What is a credit score and how to be better at one?
By Prakhar Gupta on The Capital
Whenever you apply for a loan or for a credit card, the representatives usually ask for your social security number (U.S.A.) or PAN card (India). They do so as to check whether you are eligible for the company’s flagship product. My former manager gave a concise definition that I think aptly describes a credit score — it signifies how a customer has handled credit in the past. The credit handling ability is one of the main decisive factors for any business to gauge their potential customers.
There are many reporting agencies that generate credit scores, such as Experian, Equifax, and Transunion. Your credit score is made up of different components. The weightage of each component is different among these agencies. That’s why there is a slight difference in the score reported by them. All banks try to have bureau data along with credit scores. These scores help them assess the creditworthiness of their customers. A better score increases the chances of approval for a loan or a product. Even though the score doesn’t dictate the bank’s policy alone, but it lets banks segregate you accordingly.
There are generally five components based on which credit scores are calculated. The first component is the “Payment History.” This component tells the bank whether the customer has paid his debt regularly or not. If she has defaulted on payments earlier, the chances are higher that she will default later as well, making her credit score lower than of those who pay regularly. Also, there are some banks that allow no credit deterioration if one pays her minimum due every month. The second component is the “Utilization rate.” All customers are assigned some lines of credit card or revolving lines for their personal loans. Those who utilize these lines greater than the rest are deemed as credit-hungry customers. There is no optimal utilization rate, as it varies geography to geography. For example, Indians have a lower utilization rate as compared to Americans’, due to the debt-aversion of Indians.
The third component is “Length of credit history.” Longer the history, the better is your score. Therefore, it’s advisable not to cancel your oldest credit card. One should be aware of financial charges while not using her old credit card. The fourth component is “Credit Mix”. The credit mix refers to the variety of products that you have taken. For example, a young man in his 20’s might take out 2–3 credit cards along with a student loan. Generally, this component favors a diverse mix of loans such as a mortgage, auto loan, home equity (partial equity of your home converted to a credit line), personal loan, retail accounts, credit cards, auto leases, and others. For a better score, a good mix of loans is needed. The last component is “New credit.” It refers to how many tradelines have a customer opened recently. Tradelines means the new mix of debt you might have taken. For example, while going for higher studies abroad, a student would need a student loan to finance her studies, a credit card to fulfill her daily finances, and a personal loan for some quick finances. These multiple lines of credit obtained within a small timeframe can hamper her score. For a better score, tradelines should be opened in a staggered manner rather than in one go. It would seem that the customer is a credit-hungry if lines are opened quite frequently.
Apart from these components, there is a concept of “hard and soft hit” on credit inquiries. Whenever there is an inquiry for a credit report from a credit bureau, the inquiry gets logged in somewhere. Whether it affects your credit score depends on what type of inquiry is and who has inquired about your credit score. If you inquire about your credit score or get pre-screened by a bank for a loan offer, it generally entails a soft-hit on the credit score. Soft-hits on your credit profile do not affect your credit score. Whereas, if you have inquired/applied for a loan or some other product, the bank would screen your credit profile and make a decision whether you are fit for new credit. This decision-making process entails a hard-hit on credit score. Generally, hard-hits on the credit profile affects your credit score.
The five components discussed earlier mostly cover all the behavioral aspects required to assess the creditworthiness of a customer. These credit scores are required not only by the banks but also by the insurance companies. The banks require these scores to check whether the customer qualifies the minimum threshold for the concerned product. The insurance companies too would like to see how a customer has paid off her debt. The information could translate into a decision whether she can regularly pay the premium of the insurance. Also, the banks have different strategies to acquire new customers and to serve existing customers. For example, they can extend personal loans to open market or they can extend to their existing customers. The strategy to select customers is different based on product, tenure, market, risk, geography, etc. The final conclusion is only one thing — A Lannister always pays his debt. You should too.
