What is credit scoring and what factors are considered for the calculation of scores?

[This article explains about grading of borrowers who have a short credit history, how the credit score is calculated, factors considered for the calculation of scores, and the important aspects to see in the CIR]

Originally posted on April 20, 2016, and updated and reposted on July 20, 2024

Credit scoring models are statistical tools that evaluate creditworthiness and determine the likelihood of default on credit obligations. The credit scoring models evaluate an individual profile by analyzing factors like their payment history, number of accounts, credit types, and other financial information, along with demographic information to create a credit score.

The loan applicant’s credit scores work as the first impression for any lender. Normally, the lender would evaluate other details of the credit proposal, after confirming that the credit report of the applicant is positive. The credit information report (CIR)) of the individual shows the likelihood of default based on the borrower’s credit history, present income, debt service obligations, and credit scores.

The leading credit bureaus or credit information companies in India are TransUnion CIBIL, Experian, Equifax, and CRIF High Mark are regulated and authorized by the Reserve Bank of India

CIBIL TransUnion Score 2.0 is the new version of the scoring system developed by CIBIL which is the largest domestic Credit Information Company in India. The upgraded scoring system of CIBIL has several supplementary factors that were of lesser significance in the earlier scoring system. The revised version also helps the lender to credit appraisal of borrower’s proposals, who have a short credit history or no credit history, by grading them with risk index.

Grading of borrowers who have a short credit history:

In the earlier version of CIBIL, the individuals who have a credit history of lower than six months were categorized under “No History- NH” and the loan applicant is awarded a score value of ‘0’. In the new version, the people with no or short credit history will be graded the risk indexes from 1 to 5.  The risk indexes one or two means high risk, three means medium risk, and four or five means lower risk of default. In other words, a higher the index indicates a lower risk. Hence, the new feature of the risk index will simplify the process of credit appraisal of first-time borrowers and people with short credit histories.

How is the score calculated?

According to experts in the know of the score allotting process, the past performance of the individuals on their debt obligations is the most important factor for positive scoring. Good repayment history without any delay and default contributes approximately 30 percent weightage to the score.,

An additional 25 per cent weightage score is assigned to the type of loans taken and the duration of credit history established with the proper mix of secured and unsecured loans. The higher proportion of secured loans and prompt servicing of Long-term loans earns more points to a borrower.  Whereas, a shorter credit history and a higher proportion of unsecured loans will have a negative impact on credit scoring.

A block of 25 per cent scores earmarked for credit exposure of an individual. The aggregate quantum of borrowings including the balance outstanding on credit card utilization determines the credit exposure of the applicant. High utilization of credit limits increases the credit exposure of the borrower, which would naturally reduce the ratio of income to spending and thereby reduce the credit scores.

The remaining 20 percent of scores are allotted based on other issues like frequency of application for a new loan or credit card, credit utilization, recent credit behavior, etc.

The incidents of a borrower who got sanctioned multiple loans and credit cards in a short period impacted negatively on his credit scores as the same signals the behavioral change of the borrower associated with the increased debt burden.

When an individual applies for a loan or credit card, the applicant’s credit information report (CIR) will be called for by the lender. If the applicant has made the calls at 4-5 banks at a time, CIBIL structure makes a note of such referrals as inquiries.  The frequent inquiries for credit limits have a negative bearing on credit scores. Further, a history of making late repayments of loan installments, over dues in the accounts, increased burden of repayment of debts, etc. may negatively impact the scores.

Factors considered for calculation of scores

The basis of past performances, credit type, credit duration, credit exposure, and other issues like the frequency of application for a new loan or credit card all influence CIBIL scoring. The three-digit CIBIL TransUnion scores are calculated based on the information in the ‘accounts’ and ‘enquiry’ sections of the report. The CIBIL builds up records of individuals based on information reported to it by various lenders over a length of time. The credit scores are awarded to an individual in the range of 300 to 900 of scores. It is considered that the higher the scores in the report, the chances of default is less. Generally, most of the banks accept CIBIL TransUnion scores of 750 and above level good for lending (equated to 800 scores and above in the earlier version of scoring). However, the cut-off credit scoring for eligibility for a loan may vary from bank to bank depending upon the individual bank’s loan policy.

Scores in the range of 300 to 600 are always considered a risky proposal by the lender, as it indicates past credit history of the borrower is bad. Since the chances of default are higher, in most cases, the credit proposals received from such borrowers are rejected by financial institutions without further process.

The range of 600 to 750 scores may not be either good or bad, as that implies that the borrower had difficulties in repayment of previous borrowings. Normally, the lender will be more cautious in lending against credit scores of this range. However, depending upon the loan policy of the bank, the borrower may be asked to offer additional collateral security to offset the risk of default.

The important aspects to see in the CIR:

The high credit score itself does not indicate the payment behavior of the borrower. The CIBIL credit score is based on 24 months of credit history. Nevertheless, the credit information report shows the status of earlier loans and credit cards taken by the borrower. If the status shows “settled” or “written off” in the report of the proposed borrower/Director/Promoter, the lender would likely reject such a credit proposal because of the high risk involved in it. However, if “settled” or “written off” status is found in the third-party guarantor’s CIR,  the lender may permit the borrower to replace such guarantor with someone else who is enough credit-worthy.

Originally posted on April 20, 2016, and updated and reposted on July 20, 2024

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