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Why credit scores alone may not be the best way to assess loan borrowers

While the credit score helps gauge the risk based on credit history, credit mix, payment history, and new debt if any, it offers no help in appraising the repayment capability of first-time loan applicants

May 19, 2021 / 10:19 AM IST

There is so much said and written about credit score and its significance to both borrowers and lenders that one cannot help wondering if seeking a loan would ever be possible without this three-digit number. The credit score is determined by India’s top credit bureaus, viz., TransUnion Credit Information Bureau (India) Limited or CIBIL, Equifax, Experian and CRIF High Mark.

These credit information companies evaluate your credit score after assessing all the financial transactions regarding previous borrowings or repayment of loans sought.

Estimating creditworthiness

The credit score reflects your creditworthiness. The latter does not gauge your ability to repay debt but measures a lender’s readiness to trust your repaying ability. Lenders prefer potential borrowers with high credit scores indicating that they are highly dependable.

A low credit score suggests risky lending and increased chances of default. There is a potential risk in approving loans, especially in cases where there are no collaterals. While the credit score helps gauge the risk based on credit history, credit mix, payment history, and new debt if any, it offers no help in appraising the repayment capability of first-time loan applicants.

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It would be unwise to label the current system of calculating credit scores and classifying them to judge creditworthiness as flawed. However, in the absence of such scores, should not banks or other financial institutions resort to alternative measuring techniques for estimating borrowers’ potential for repaying loans taken?

One way could be to assess the financial data of the potential borrower, be it an individual or a company. The second method could be to check their financial standing, which can be done by going through their income tax returns of the past three to five years. Another way could be to ask about their liquid assets or seek information regarding insurance plans they have bought in the past.

Also read:  How CIBIL and Experian score first-time loan applicants

Going through customers’ financial data 

Banks and financial institutions do not approve loans unless they are sure about their customers’ financial status. Therefore, they seek information about the source of earnings, details of employment to check for income regularity, family size, nature of the property, and the number of dependents to gauge monthly expenditure.

While questions regarding financial status may seem innocuous and unwarranted, responses to these questions go a long way in realizing customers’ potential for repaying their loans. Banks seeking Income Tax details of their customers of the past three to five years is normal practice, especially, if the person concerned does not have a proper credit score or cannot offer any collateral to secure the loan amount.

For a business institution, it makes sense to ask for its financial statements over the past three years, including their profit/loss accounts, cash flow and fund flow statements. These enable a deeper understanding of the financial standing of the business, the frequency of fund flows, growth potential and the company’s debt-to-income ratio.

While there is no stringent definition of a good debt-to-income ratio, as the same differs from business to business, banks prefer to lend to organizations with ratios of less than 36.

Whether the business is purely regional or has the potential to go global is another aspect that lenders may investigate. Some businesses run on credit; the books of accounts highlight how much materials and services have been availed on credit and must be repaid within a particular duration.

Also read: CRIF report on the rise in personal loan borrowings: How to avoid a debt trap

For individuals, banks check financial accounts highlighting regular expenses made on essentials and luxury items using debit cards or cash withdrawals to gauge lifestyle quality. Lenders are averse to lending to customers living beyond their means.

Knowledge about assets, the extent of their liquidity, and details of insurance, if any, are facts that lenders would always like to know. While a balance sheet consisting of fixed assets indicates greater stability, a good margin of cash in hand or with a bank indicates the ability to make loan repayments on time.

Banks have a leaning towards customers with term insurance or companies with business insurance. The insurance amount ensures that the loans would be repaid in the event of sudden loss of life or unforeseen down-scaling of the business.

Checking the credit scores of borrowers (individuals or companies) is the common norm for lenders during loan application analysis. However, going back to the basics can help ascertain if potential borrowers can and are willing to repay the loan.
Atul Monga is Co-founder & CEO, Basic Home Loan
first published: May 19, 2021 10:19 am

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