The economics of Credit Score

Credit Score is a quantification of the credit-worthiness of companies and individuals. In India, CIBIL score is the often used metric for Credit Score. Various measures such as credit history, amount of credit and type of credit mix are used to arrive at a number ranging from 300 to 900, and a higher score reflects the ability of individuals to repay a loan successfully.

Advertisement

This measure was initially used as a tool to judge the credit-worthiness of commercial entities, and later on was extensively utilised for individual debtors as well. Amid increasing utilisation of loans for acquiring various goods for a better standard of living, many individuals struggle with their Credit Score after missing their credit card payments or loan instalments. To better understand the concept, it makes sense to unravel the fundamental economic principle behind Credit Score.

For economists, market is seen as a governance mechanism which takes care of the varied needs of people by making them meet the suppliers of these products. If anyone wants a loan, there would be someone available in the market to provide that loan. If markets are functioning properly, all those people who demand a loan will get a loan for a price.

The price of the loan is nothing but the interest rate charged on the loan. It is, however, possible that the market for loans does not work because of various reasons and many people who demand loans cannot avail of these. One of the main reasons for the ‘market failure’ in the market of loans is defaulters who are not able to repay their loans. It is very difficult for any bank to know beforehand whether an individual will repay the loan or not.

In the absence of perfect symmetric information about the ability and intention of the debtor, banks facing potential default will be forced to raise the rate of interest to cover their risk of losing financial resources to default on repayment of loans. The rise in rate of interest will drive out prospective debtors who might have had the intention to repay loans, as the high interest rate makes the loan too pricey for such individuals. As a result, the market will be full of those debtors who do not care about the rate of interest as their intention is not to repay the loan. Banks will shy away from offering loans in these circumstances. This process would lead to dismantling of the market for loans.

To deal with this possibility of ‘market failure’, Credit Scores are utilised to get a glimpse into the ability and intention of individuals to repay loans.

A good Credit Score ascertains that the individual has taken a loan before, and has repaid it in a timely and responsible manner. Such individuals are seen as credit-worthy, reliable customers and are offered a good deal in terms of lower rate of interest. Even a marginally lower rate of interest can lead to considerable savings in terms of interest paid over the years in the repayment of a loan. Conversely, individuals who have defaulted in repayment are either denied loans or are charged a higher rate of interest to cover for the risk associated with the loan.

Thus, Credit Scores can be seen as an innovative tool to ensure that the market for loans keeps functioning by resolving the information asymmetry faced by financial institutions. Credit Score can help in planning a sustainable financial future for both debtors and creditors alike.

For individuals, it makes sense to avail of loans only when they are able to repay it. One may avoid falling into the trap of too many loans as this might lead to a situation of default on repayment and, therefore, a low Credit Score might impinge your future ability to get a loan when actually needed. It takes time to build a healthy Credit Score, therefore it makes sense to take smaller loans and build credit history for a couple of years before planning to go in for a major loan.

For financial institutions, Credit Score is an important metric leading them to better serve the financial needs of people. It makes sense for institutions to create more awareness and transparency about Credit Score to ensure that financial inclusion takes place in the real sense.

Ace your CIBIL score

• CIBIL Score is provided by ‘Trans Union CIBIL Limited’, a credit information company in India. The range of CIBIL score is 300 to 900. A score above 750 is excellent, while that from 300 to 550 is considered poor.
• To improve Credit Score, repay outstanding amount in a timely and responsible manner.
• Avoid indulging in loans and credit card products to buy goods you cannot afford at current income levels.
• Limit new credit inquiries and keep track of the credit report.
• Monthly instalments may be kept at 30 per cent of income.
• Like CIBIL, the CRIF High Mark, Equifax and Experian

  are other credit bureaus providing Credit Scores.

— The writer teaches economics at NMIMS, Chandigarh