What is a credit score and how is it calculated?

What is a credit score and how is it calculated?

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In the modern financial landscape, the credit score has become an essential factor that can significantly influence your financial opportunities. When applying for education loans or a credit card, a credit score can often be the deciding factor. This three-digit number holds immense importance. But what exactly is a credit score, and how is it determined, especially in the Indian context?

Let’s delve deeper to understand the intricacies of credit ratings and their calculation.

What is a Credit Score?

A credit score is a three-digit number that banks or financial institutions use to determine a potential borrower’s eligibility for an education loan or credit card. It provides a numerical insight into an individual’s creditworthiness, essentially gauging the likelihood that borrowers will repay borrowed funds based on their financial history and behavior. Lenders—like banks, financial institutions, NBFCs and credit card companies—rely on this score to evaluate the risk of lending money. A higher credit score signifies a lower risk, making the borrower more likely to obtain favorable terms on student loans and credit.

Components of a Credit Score

Credit scores are typically derived from five main components. While various credit bureaus employ distinct methods and algorithms, there are four primary credit bureau agencies in India: CIBIL, Experian, Equifax, and CRIF High Mark. Given the different scoring systems these agencies use, a borrower’s credit score can vary from one bureau to another.

Let’s delve further into the factors that influence the calculation of a credit score.

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1) Payment History

The borrower’s payment history may include transactions from credit cards, personal loans, auto loans, motorcycle loans, student loans, and home loans. This history sheds light on missed or late payments, bankruptcies, and the strategies borrowers have employed to clear their debts. The algorithms for credit scores consider their payment history, amounts owed, and the recency and frequency of missed payments. These factors collectively influence a borrower’s credit score.

2) Credit Utilization

This metric examines the degree to which borrowers use their available credit limit. It’s derived by dividing their credit card balances by their credit limits. A high credit utilization ratio can hint at financial distress, potentially diminishing the score. Ideally, maintaining a credit utilization ratio between 30 to 40 percent is recommended. Ratios exceeding this bracket can adversely affect the credit score.

3) Credit History Length

The duration of a borrower’s credit history also holds significance. An extended credit history illustrates their prowess in managing credit over prolonged periods. Hence, retaining older credit accounts can reflect responsible credit behavior favorably.

4) Types of Credit

The variety of credit products in a borrower’s portfolio also impacts the credit score. Possessing a diverse set of credit items—like credit cards, vehicle loans, personal loans, and home loans—can elevate their score. Thus, the total number of accounts a borrower possesses is factored in when calculating the credit score.

5) Recent Credit Enquiries

This factor evaluates the recent credit accounts for which borrowers have applied. Numerous inquiries within a brief period might suggest concerns about their financial stability, potentially lowering their credit score.

Credit Score Calculation Process:

Let’s take a closer look at how credit scores are calculated:

● Data Collection
Credit bureaus gather data from various lenders, financial institutions, and other relevant entities about borrowers’ credit-related activities, encompassing payment history, outstanding debts, credit limits, and beyond.

● Scoring Algorithm Application
Credit scoring models, like those from CIBIL, deploy proprietary algorithms on the amassed data. These algorithms assess and weigh the aforementioned factors to deduce a borrower’s credit score.

● Score Generation
Subsequently, the definitive credit score is formulated, typically oscillating between 300 to 900 in the Indian context. Here, loftier scores are indicative of superior creditworthiness.

Read More: Checkpoints to consider while applying for Unsecured Education Loan

Tips for Improving Credit Score:

1) Pay Bills on Time: Regular and timely payments of student loans, credit card bills, and other financial commitments are vital for sustaining a commendable credit score.

2) Manage Credit Utilization: Endeavor to keep your credit card balances considerably below your designated credit limit to ensure a favorable credit utilization ratio.

3) Monitor Credit Report: Periodically scrutinize your credit report for any inaccuracies or discrepancies that might be adversely affecting your score. Remember, each borrower is entitled to one free credit report every year from each credit bureau.

4) Limit Credit Applications: Exercise caution when applying for new credit accounts. Each application typically triggers a hard inquiry, which might slightly dent your score.

5) Balanced Credit Mix: Foster a harmonious blend of various credit types, showcasing your aptitude in managing diverse financial responsibilities.

Conclusion

In India, the credit score is a pivotal metric, reflecting the fiscal health and reliability of borrowers. By grasping the elements shaping the score and familiarizing oneself with its computation, borrowers can actively steer and enhance their credit stature. A robust credit score paves the way for attractive loan conditions, competitive interest rates, and an overarching fiscal stability. As the contours of India’s financial domain continue to transform, it’s paramount for individuals to stay abreast of credit scores and cultivate judicious financial practices for a prosperous fiscal journey ahead.

If you are going to college this year, Varthana student loan is obtained jointly with parents or guardians. Your co-borrower must submit proof of income as well as other documentation in this scenario. If the course you want to take and the institute you want to attend are both on Varthana’s database, you may easily apply for a student loan based on your qualifications. Apply now for a student loan here.

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