Why your credit history matters

It is entirely likely that the average reader may not be fully aware of how credit history is determined or why it matters. Simply put, a credit history is the profile of an individual that tracks their entire record of credit-based financial transactions. It keeps records of mortgage payments, credit card transactions, personal loans and occasionally even post-paid phone or internet services.

How it works

The credit history report records how much is outstanding, how old the account is, what percentage of the total credit limit is being utilised and whether payments for the preceding five years have been on time. All of this information is combined to create a credit score which, along with information about a person’s income, determines their creditworthiness or the probability that they will pay back their loans.

This creditworthiness is often quantified, especially in the case of CreditChex, the only private credit reporting agency in Pakistan – a joint venture between the JS Group and Experian.

Every person is given a score that represents their relative creditworthiness at a given moment in time compared with all of the other people in the credit bureau’s database. So your score is a reflection not just of how good your own creditworthiness is, but also how well other people pay off their debts.

Why it matters

The importance of a credit history is likely to increase for the average urban professional over the next few decades. It is entirely likely, for example, that young professionals will seek to buy a house using mortgage financing or lease a car for their household. All of these transactions rely on having a good credit history.

While many banks in Pakistan still do not rely on a credit bureau for assessing a client’s creditworthiness, the use of such tools is becoming more prevalent and is only likely to increase with time. So having a good score is likely to become more and more important over the coming decades.

The better the credit score, the more likely that a loan application will be accepted. Even among accepted applications, a higher credit score is likely to result in a lower interest rate being applied to the loan.

How you can improve your score

The single most important thing that a person can do to improve one’s score is to pay all amounts due on time. This may go against the grain of Pakistani financial culture but it simply means that the person who pays on time is only likely to stand out more positively. The relative timeliness of payments accounts for about 35 per cent of your score.

The second most important factor is the degree to which a person utilises the credit available to them. For example, if your credit card limit is Rs100,000 and you currently utilise Rs5,000, the utilisation rate is five per cent. Utilisation rates should not exceed 25 per cent and good scores require rates of less than seven per cent. This component constitutes another 30 per cent of your score.

Other factors that count include the length of credit history, which makes up 15 percent of the score – one should not close old accounts since a longer record is better than a shorter one.

The other 20 per cent of the score is divided equally between the diversity of credit lines (different kinds of lines are better than only one kind of credit) and the number of times one has sought credit (fewer times are better than more frequent inquiries for credit).

The writer is a financial and management consultant based out of Karachi

Published in The Express Tribune, September 20^th, 2010.