Can a good credit score help you reduce interest rate on your loan?

At some point in our lives, we need financial funding for various reason. And you must have heard that banks are always guiding you to maintain a good credit score. This one indicator plays a major role in what happens to your loan request. Your credit score helps you determine two things. Firstly, considering that lending money comes with a list of risks, your credit score helps lenders in understanding how reliable and unreliable a customer you are in regard to repayment of debt. Secondly the credit ratings also supports in determining the type of loan that is suitable for you. 

Aditya Kumar, Founder & CEO Qbera.com says, "If you’re a potential borrower, you’d have time and again come across a good number of articles that talk about the importance of having a good credit score. Well, for starters, your credit score forms the basis of your overall creditworthiness. While credit scores are certainly important for secured loans, they have larger weightage in influencing unsecured loan applications - as unsecured loans such as personal loans do not require any collateral, the credit score as an assessment parameter becomes all the more important for lending institutions to accurately classify creditworthy individuals and provide them with credit."

According to Kumar, the lending market today isn’t just confined to private and state-run banks – the market has expanded significantly, opening its boundaries to include new-age lenders such as Fintech and P2P lenders as well. As a matter of fact, these very players that have risen in popularity in present times have enabled a larger section of working-class professionals to get easy access to credit.

Kumar adds, "When we talk personal loans, the closest thing that we lay emphasis on is the interest rate. The first thing that concerns most borrowers intending to opt for personal finance is the interest rate on the credit instrument they’re borrowing. Different lenders offer credit at different interest rates."

"As such, when we talk interest rates, personal loans have become more popular than credit cards in recent times, with an increasing number of individuals availing personal loans to clear their outstanding credit card dues – this is primarily because the interest rate on personal loans hovers around the 12%- 15% p.a. mark, while the interest on credit cards stands at a massive 35%-40% p.a. on an average," says, Kumar. 

Coming back to exploring the relevance between good credit scores and interest rates, first of all, it is important to note that lending institutions have their own eligibility criterion as far as credit scores are concerned. Meaning, you will only be offered a personal loan if your credit score falls within a range specified by the lender; and yes, only then does interest-rate range on your loan application become important. Speaking of which, a good credit score will definitely help you get a reduced rate of interest on your personal loan.

Many lenders today adopt what is referred to as a risk-based model, wherein the risk factor in the case of different borrowers is individually determined. In accordance with the quantum of risk, interest rates and other charges (the processing fees for instance) are arrived at. This essentially means that different borrowers will be allowed to borrow at varied rates, with the individual borrower’s risk profile determining the cost of borrowing. Going by this, if we have two cases – one where a borrower has an impeccable credit record and another where a borrower’s credit record reflects a certain degree of blemishes, the borrower in case 1 will be given a much reduced interest rate on his/her loan application while the borrower in case 2 will be provided with a higher interest rate, allowing banks to cover their risk of lending. The risk is evaluated on the basis that the customer will make a delayed payment, or fail to repay on time.

Technically, even if you approach a lender that is currently offering the lowest or most affordable interest rate in the market, the rate you’re given will predominantly depend on your credit score and repayment history, after your risk profile is thoroughly evaluated. So if your credit score or repayment history isn’t worthy of the best possible interest rate, you simply won’t be given the lowest rate. The risk-based pricing model is used across the lending industry, and holds true for all types of loans, be it secured or unsecured.

The interest rate in accordance with the risk-based pricing model is determined not just by the value of lent money over a set period of time, but also by the lender’s calculation of the probability that the consumer will default on the loan. Default here mostly refers to defaults on monthly repayment models.

So, to sum it up, if you want to get the best possible interest rate on your loan, it almost entirely depends on your credit profile – how consistent you’ve been with your repayments, the number of credit sources you currently have, and the frequency of instances of late payments or defaults.