(Case Study) Akshay and Abhijeet have both applied for home loans at the same bank, where they are both account holders. Their loan amount too is the same, and their paperwork is in order. Akshay has a credit score of 870, while Abhijeet has a credit score of 700. Now here’s the deal – while both Akshay and Abhijeet were offered the loan they had applied for, the terms and conditions of their individual loan offer letters were starkly different!
What went ‘wrong’, then? Well, nothing wrong as much as the credit score making a difference to the loan applications. Akshay got a loan for a higher amount at a lower rate of interest, while Abhijeet’s loan was for a lower amount and the interest rate offered was significantly higher. This resulted in Akshay’s saving on his overall home purchase while the cost went up for Abhijeet.
Simply put, this is broadly the concept of risk-based pricing. Read on to know more, and what you can do to get yourself the most competitive loan when you require one.
Risk-based pricing is a methodology that a large number of lenders adopt universally in the financial services sector to determine the interest rate at which they are willing to lend to a particular individual. This pricing is determined primarily by how the lenders perceive a borrower will repay an amount loaned to them, basis their credit score. When you apply for a line of credit, the lender in question views your credit score, and basis the same deems you to be creditworthy or otherwise. It is this information that they factor in to determine the rate of interest that the fresh credit will be given at.
Simply put, a borrower with a better credit history will get a better (or lower) rate of interest, as the lender believes that it is less risky to lend to this person.
As mentioned above lenders who use the risk-based pricing model refer to a person’s credit score, which is nothing but a three-digit representation of their credit history that is mentioned in depth in their credit information report. Ranging between 300 and 900, a higher score is obviously considered to be good from a lender’s perspective. While it is not always that a low score will mean no loan, and there are lenders who for instance will provide personal loan for low CIBIL score, you will wind up paying more by way of interest cost.
While banks and financial institutions today rely largely on the credit score before making a lending decision, unlike most developed nations, they have not formally adopted the risk-based pricing model in India. So yes, the credit score plays a pivotal role in what rate of interest you will pay for your loan, but it is not considered in isolation. Other factors such as the borrower’s income, the ability to pay off a loan as a result, other outgoing and expenditure is also carefully scrutinised before arriving at a lending decision.
Therefore in Akshay and Abhijeet’s case too, these factors would have been taken into account by the lender who would have taken a decision on their loan applications at the time of credit underwriting. Of course, this does not undermine the critical nature of the credit score, because a good score lends itself to better rates and loans at the most competitive terms.
Yes, there are loans for bad credit out there, but the downside to these is that not only do you wind up paying more by way of interest, but it is also likely that you would need to spend more out of pocket owing to a lower loan amount being sanctioned. Both these factors add up to a higher cost of purchase altogether, something that could have been avoided with a better credit score and consequently being viewed more positively by a lender.
It is therefore a good practice to check your credit score prior to availing of a loan, maybe even as much as six months ahead of when you plan to apply for the loan. This will give you enough time to work on improving your credit score if required, and eventually allow you better access to the loan you had applied for.