Does your credit score impact all loans? Ideally, the answer should be YES, it SHOULD. However, in reality, it does not. Let us explore this concept and see why it is beneficial to the banks as well as the borrowers.
What Are the Pre-requisites of a Good Credit Score?
The credit behaviour of the borrower should exhibit the following attributes:
- Maintain an impeccable loan repayment record by paying all loan instalments and Credit Card payments on time and in full.
- Manage your credit portfolio well by maintaining an acceptable credit utilisation ratio
- Have the right balance between your secured and unsecured loans
- Refrain from applying for loans frequently
- Exhibit a sufficiently long credit history
A borrower who diligently adheres to the above requirements can have a high credit score in the range of 750 and above. It makes them eligible to get various benefits such as:
- Concession in rate of interest
- Waiver or concession in charging of processing fees and so on.
What Are the Benefits to the Bank?
Banks need good borrowers that repay their loans on time. The following benefits accrue to the banks when they increase their share of borrowers with a good credit score:
- The bank can improve its share of performing assets. As it is, the banks today have a load of non-performing assets (NPAs) in their advances portfolio.
- Hence, the bank earns a higher income by way of interest
- The bank has to make less provision because of the good quality of the asset. It affects the profitability of the bank positively.
- The banks can improve the risk-weighted assets portfolio (a critical concept today because of the introduction of the MCLR or the marginal cost of funds based lending rate based lending)
- Improve their Capital Adequacy Ratio
The Changing Scenario
The banks accept that the intention of the borrower to repay the loan also plays a big part in the improvement of the credit score of the individual. Hence, banks have started incentivising such borrowers by offering them concessions in the rate of interest and other charges. Some banks like Bank of Baroda and IDBI Bank Limited have begun the process of giving preferential pricing on loans to borrowers with a good credit score.
The concept of offering such benefits is prevalent in the USA and other developed countries. It is now finding its feet in developing economies like India. At present, the banks give this benefit to Home Loan borrowers alone. There is scope for including other loans except for the education loans in this concept.
The Research Behind the Concept – Some Examples Where Banks Have Provided the Benefit of Risk-based Pricing of Loans
Certain banks have analysed their delinquency data. Statistics show that the delinquency rate was 0.07% of the accounts having a credit score above 760. The figure increases to 0.35% in case of accounts with a credit score below 760.
Bank of Baroda has started offering the risk-based pricing from April 2016. It was after the introduction of the MCLR concept. The move has yielded good results for the banks as they have succeeded in attracting more customers with good credit scores into their fold.
- Statistics reveal that 19% of their customers had a score of less than 725 before April 2016. Now, the figure has come down to 1%.
- Similarly, their sourcing for customers with a score above 760 was 31% before April 2016. Now, this figure has improved to 56%.
As a result, some banks are offering risk-based pricing in all retail loans.
IDBI bank is also actively offering the risk-based pricing to its home loan customers. They are also looking to expand this concept to include the Personal Loans.
What to Expect in the Future
These two banks have started the process of providing risk-based pricing. It is a matter of time before other banks will follow suit. Customers should understand that it benefits them more than the banks. A quick example can explain what a reduction of 0.5% in a Home Loan can do over the entire tenure of the loan.
- The EMI (Equated Monthly Instalment) on a Home loan of 30 Lakhs @ 9.25% for 30 years is 24,680. Over the entire tenure, you pay total interest of 58.85 Lakhs.
- In case you get the benefit of 0.5% for the whole tenure, your EMI will reduce to 23,601 and the total interest outlay for 30 years reduces to 54.96 Lakhs.
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