How Credit Scores will Affect Loan Interest Rates?

26-Nov-2015 written by : FSI-Team

Rahul: I am relived; finally my home loan from ABC Bank for a Rs. 25 lakh got sanctioned.
Akash: I also got a loan sanctioned from them a week back for the same amount.
Rahul: Oh really! for how many years?
Akash: For 15 years, at 9.75%.
Rahul: Mine is also the same duration but how come I am being charged a higher interest?

Do you feel that the above conversation is just for the sake of an example and this actually does not happen? Two people cannot be given a loan at different rates if the duration and amount is same? Think again; there can be a difference in loan rates for various reasons. One of the reasons that can help you negotiate a lower loan rate is your credit score.

How Are Interest Rates Determined?

Loan interest rates are determined by the macroeconomic parameters and also the individual bank policies. The interest rates on loans are dependent on the repo rate fixed by the Central Bank (which is RBI in India) and the base rate of the bank. While the repo rate is decided by the RBI based on the economic condition of the country; each bank fixes its base rate depending on its own rules and policies. Banks charge interest to stay in business, earn profit and also for letting the customers use the funds which are not theirs.

While as a customer you can do nothing to change the repo rate or the base rate; you could negotiate with the bank to lend you at a lower rate. Preferential rate might be given by banks to a certain category of customers (like women to encourage them in being independent), customers who have a substantial relationship size with the bank or who pose a lower risk profile as per the bank.

How Are Interest Rates Affected By Credit Score?

A good credit score reflects good credit behavior, sound financial health and a low risk profile. When a bank lends to a person with a high credit score they are reasonably sure that the borrower will return the funds timely without default. Banks also charge interest for the risk that they undertake when they

lend money to a borrower. Generally a credit score above 750 is considered to be good score at which most banks will be willing to lend. For lower scores, the customer is dependent on the whims and fancy of the bank. There might be some banks that may offer a loan for low credit score but then the interest rates for such loans are high. So in a nutshell a high CIBIL Score indicates a low risk profile which can prompt the bank to lower the interest rate for the prospective client and the converse is also true. If the CIBIL score is low then the bank may either outright reject the application or ask the applicant to borrow at a higher rate. Thus the credit score affects the loan interest rates in the following three ways:

  • Limiting or Expanding the Choice:The first use of a CIBIL Score is it helps a bank in deciding whether to accept to reject a loan application. If the score is low then the application is outright rejected. Thus a good credit score gives the applicant a choice to approach the financial institution which offers the lowest rate as he/she is sure that the application will not be rejected. With a bad score the applicant does not have this choice.

  • Negotiating Power:The credit score reflects the risk profile of the applicant. With a good CIBIL score an applicant can negotiate a lower interest rate with the bank that he is applying to. The bank may itself offer the loan at a lower rate (lower that the advertised rate) to the applicant. In case this does not happen the applicant can negotiate a lower rate for himself.

If you plan to borrow in the near future then you should focus on how to boost your credit score so that you can borrow at comparatively lower rates. Even a difference of half a percent can have a substantial impact on overall interest outflow over the entire loan period.



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