There are plenty of reasons to take out a loan, whether you want to buy a car or finance your studies. If you do decide to borrow money, the lender will do a credit check before granting you a loan. Continue reading to discover what happens during a credit check, as well as tips on improving your credit score.
Banks, of course, have a vested interest in ensuring that their clients will pay back loans on time and in full. Not least because the money they provide via loans doesn’t really belong to them – it comes from their client’s savings. There are also laws requiring banks to only loan money when it is probable that the borrower will be able to pay it back within the agreed upon term. This is because if a loan is granted to someone who is unable to pay it back, they might take out more loans to pay it off and, in a worst-case scenario, end up in a debt trap.
What happens during a credit check?
A credit check is, at its core, divided into two parts, the personal and economic check. It is important to supply the bank with all the information they need, such as your monthly salary, your outgoing costs and other financial obligations and your economic circumstances. This information is then used to assess how reliable you are; they are checking, for example, that you have paid all your debts up until this point. In addition, the bank wants to ensure that you are trustworthy, reliable and also realistic regarding your options.
To pass the economic check, you will need to have secure, stable assets. The bank will ask for a self-declaration and a list of your expenditures.
The bank will assess your income and outgoing costs
On the income side, the bank might include, in addition to your salary or pension, any child allowance, income from rental properties or support payments you receive. Your outgoing costs might include any rent you pay, ancillary costs such as phone, electricity and internet services, insurance policies, support payments you make or mobility costs such as petrol, taxes and insurance for your vehicle. The bank wants to see that, once your regular outgoing costs have been deducted, you still have enough money left to afford the costs of day-to-day life.
Credit score provides information on payment history
The bank might also take into account reports from credit agencies, such as the Schufa in Germany. These agencies save data on consumer payment histories. This is then used to calculate a credit score, that is the probability, as a percentage, that a person will meet their financial obligations. The credit score takes into account information on things such as your current account(s) or the number of credit cards you have.
Outstanding payments, termination of loans or long-term overdrafts on agreed upon drawing limits have a negative impact on your score. But there are more factors taken into consideration; if you have taken out a large number of loans, this will also have a negative impact on your score. Age, gender and where you live, on the other hand, make no difference to your credit score.
Payment history and collateral
If you apply for a loan at the bank which holds your accounts, they will also examine your previous account transactions. This gives them insight into your payment history. How long you have had an account at the bank also plays a role. Other factors that can influence your credit score include savings and other assets such as securities accounts, investment accounts or claims from insurance policies, such as life insurance. From the point of view of the bank, these factors could reduce your risk of defaulting, that is the risk that you will be unable to fully pay back the loan. The bank will therefore ask you to list them during the application process.
Tips for consumers
- How can I improve my credit score?
- Always make your loan payments on time.
- Never allow long-term overdrafts on your account that go beyond the agreed upon drawing limits.
- Only ever hold as many credit cards as you actually need. This is because every credit card has a limit that could be taken into account when determining the maximum amount of money you can borrow in the future. Whether or not you actually max out your cards could be immaterial.
- Avoid applying for loans unnecessarily.
Whether or not a bank will grant you a loan, and under what conditions, is always based on an interplay between a variety of factors. Every bank places a different weight on each individual piece of information, and may come to different conclusions regarding things such as interest rates. This means that it makes a lot of sense to shop around to find the best conditions.
