After Covid, banks are relying on technology to lend at scale. And this is where credit scores come into play. It allows banks to judge a customer’s creditworthiness quickly. So I came up with this quick primer about credit scores and why you need to generate and maintain a credit score for yourself.
- What is a CIBIL (credit) score?
- Why do you need a good credit score?
- How to generate a CIBIL score if you don't have a source of income?
- Does CIBIL determine my credit utilization based on my credit card bill amount?
Factors affecting your CIBIL score
1. On-time payments
This is the most important factor. Make sure you pay your loan EMIs on or before the due date. This will remain on your record for up to 3 years and your CIBIL score will recover slowly over the period.
From my lending experience, the most common way people screw up their credit scores is when they dispute a charge (typically annual fees) and don’t pay it. This ends up being reported to CIBIL as a default and their scores drop to 600-650 range. It is better to pay it and dispute the charge with the banks and get a refund later.
2. Secured vs Unsecured
When you get a loan by pledging something you own, it is called a secured loan. The pledged asset is called a security. CIBIL scores increase faster with secured loans because you are more likely to repay your loan to get your security back.
Gold loans, Home loans, Loan against property, Loan against shares, Overdraft against Fixed deposits are examples of secured loans.
Credit card and personal loans are the most common unsecured loans.
You can still build up a credit score with unsecured loans, but in my experience, I have seen only people who have taken secured loans breach the 800 score. It doesn’t mean it is impossible to get there with unsecured loans, but the time frame will likely be a lot longer.
3. Age of Loans
If you have taken a loan or credit card only recently, CIBIL has less data to go on. So the longer you have a track record of on-time repayment, the better your score will be. Also if you close your oldest credit card/loan that you had for (say) 5 years after getting a new one, you might see a dip in your credit score. This is because CIBIL will compute your score considering the history of credit based on the oldest loan you have taken. However, this is not to worry as the drop will likely be 10-20 points which can be built back over time.
4. Multiple loan enquiries
Whenever you get a new card/loan, your CIBIL score drops by 5-10 points when it gets disbursed/approved. Your CIBIL score also drops when you apply for credit multiple times. This is because CIBIL considers this as a sign that you are trying for credit but you keep getting rejected because the lender does not consider you to be creditworthy.
The process of applying for a credit card/loan alone doesn’t make the credit score drop. This is because lenders initially do a ‘soft’ pull. I.e. they make an enquiry for a loan of ₹ 1000. This doesn’t affect your score. At this point, your CIBIL report shows a enquiry for ₹ 1,000.
Once the loan is approved, the lender makes a ‘hard’ pull, i.e. the lender reports that you have applied for and informs CIBIL of the full loan amount that you have applied for. At this point, your CIBIL score would drop by 5-10 points and would gradually increase back again with on-time payments.
However, if there are multiple enquiries for a loan of ₹ 1,000 then your score might dip by 5-10 points for each successive enquiry itself.
5. Utilization of your limits
CIBIL prefers that you use only up to 30% of your credit card limit. The reasoning here is that if you carry a huge balance on your credit card every month, you are spending a lot and are more likely to default on a payment.
What is a Credit score?
TransUnion CIBIL is a credit information company that gets your loan repayment history from banks and creates a score based on certain factors. Banks buy this score from CIBIL to see your creditworthiness. Higher the score, better the chances of getting a loan approved. Conversely, a lower score indicates that the borrower is more likely to default and will have less chances of getting approved.
CIBIL score ranges from 300-900. There are also some special scores which I'll explain below.
You have never taken a loan in your life
Your credit history is less than 6 months (or) you had taken loans earlier but it is closed now and it has been more than 6 months since you are debt-free
The following table describes the credit scores of borrowers who have been sanctioned loans in the recent past. As you can see, bulk of the bank money has been going to borrowers with great CIBIL scores. [Source: CIBIL website]
% of loans sanctioned
Why do you need a good credit score?
- Cheaper loan interest rates allow you to repay faster
- Loan applications are processed faster
- Cost of education is rising by 10-12%(approx) every year. A good credit score can make that education loan for a bachelors’ /master’s degree possible.
- Companies look at CIBIL scores of their applicants (especially in the finance/fin-tech industry). Low/bad scores have been grounds to reject an applicant.
How to generate a CIBIL score if you don't have a source of income?
I wrote about it earlier here.
Does CIBIL determine my credit utilization based on my credit card bill amount?
No. CIBIL gets your outstanding from the credit card company once a month on any random day. So it is important to note that 30% means the day end outstanding on your credit card on any given day and not the bill amount for that month.
But I have a low credit limit on my credit card and my purchases will inevitably be more than 30% each month…
You can ask for a credit limit upgrade (after 6 months to a year) if you have been paying on-time. If that is denied, whenever you make a purchase that exceeds 30% of your limits, you can pay off a portion of your credit card outstanding to bring it under 30%. While this has a low impact anyway, (about 5-20 points might be deducted for high utilization) it might make a difference to some.
Note: The movement of CIBIL score increases are based on my observations from my experiments and also from work experience. YMMV.