Evaluating creditworthiness: credit score vs credit risk assessment

Synopsis:?In today’s blog, we will explore the key differences between a credit score and a credit risk assessment for evaluating a borrower’s creditworthiness for the purposes of sanctioning a loan.

The decision between a loan extension and a loan denial largely depends on the borrower’s creditworthiness. While traditionally, lenders have relied on credit scores to determine whether it makes sense to sanction a loan, they are by no means an adequate test of a borrower’s repayment capacity.

Over time, the credit process has evolved, with lenders accounting for factors that extend beyond typical credit scores. So, how does the credit risk assessment framework differ from conventional credit scores? We highlight the differences below.

What is a Credit Score?

A credit score is a three-digit number assigned to an individual based on a rigorous analysis of their credit history. In other words, it is a numerical rating of an individual’s or a company’s creditworthiness.?

In India, only four companies: TransUnion CIBIL, Equifax, Experian, and CRIF Highmark are allowed to issue credit scores, with the?CIBIL score ?being the most popular credit score rating model out of them all.

Generally, credit scores vary in the range of 300-900, with higher numbers denoting better repayment ability. Borrowers with credit scores exceeding 750 are typically perceived as being more creditworthy. Download the?Protium App ?to check your?credit score for free .

How do Lenders Compute and Use Credit Scores?

While the specific calculations vary across Equifax, TransUnion CIBIL, Experian, and CRIF Highmark—which also explains the variation in credit scores—credit scoring agencies commonly consolidate the borrower’s repayment record and credit history to generate a credit score.

Additionally, they factor in the credit utilization ratio (CUR), which is indicative of the available credit limit; a higher CUR lowers credit scores.?

Curiously, even the number of inquiries made by lenders has an impact on credit scores, as they are considered “hard inquiries,” lowering the scores marginally with every new credit check.

Finally, based on the credit score they have arrived at, banks and NBFCs make their lending decisions.?

A good credit score, while desirable, does not automatically make a borrower a shoo-in for loan approval, but it raises the chances of a sanctioned loan exponentially.

What is Credit Risk Assessment?

Credit risk assessment entails a comprehensive review of a borrower’s ability to meet their debt obligations. In other words, it is concerned with the probability of a lender losing money on extending a loan to a certain borrower.?

How do Lenders Use Credit Risk Assessments for Evaluating Creditworthiness?

While there are several frameworks for conducting credit risk assessments, the?5Cs analysis ?is used most commonly. In this method, lenders evaluate the borrowers based on their character, capacity, collateral, capital, and conditions.?

Character: A potential borrower’s character is determined based on their credit history—CIBIL scores are a good indication. The reasoning is that an individual with a decent past repayment record will continue to be creditworthy into the future.

Capacity: It concerns the borrower’s ability to meet the principal and interest obligations through cash flows generated and involves the computation of debt service coverage ratios.

Collateral:?This factor comes into play when a borrower applies for a loan by pledging an asset. The availability and high quality of collateral lower the risk of lending.?

Capital: Lenders take stock of the overall financial position to analyze whether the individual/firm will be able to service its obligations during emergencies.

Conditions: Here, conditions refer to both the terms of the loan and the economic outlook, which can have a significant impact on a debtor’s repayment capacity.

Thus, a credit risk assessment arms lenders with an in-depth overview of a potential borrower’s credit profile. It also helps lenders determine the appropriate loan amount, interest rate, and corresponding repayment terms.

If a credit risk assessment judges an individual or a firm to be of higher risk, then the lenders may offer loans at higher interest rates, with some completely abstaining from sanctioning loans at all. Similarly, lower risk perceptions will result in credit sanctions at lower interest rates.

Credit Score vs Credit Risk Assessment: The Differences

So, what are the differences between credit scores and credit risk assessments?

1. Scope of Evaluation

A credit score is limited to an individual’s credit history and is generated by credit reporting agencies. On the other hand, a credit risk assessment is broader in scope, as it involves a comprehensive analysis of an individual’s overall financial capacity to arrive at a decision, including credit scores.

2. Factors Involved

An individual’s credit score depends on factors like payment history, credit utilization, length of credit history, types of credit used, and recent credit inquiries. Conversely, a credit risk assessment goes beyond credit history by accounting for liquidity position, debt-to-income ratios, employment history, loan terms, and even prevailing economic conditions.

3. Methodology

Credit scoring agencies stick to their standardized, proprietary algorithms for assigning numerical values to prospective borrowers. However, a credit risk assessment involves more subjective elements, such as evaluating a borrower’s character as well as analyzing the likely economic outlook.

4. Impact on Lending Decisions?

A credit score is a standalone factor that lenders may initially rely on to screen their loan applicants, with individuals with higher credit scores given a higher preference. But a credit risk assessment framework uses credit scores in conjunction with other factors to glean a more nuanced evaluation of a borrower’s creditworthiness and risk.?

5. Accessibility

Credit scores are readily accessible and can be obtained from credit reporting agencies. Indeed, credit scores can be easily looked up with?ProGenie on the Protium app . However, credit risk assessments are harder to come by, as they are typically undertaken by dedicated credit teams at lending companies.

Bottom Line

Financial lenders have moved beyond their sole reliance on credit scores for sanctioning loans. Instead, they are walking down the extensive credit risk assessment route, which in addition to credit history also provides for a borrower’s overall financial position, liquidity, and economic conditions.?

In fact, lenders like Protium have expanded the credit assessment framework further with their proprietary?algorithm-based risk assessment engine . By assessing revenues and future growth, Protium has been timely extending customized loans to individuals and MSMEs alike by conducting a comprehensive credit risk assessment.

In today’s world, where opportunities to grow your business are endless, having access to credit can be a game-changer. At Protium, we employ a high-degree, robust credit assessment framework and with the advent of our app, we aim to take it a notch higher. The Protium app allows you to take control of your credit score and maximize the scope of getting a business loan at favorable rates. What’s more? You can check your credit score for free! So, download the Protium app now –?https://link.mobile-app.protium.co.in/N7Pk ?