Most of us don’t like the idea of taking debt unless needed. However, the vicious circle of credit wants us to first borrow money in order to build a positive credit history that would, in return, help us take a loan at considerable rate of interest in case of financial emergencies. Whether one has to lend money loan due to an emergency, to fulfil certain life goal or just to build credit, people tend to pay the loan amount early when they have extra cash in order to stay away from deb. But is it recommended? And how will it affect your credit score? Let’s find out! But, before we understand the effect of early loan repayment, let’s understand how loans affect our credit score.
Impact of Loans on Your Credit Score
Surprisingly, taking a loan is a step ahead towards creating a positive credit score, given that you pay the debt amount on time. Here’s how it affect your credit score.
If you already have a credit bill, then opening a new loan account will add diversity to your existing credit, which will enhance of your credit score
Duration of Credit History
Another thing that installment loans help you is to manage your credit over a long period of time. If you have a long history of great credit, then it will not only increase your credit score, thus making loan process easier for you.
Raise Credit Score with Timely Payments
Since, on time payments play the biggest role when it comes to increasing credit score, timely loan payments will not only improve your credit score but will make you an attractive borrower for future.
So, Should One Go For Early Loan Repayment?
Well, experts suggest that having an open loan/debt account is beneficial for your credit score rather than a closed one, which is what your installment loan becomes once it is paid off. So, if you have multiple debts, then you might consider closing one earlier. But in case of single loan, then you might consider it paying as per the schedule. Also, one must remember that paying off loans early will not have any positive impact of your credit score. However, depending upon your credit history, closing your loan account is not recommended in the following cases:
Limited Credit History
According to Experian, one of the major credit bureaus in India, open and active credit account enhances your score. So, in case you have limited or only open loan account, then it is not advisable to close it early. Yes, it will help you save money in interest but will not help in your credit score.
Establish Credit History
In case you have an established credit history, then with too much debt, the lender may see you as a risk. It is important to maintain the debt-to-income ratio. This is basically the percentage of your gross monthly income applied towards debt. This means that the gross income should be able to afford the debt taken.
Instead of paying off the loan, you can pay down the balance. One of the major factors affecting the credit score is the percentage of the available credit compared to the limit. Therefore, if you have taken a new loan or having an outstanding credit card bill, then paying off your personal loan can help lower the ratio.
Hence concludes that if you are paying off the loan early just to enhance your credit score, then don’t go ahead. Instead, you can invest that money in various schemes like mutual funds or fixed deposits or just save it for financial emergencies. Whether you pay the loan amount early or as scheduled, one thing that every borrower should keep in mind is to always pay the due bill on time.
When it comes to lending money, even the banks needs to be assured about the person to whom they are giving loan. Approximately 5 years back, customer background verification for credit worthiness was a difficult task. However, Credit Information Companies (or Credit Bureaus) have made this task easier. Credit Information Companies are financial institutions who collect and maintain credit and loan related information of individuals and commercial entities. Based on this information, they generate a credit report and score of every individual that helps the bank in approving or rejecting the individual’s loan application.
As per the latest guidelines, it is mandatory for every bank and financial institution to be a member of atleast one Credit Information Company in India. These companies collect and maintain the credit/loan information of every individual who has a PAN card from the member credit institutions. This information is updated regularly every month or on short intervals.
How Does Credit Bureaus Work In India?
As mentioned above, Credit Bureaus of Credit Information Companies collect, maintain and provide credit information (related to credit cards and loans) of an individual from banks and other member institutions and share the same with them that defines the credit worthiness of an individual. This helps the bank authorities to make a decision of whether to lend money and if yes, then at what terms and conditions. Here, one must note that CIC does not act as a watchdog. It caters the information related to salary, savings account, fixed deposits and other information are not shared by the members.
For example, if you wish to take a personal loan from a bank, your bank will contact the credit bureau for your credit report and score. This report contains all the payment history, including past defaults (if any). Based on the credit score and report, your bank will make a decision on whether the loan should be granted to you or not. More credit score means higher chance of getting a loan at a considerate interest rate.
In India, there are four credit bureaus namely TransUnion CIBIL, Equifax, Experian and Highmark.
India’s first credit bureau/credit information company, TransUnion CIBIL plays an important role by helping banks and other financial institutions to manage their business. It is organized into 3 divisions, namely consumer bureau, commercial bureau and MFI bureau.
Year Of Establishment – August 2000
Scoring System – 300-900 (900 is the best credit score)
Charges – Free credit report once a year. Beyond that, it charges Rs. 550
Time taken to generate report – 7 days
Equifax India is a joint venture between Equifax USA, State Bank of India, Kotak Mahindra Bank, Bank of Baroda, Religare Finvest Ltd., Sundaram Financial Services and Union Bank of India. It offers a range of credit services including information, business analysts and risk management.
Year Of Establishment – 2010
Scoring System – 1-999 (1 being the lowest)
Charges – Free credit report once a year. Beyond that, it charges Rs. 400 (+taxes)
Time taken to generate report – 10 days
Experian Credit Information Company of India or simply Experian is a joint venture of GUS Holdings, Axis Bank, Union Bank of India, Indian Bank, Federal Bank, Punjab National Bank, Sundaram Finance Ltd, Magna Fincorp Ltd and VIC Enterprises Private Ltd to provide credit information services to banks and individuals in India. It has also tied up with online financial marketplaces like Paisabazaar to offer free credit report and score to its customers.
Year Of Establishment – 2006 (got license in 2010)
Scoring System – 300-900 (900 is the best credit score)
Charges – Free credit report once a year. Beyond that, it’s Rs. 399 (including taxes)
Time taken to generate report – 20 days
CRIF Highmark is the only credit bureau in India that caters the need of segments like MSME, commercial borrowers, retailer, micro-finance borrowers. It provides analytics, data management and related credit services in order to sustain the financial needs of business and customers.
Year Of Establishment – 2007 (got license in 2010)
Scoring System – Not Available
Charges – Rs. 399
Time taken to generate report – 5 minutes
Credit scores have acquired a position of vital importance. They are used to ascertain whether an individual is eligible for a loan or not. At face value, it is just a number that denotes a person’s credit worthiness. But few people know how their credit scores are calculated.
Earlier, banks used to take borrowers on their word and this proved to be a less than adequate. Quite often, good applicants would get rejected while others would get their loans approved despite several red flags. Lying on loan applications has cheated banks of crores of rupees. It also led to the proliferation of unscrupulous agents that could work their way around the system to get almost anyone approved, provided they were compensated well. Thankfully, the widespread adoption of CIBIL scores as a tool to determine credit eligibility has ended the deteriorating conditions.
The Credit Information Bureau Limited is India’s first credit rating agency. Originally, they collected credit information of companies and rated them accordingly. This helped in restoring faith and brought transparency to the financial systems. Now, a similar rating is also provided for individuals in the form of a credit score. The credit score is measured out of 900 points and gives a clear indication to the lender about the applicant’s financial abilities and behaviour.
CIBIL has its own methodology for calculating credit scores. They use sophisticated algorithms which are specifically designed for credit rating calculations. Some of the criteria they use to calculate an individual’s credit score are briefly explained here.
The credit history of an individual shows their complete financial history with credit and debt data. This data helps in categorising the individual as reliable or risky. An individual’s ability to repay loans on time contributes greatly to their credit rating. This shows that the individual in question is capable of repaying their loans. A higher score means that the person is more likely to get approved when they apply for any credit product.
Balancing the Loan
Another criterion that greatly affects an individual’s credit score is the total amount that has been borrowed and the share of the total that has been spent. If the individual spends the amount carefully, then this shows them to be responsible borrowers and spenders. On the other hand, if an individual were to fritter away the loan amount within a short period of time, they would be considered risky. Such behaviour does not bode well for loan applicants.
The duration or tenure for which a loan was active and the payments made during that time is a major contributor to a person’s credit score. A good history of timely payments without any late or skipped EMIs shows that the individual is a responsible borrower who takes their repayments seriously. This is also an indication that the person is a wise spender who does not make spending decisions in haste.
Application for New Credit
If the applicant has applied for a loan then the creditor will run a credit check. Each such check shows up in the credit history. If there are too many queries then it will negatively impact the credit score. This is generally an indication of a desperate need for funds, usually without the means to repay it. Banks are wary of such applicants and often deny them.
A Mixed Bag
If an individual keeps opting for the same type of loan or credit product over and over again, it will have a negative impact on their credit score. Therefore, it is important to have a mix of secured and unsecured loans in order to balance out one’s credit portfolio and obtain a higher credit score. This shows that the borrower’s finances are diverse and they have other financial options at their disposal.
Your CIBIL Credit Report is like your financial report card. It highlights your financial behaviour and whether you are a good investment for the lender. A good credit score speaks volumes about a person’s ability to handle and manage various types of debt including loans, credit cards, etc. Such individuals are in a position to bargain for better interest rates and other favourable terms and conditions for their loans. It is important for people who are applying for loans to ensure that their credit score is good. You can do so by requesting your won credit report. A score of 750 or above is considered to be good by banks. If they are in the red, then steps must be taken to improve it. People with low scores should avoid applying for new loans and instead work to pay off any outstanding debt first. If you find any errors in your credit history, they must be corrected. Rectifying errors as quickly as possible will improve your credit score significantly.
Your Credit Information Bureau Limited (CIBIL) TransUnion score is a crucial factor in determining your creditworthiness for any credit instruments like loans or credit cards you may apply for. Your CIBIL score is affected by how you handle your debts and your credit history as shown in your credit report. Your credit report contains details such as past credit availed, payment regularities, etc. A high score, usually 800 and above, means high creditworthiness, whereas a score that is closer to 300 is considered low and labels you as a risky borrower.
A good CIBIL score is your ticket to quick and hassle-free loan and credit card applications and is used as a yardstick by financial institutions to decide whether to extend a new loan or credit card to you and what interest rate to charge on your loan.
The following tips can help you get your credit score under control:
1) Check your credit report periodically
A healthy CIBIL score is rooted in a clean credit report. Request a copy of your credit report and check all entries thoroughly. If you spot any mistakes and/or erroneous entries, have them resolved with the reporting agency/credit bureau at the earliest.
Sometimes, financial institutions/banks might not update credit bureaus regarding repayments in a regular manner. In such cases, your credit report may reflect even settled dues and closed loans as unpaid. Such out of date information could also be the outcome of clerical errors or fraudulent transactions (resulting from identity theft) in your name.
2) Pay your credit card bills and loan EMIs on time
Regularly paying off your outstanding credit card bills within the stipulated time frame has a positive impact on your credit score. Payment regularity contributes 30%–35% to your total credit score. Having no late on your credit card outstanding balances and not missing loan EMI payments contribute significantly to a healthy credit score.
3) Outstanding debts be gone
To improve your credit score, pay off old debts and outstanding loans. Begin with paying off unsecured loans that carry higher interest rates such as personal loans, credit card outstanding balances, etc. Then focus on other debts. Making timely payments to get rid of your outstanding dues helps boost your credit score.
On the contrary, if you square off all your credit card dues suddenly at one go, it could indicate instability of your financial standing, thus negatively impacting your credit score. While regular repayments boost your credit health, sudden one-time squaring of debts has the exact opposite effect.
4) Spend small, pay in full
Avoid making purchases on your credit card that you doubt you can repay by the end of your billing cycle. Keep a strict control on your credit card spends and always try to pay off the entire outstanding in full each month. Try bringing down the balance of each credit card to 30% or less below your sanctioned credit limit. Settle dues for the card with outstanding balance closest to the maximum credit limit first. This will protect you from falling prey to the “minimum amount” debt trap that entails high interest charges and make the repayment drag on for months or years.
5) Limit your credit utilisation
Your credit utilisation is the amount of credit you use vs. the total credit sanctioned to you. At any point in time, your credit utilisation should ideally remain within the 30-40% range, never exceeding 40%. This will help you maintain a good CIBIL TransUnion credit score.
6) Ensure a healthy credit mix
Business and home loans are secured loans, good for asset creation. Repaying these loans on time improves your credit score. Credit card and personal loans fall in the unsecured category and too many of these will be a reflection of poor credit behaviour and adversely affect your credit history. You must therefore act accordingly to find the correct mix of credit instruments.
7) Put a cap on the number of credit cards you own
Owning a credit card may help you qualify for loans, however, having too many credit cards and making major spends increases the credit utilisation ratio and has an adverse effect on your credit score. Applying for a new credit card when your credit score is already on the lower side is not a good idea.
A low credit score can be prevented by avoiding excessive usage of credit cards and by not keeping more cards than you need. Limiting expenses between 30-40% of your total credit limit prevents your debts from spiraling out of control.
8) Consider a secured credit card
If you have an unsatisfactory CIBIL score but want a credit card nevertheless, consider a secured credit card. Several banks like Citibank, ICICI, SBI, RBL Bank etc. offer secured credit cards that are backed by fixed deposits made with the bank. Secured credit cards help you establish good credit history.
9) Keep a track of your joint, co-signed, and guaranteed accounts
Regularly monitor the statements of your co-signed loans because any negligence on the part of the primary applicant makes you equally liable and can adversely affect your credit score.
10) Limit loan inquiries
Each time you enquire for a loan, your lender makes a credit enquiry and these enquiries are recorded in your credit report. Multiple inquiries in a short span puts a red flag against your name and negatively impacts your credit score, making it tough for banks to decide whether to extend the loan to you or not. If you already have a low credit score, avoid making too many new loan enquiries.
Once you successfully restore your score, make sure not to stack up excess credit nor fall back on timely payments. To build a strong CIBIL score, excellent financial discipline is essential, which in turn is the key to sound and long term financial health.