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How Credit Score is Calculated?

A person’s credit score is a number that banks and other lending institutions use to ascertain their “creditworthiness”. This number is usually between 300-900, and it depicts the individual’s ability to repay borrowed credit, like loans.

It is important to have a good credit score, as it proves that a person has shown responsible credit behavior in the past. This, in turn, gives potential lenders more confidence to approve requests for credit.

In India, the Reserve Bank of India (RBI) has licensed four credit information companies who calculate the credit scores of citizens. TransUnion Credit Information Bureau (India) Limited (CIBIL), CRIF Highmark, Experian, and Equifax.

But it is also important to know how these scores are calculated, as it can help ensure that your credit score stays high.

What is a Good Credit Score?

While different credit bureaus use different scoring models while calculating credit scores, in general credit scores are as follows:

  • 300-579 – Poor
  • 580-669 – Fair
  • 670-739 – Good
  • 740-799 – Very good
  • 800-850 – Excellent

Credit scores above 700-750 are generally considered good. But, every lending institution has their own risk grading. For instance, while one bank may consider a score above 700 to be good, another may prefer a score above 750.

How is your Credit Score Calculated?

As already mentioned, a person’s credit score is a number between 300-900 (with 900 being the highest score possible). These scores are calculated by an algorithm used by credit information bureaus using a number of factors. These include:

1. Payment history

One of the main factors that goes into calculating your credit score is your repayment history. This includes payments of your credit card bills, loans, and EMIs. Banks and other financial institutions send this information to credit bureaus on a monthly basis.

If you have ever skipped or delayed a payment towards your bills and EMIs, it will be reflected in your credit report, and this will make your credit score lower.

2. Credit utilization

Credit utilization refers to the amount of your credit that you use. This should be kept below 30% of the total credit available to you. For example, if your credit limit is ₹1,00,000 per month, you should try not to use more than ₹30,000.

Ensuring that your credit utilization is low will help to keep your credit score down. To do this, you can use a debit card or cash for regular purchases, consider asking for your credit limit to be raised, or opt for a second card.

3. Credit duration

The length of your credit history is an important factor. It is essentially how long you have had a credit account, as an older account and older credit cards can reassure lenders that you have been paying your bills regularly over time.

Another key factor used to determine credit score is the time frame you have taken to service your credit. For example, if you have opted to repay your loan over a longer period of time (and made prompt and timely payments on this loan), as opposed to taking out a short-term loan, it can help to improve your credit score.

4. Credit mix

The kind of credit that you have opted for is also a factor that can play a role in determining your credit score. There are two main kinds of loans, unsecured loans and secured loans. Unsecured loans include credit cards and personal loans, while secured loans include auto loans or home loans.

In general, having a higher number of unsecured loans may be seen in a negative light by lending institutions. As you may be seen as a risky borrower, it can lower your score.

On the other hand, a higher number of secured loans are preferred by lenders and credit bureaus and can help to increase your credit score.

Thus, it is recommended to opt for a healthy mix of unsecured loans and secured loans.

5. New credit enquiries

One of the final factors that can affect your credit score is the number of times you have applied for credit. This includes applying for credit cards, loans, etc. Each time you apply for new credit, the bank or lending institution will make what is known as a “hard enquiry” of your credit score so that they can learn about your credit history.

Such hard enquiries can have an impact on your credit score. Thus, it is advisable to apply only to institutions that will likely accept your application.

Note that “soft enquiries” are when someone checks your credit history for a reason that is unrelated to lending money. For example, when you check your own credit score. These enquiries also appear on your credit report but do not affect your credit scores.

It is important to remember that each of these factors noted above counts for a certain percentage of your credit score. For example, your repayment history holds the highest weightage (about 35%), while the second most important factor is credit utilization (about 30%).

The length of your credit history – i.e., credit duration – accounts for 15%, while the type of credit used and the number of new credit enquiries both count for 10% each.

 

Knowing all of these factors, and how they can affect your credit score can help you know how to avoid having a weak score.  This can be very important as you do know when you might need to apply for a loan.

Thus, ensure to keep monitoring your credit score and your credit profile regularly to ensure that your score is high. This way, you can fix any errors in your credit report in a timely manner, and you are “credit-ready” at any time.