How Do Banks and NBFCs Evaluate Loan Applicants?
When someone applies for a loan, they might think that having a good credit score from a credit bureau is enough to get approved. While that's partly true, Banks and Non-Banking Financial Companies (NBFCs) create their own internal scores to evaluate risk, and credit scores from bureaus are just one part of that. These lenders use complex systems (like machine learning models) to predict how risky a borrower might be. Let's break down the main factors they consider in simpler terms.
Key Assessment Factors
1. Income Profile
- Income: How much does the borrower earn? This could be from a job or a business. If the bank doesn't know the exact income, it estimates it conservatively.
- Debt: How much money does the borrower already owe to other lenders? If they have many loans, it may hurt their chances.
- Expenses: What are their regular monthly expenses like rent or bills? This helps estimate their remaining residual income.
- Residual Income: After paying all bills and debts, how much money is left? More leftover income improves their chances.
2. Employment
- Job Stability: Where does the borrower work? Someone working at a large, stable company (like Infosys) is seen as less risky than someone at a small startup.
- Government Employees: People working for the government are often considered more stable than private-sector employees, which might improve their chances of approval.
3. Credit History
Existing Credit: Does the person have a credit history? If yes:
- Past Behavior: Have they missed payments or defaulted on any loans? Late or missed payments are a big red flag.
- Credit Use: Have they taken a lot of unsecured loans (like personal loans or credit cards)? Or secured loans (like home or car loans)? Too many unsecured loans can make them appear financially unstable.
- Credit History Length: The longer they've been managing credit responsibly, the better.
New-To-Credit: If they have no credit history at all, they're considered "New-To-Credit." Banks may be more cautious, but NBFCs are often more flexible, offering secured credit cards or other ways to build a credit history.
4. Loan Applications
- Multiple Loan Applications: If a person applies for loans or credit cards with many different lenders in a short period (say, more than 3 in the last 6 months), it might signal that they're facing financial trouble, making them a riskier borrower.
5. Loan Amount
- Loan Size: How much money is the person asking for? If someone with a low income is applying for a large loan, they'll be seen as a higher risk.
How Are Borrowers Categorized?
Lenders use a scoring system to categorize borrowers into risk bands. Based on where someone falls, they either get approved or denied. Here's a simplified version:
| Risk Band | Population | Bad Rate | Cumulative Bad Rate |
|---|---|---|---|
| 1 | 1000 | 6.0% | 33.5% |
| 2 | 1000 | 5.5% | 27.5% |
| 3 | 1000 | 5.0% | 22.0% |
| 4 | 1000 | 4.5% | 17.0% |
| 5 | 1000 | 3.5% | 12.5% |
| 6 | 1000 | 3.0% | 9.0% |
| 7 | 1000 | 2.5% | 6.0% |
| 8 | 1000 | 2.0% | 3.5% |
| 9 | 1000 | 1.0% | 1.5% |
| 10 | 1000 | 0.5% | 0.5% |
For example, if a lender has a rule that they can only take bad rate up to 4% then anyone in risk bands 8, 9, or 10 will be granted the loan. People in lower bands mostly will get declined, though sometimes lenders will reconsider applicants in the middle bands (6 or 7) if they provide more data or clarifications (like proof of income).
In short, while having a good credit score helps, a lot of other factors go into deciding whether or not you'll get a loan. Banks and NBFCs use a combination of your income, debts, job stability, credit history, and even the amount you're borrowing to figure out how risky you are. If you're looking to improve your chances, it's important to keep these factors in mind and manage your finances responsibly!
Understanding Risk Score Ranges
Excellent (750-850)
Demonstrates exceptional creditworthiness. Likely to receive the best rates and terms on loans and credit cards.
Good (700-749)
Above-average creditworthiness. Qualifies for favorable rates and terms.
Fair (650-699)
May face higher interest rates or stricter terms. Improvement opportunities exist.
Poor (300-649)
Limited credit options. May require secured credit products or credit-builder loans.
How to Improve Your Risk Score
- Pay Bills on Time: Set up automatic payments or reminders to avoid late payments
- Reduce Credit Utilization: Keep credit card balances low relative to credit limits
- Maintain Old Accounts: Keep older credit accounts open to lengthen credit history
- Limit New Applications: Apply for new credit only when necessary
- Monitor Your Credit: Regularly check your credit reports for errors
- Diversify Credit Mix: Maintain a healthy mix of credit types when possible
Conclusion
Understanding and managing your risk score is essential for maintaining good financial health. By focusing on the key factors that influence your score and following best practices for credit management, you can improve your score over time and access better financial opportunities.
Frequently Asked Questions
What is a risk score?
A risk score is a numerical representation of your creditworthiness, calculated using various factors from your credit report. It helps lenders assess the likelihood that you'll repay borrowed money.
What factors affect my risk score the most?
Payment history (35%) and credit utilization (30%) have the biggest impact on your risk score, followed by length of credit history (15%), credit mix (10%), and new credit (10%).
How can I improve my risk score?
You can improve your score by paying bills on time, keeping credit utilization low, maintaining older accounts, limiting new credit applications, and regularly monitoring your credit report for errors.