Credit Card Utilization Impacts Credit Ratings

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Tambov, Russian Federation - May 25, 2014: Dollars and credit cards with the logos of Visa and Mastercard. Visa and Mastercard are a two biggest credit card companies in the world.

Often the credit card companies try to lure the customers with extraordinary benefits/ reward points/ Cash back offers, all in favour to maximize the spending capacity of the customers. But what happens to our credit score when we exhaust our credit limit every month.

International Credit Rating agencies such as Standard & Poor, Transunion, Moody’s or Indian rating agency such as CIBIL work to quantitatively define the likelihood whether a borrower will be able to pay back its obligation or not. These quantitative assessments are in the form of a three digit numerical scale. Higher the score more is the likelihood of the borrower to pay back and vise-versa. Credit ratings are calculated at every level- individual or company.

Banks give credit cards/ loans only after the credit rating of a borrower is assessed. In India, the limit given on credit cards is generally twice/thrice the monthly earning capability of the borrower, after which the borrower is free to spend the money until its limit exhausts.

Did you know that as and when the customer spends more than 30% of its credit limit- the credit rating of the person declines. But WHY???

So, when a person spends more than 30% on his credit card, he becomes more riskier thus leading to a decline in the ratings. Also, if the borrower has more than 1 credit card/ loans he becomes even more riskier and likelihood of him paying back the credit/loan amount decreases (given his income remain the same) thus reducing his overall credit rating.

Then WHY do banks promote the customers to spend more??

The interest charged to the customers on credit card/loans is the reward that banks get for taking risk. Banks promote more spending to increase their interest income from the credit products.

Moreover, if we look at the overall %bad population in a bank (i.e. the number of customers that have defaulted), this population lies between 2% to 4% of the total number of bank customers. Thus, Since not every borrower defaults, the downside involved when the borrower defaults reduces. We can also reiterate due to the large customer base of the bank the interest income earned is more than the loss on default.

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