The financial system works on trust. Trust is formed mainly through familiarity. Let me explain this with an example. Consider you have some surplus money which you are willing to lend out to earn some interest. Now, who would you lend to? – most will limit lending to the people they personally know. This limits the availability of credit to many people.
Another issue is – how much interest should you charge? Logically, you should charge more interest on loans which are riskier than the less risky ones. But, how do you determine the borrowing behaviour of the borrower – which partially determines the risk of the loan. Even if you personally know this person, you may not have all the information about their finances and you have to depend on the information they provide to you – this is called information asymmetry i.e. difference between information available between the borrower and lender. One way to deal with this situation is to take a blanket approach and base the lending rate on the overall default rate and charge everyone the same interest rate. But, this encourages bad credit behaviour because people who managed their finances well carries the burden of people did not.
So, what is the solution of this problem. What if there is a central database of all borrowers from which a lender can know their past borrowing habit and base the lending decision and interest rates on that – this is the rational behind creation of Credit Bureaus and Credit Information Companies (CIC).
A Credit Bureau collects the information from lenders and provides the information to a Credit Information Company (CIC( who stores the information and provides the information to lenders. There are four CICs in India – CIBIL, Equifax, Experian and High Mark Credit Information Services.
WHAT IS A CREDIT SCORE?
A Credit Score is summary of credit history represented in three digits ranging between 300-900. It is derived from past credit behaviour of the borrower as represented in Credit Information Report (CIR) and indicates the “probability of default” based on credit history.
Your credit score is calculated based on your credit history, credit utilisation, length of credit history, recently reported balances and new credit accounts etc.
HOW BANKS USE THE CREDIT SCORE?
Credit Score is one of the first checks for a loan application. So, a good Credit Score increases the chances of getting a loan. Generally a Credit Score of 750 and higher is considered good. Apart of Credit Score, banks also check current loans and behaviour which is reflected on the Credit Information Report (CIR).
A good Credit History is the necessary but not sufficient criteria to get a loan. The lenders also want to evaluate your ability to pay back in the future. One of the way to do is calculate the ratio of your current EMIs and your current income. The lender can decide how much EMI you will be able to pay comfortably in addition to current EMIs.
ARE CREDIT SCORES FROM DIFFERENT CICs EQUIVALENT ?
It may not be. As different CICs use different methodologies to calculate the scores and source of their information may also vary. That is why if you are thinking about taking a loan, you should check your Credit Score from all the CICs – not just one.
ARE CREDIT REPORTS ALWAYS CORRECT ?
Not necessarily. The correctness of the Credit Report depend on how updated the data is with the CIC. The lenders from which you took loans before may fail to report information on your repayment. The Credit Card which you requested to close – may show up as active. This is why CICs allow you to raise disputes on the reports.
Given how important the Credit Reports are – you should check Credit Reports from all CICs considerable time before your are planning to apply for a loan. This will give you time to raise and close a dispute and contact the past creditors for reports on your repayment.