of a borrower to repay a loan.
- It helps potential lenders determine the risk of lending to the borrower.
- It helps lenders evaluate how much of a default risk the borrower poses.
- It shows the borrower’s payment patterns on past loans or credit cards.
In India, credit scores are provided by four leading credit bureaus, CIBIL, CRif highmark, Experian, Equifax who assess the credit history and other credit information of borrowers. Based on this data, the credit bureaus calculate your credit score.
A credit score is a three-digit number, and it ranges between 300 and 900. The higher the credit score, the more favourable are your chances of securing a loan at the best possible interest rates.
How does a credit score impact your chances of securing a loan?
The credit score impacts the chances of securing a loan in two significant ways:
- Loan Eligibility
Lenders have varying eligibility for different loans. However, all lenders use the credit score and history of a potential borrower to determine loan eligibility. It’s the first factor that a lender checks before considering other eligibility requirements.
Borrowers with a high credit score will find it easy to get large unsecured loans from banks and other lenders. On the other hand, borrowers with poor or low credit scores will have a hard time clearing the eligibility criteria set by lenders.
Having an ideal credit score opens the door to various loan opportunities. When you have a good credit score, it increases the options available to you. You can choose between different lenders based on the loan terms they offer. Whether you need an instant personal loan, a home loan to build your dream home, or a two-wheeler loan to purchase a bike, a good credit profile makes it easy to secure your preferred loan. It makes borrowing easy and opens the loan options available to you.
- Loan Interest Rate
Your credit score not only improves your chances of securing the loan but also plays a crucial role in determining the rate of interest. Having a low loan interest rate reduces the overall loan burden significantly.
Lenders generally offer competitive interest rates to borrowers with higher credit scores and clean credit history. You may notice that it’s possible to get your loan application approved even with a low credit score. However, the interest charged by the lender will be significantly higher than the interests charged for a borrower with high credit scores.
When you have a low credit score, lenders consider you to be at a higher risk of default, which increases the risks borne by them. As a result, they charge you a higher interest rate to ensure that a significant sum of the loan amount is repaid early on.
Now that we’ve seen the two major impacts of credit scores on loans, let’s take a look at what goes into the credit score.
How are credit scores calculated?
The credit score of an individual is determined by calculating several factors. The five major factors that influence your credit score are:
- Repayment History: The repayment history contributes to around 35% of your overall credit score. It’s calculated based on whether you pay your credit card bills/EMIs on time, whether you have defaulted on loan payments in the past, etc.
- Credit Utilisation Ratio: The credit utilisation ratio contributes to around 30% of your overall credit score. This ratio shows how much credit you have utilised against the overall credit available to you. The lower the ratio, the better it is for your credit score.
- Length of Credit History: This factor contributes to around 15% of your credit score. It’s based on how long you have been using credit and how punctual you have been on the repayments. Having a long credit history is favourable for your credit score. This is why financial experts recommend not closing an old credit card as it erases the associated credit history of the card from your credit report.
- New Credit Enquiries: Applying for several loans or credit cards within a short span is not favourable for your credit score. It gives the impression that you’re credit hungry, causing your credit score to take a hit. Every time you apply for a loan or credit card, it causes a hard inquiry on your credit report, which brings down your score by a few points. This factor contributes around 15% to the overall credit score.
- A mix of Credit: Having a combination of credits – both secured and unsecured loans – reflects favourably on your credit score.
What is the ideal credit score for loans?
Having a score above 750 makes it easier for a borrower to avail of loans at competitive interest rates. That doesn’t mean a borrower with a credit score of lesser than 750 will not be able to get a loan. He will still be able to borrow, but the lenders willing to extend credit will be lower and the options limited. Also, the interest rates charged will be higher than those offered for borrowers with good credit scores.
How can I improve my credit score?
Now that you understand the role of credit scores in impacting your loan application, here are some tips to boost and improve your credit profile.
- Check your credit scores periodically. This gives you a clear idea of where you stand and what should be done. You can check your current credit score for free at CreditMantri. Just provide a few essential details like your name, mobile number, PAN card, and your latest score will be available within a few minutes.
- Pay your credit card bills, EMIs, and other debts on time.
- Pay your credit card bills in full every month.
- Do not apply for too many loans/credit cards within a short span.
- Take a short-term loan and pay it regularly, on-time, to boost your credit score.
As you see, your credit score not only impacts your chances of getting the loan but also affects the interest rate sanctioned on your loan. Having a good credit score makes it easier to secure a loan while lowering the overall loan burden. So, it’s highly recommended that you check your credit score and work on improving it before you apply for a loan.