A guide to credit scores and how to improve yours | The Financial Express

A guide to credit scores and how to improve yours

While ignorance is bliss in some cases, when it comes to personal finance, it is a mistake that will haunt you whenever you make that first move towards taking a loan, no matter how big or small.

A guide to credit scores and how to improve yours
The credit score is a number between 300 and 900 which indicates how likely you are to pay your dues promptly.

By Sonali Jindal, Co-founder and COO, RING

“Loans”, “credit”, and “debt” are terms that all of us hear as soon as we become young adults. However, most of us don’t understand what they mean or how they work until well into adulthood. While ignorance is bliss in some cases, when it comes to personal finance, it is a mistake that will haunt you whenever you make that first move towards taking a loan, no matter how big or small. Instead of waiting to learn about jargon and scores when you apply for credit, it is wise to learn and maintain your credit score before such situations arise.

Functionally, the credit score is a number between 300 and 900 which indicates how likely you are to pay your dues promptly. The higher your score, the better a borrower you are, and the better your terms of credit will be. Quite simply, a strong credit score encourages banks and NBFCs to give you higher credit limits and thus increase your spending potential. Naturally, this makes credit scores immensely important for anyone with a bank account.

Who uses your credit score?

Whenever you make a financial transaction, check for a line of credit, open a new account, etc., your bank passes that data on to CIBIL, which maintains and compiles it in your CIBIL report. If you decide to apply for a loan, the creditor will file an inquiry for your report which will give them your credit score and dictate what terms they can offer you.

The 300-900 range can be formalised into five brackets for convenience: 300-600 (needs attention), 600-649 (doubtful), 650-699 (satisfactory), 700-749 (good), 750-900 (excellent).

How is Your Credit Score Calculated?

Five factors contribute to your final credit score calculation:

1. Repayment History

Perhaps unsurprisingly, the overall measure of how successfully you have managed to repay your debts is the first and most important data point; accounting for 35 per cent of the credit score.

2. Credit Balance and Utilisation

The amount of credit available to you along with how much of that credit you have spent makes up 30 per cent of your score. The ratio of used credit to available credit is important because it indicates how cautious or blasé a person is.

3. Duration of Availing of Credit

Naturally, long-term credit paid regularly without any misses or complications leads to a better score. This aspect counts for up to 15 per cent of your score.

4. New Credit

CIBIL tracks the number of times you inquire about a new line of credit or a loan. Too many inquiries can lead to an impression of credit-hungriness which negatively impacts your score. This can account for up to 15 per cent of your score.

5. Credit Mix

Having a healthy combination of long-term, short-term, secured, and unsecured credit over a long time shows a more reliable personality which leads to a higher score. This is the smallest sector and accounts for up to 10 per cent of the score.

What makes a good credit score?

Naturally, it is important to understand how you can improve your credit score. At a fundamental level, this simply involves being responsible with your money. Pay all your EMIs and credit card debts on time and do not default on any agreement.

A more targeted approach to improve your credit scores within 6-12 month increments may include:

Start early

Perhaps a simplistic but important point, especially for those just becoming eligible for financial activity, is to have a record of credit and responsible repayment as soon as possible. Naturally, most 21-year-olds do not feel the need to apply for a large loan, but they can establish a solid record of good credit by availing small credit lines for essential purchases. By doing this continuously, when they do end up going to the bank for a home loan or a car loan, they will be in a far better place to do so on account of their strong credit scores.

Don’t cancel extra credit cards

If you find yourself with more than one credit card of which you only wish to actively use one, it is advisable to not deactivate the other cards. Breaking lines of credit with a bank counts against your credit score. The preferred alternative is to hold such credit cards, remove the recurring payments, and check on them every few months to make sure no payments are going through them. This shows you as holding multiple lines of credit over a long time consistently.

Optimise your credit utilisation

As mentioned previously, the ratio of credit utilisation to credit availability is an important metric in your score calculation. Apart from making sure that you use as little of your credit limit as possible (ideally ~25 per cent), you can contact your bank and have your monthly credit extended. As long as your expenditure does not increase, this will translate to the same amount of expenditure being compared to a higher potential limit.

Get live Share Market updates and latest India News and business news on Financial Express. Download Financial Express App for latest business news.

First published on: 29-10-2022 at 13:03 IST