Creditworthiness and Credit Rating

In everyday life the term creditworthiness is now omnipresent. When opening a checking account, taking out a loan, signing a mobile phone contract or even renting an apartment, a credit check plays an important role. But what exactly does the term mean and what connection exists between creditworthiness and entering into a contract? This guide presents all important information about credit assessment and its effects in more detail.

Fundamentally, creditworthiness (ability to pay / credit standing) describes a debtor's ability to repay their debts. "Debtor" is deliberately kept general, because depending on the situation this can come from very different areas.

Private individuals: There are many types of contracts where the provider extends credit to the customer or must rely on their ongoing ability to pay and creditworthiness.

Companies: Whether companies take out loans or issue bonds — in both cases the company's creditworthiness plays an important role.

States: States issue bonds and thus indirectly take up loans. Rating agencies also assess the creditworthiness of states.

Personal and economic creditworthiness — the two components of credit standing

Creditworthiness essentially consists of two different sub-aspects. On the one hand there is personal creditworthiness and on the other hand economic creditworthiness. But what distinguishes these two types?

Personal creditworthiness — willingness to pay

Personal creditworthiness deals with a debtor's willingness and reliability to make payments. It is therefore about whether the borrower always does everything to pay their liabilities. A person’s or company’s payment behaviour plays an important role. The following questions are particularly important:

• Does the debtor pay their bills on time?
• Have liabilities been fully repaid in the past?
• Were there payment difficulties and significant delays?

Economic creditworthiness — ability to repay

This aspect describes the debtor's economic capacity. Thus the question is whether a borrower or an issuer is financially able to fully meet their financial obligations. The following issues play a special role:

• What does the debtor's asset situation look like?
• What is the debtor's income situation?
• What is the debtor's expenditure situation?
• How will the above situations change in the future?

Creditworthiness of private individuals — cooperation between credit bureaus and businesses

When it comes to the credit rating of private individuals, companies work with so-called credit bureaus. The process runs in two stages.

1. Companies report contract conclusions and payment difficulties to credit bureaus.
2. Credit bureaus provide relevant data to the respective company before a credit decision or other contract conclusion.

The credit rating of private individuals is based on two different aspects: so-called positive and negative attributes, and scoring of the probability of default.

Creditworthiness of companies and states — published ratings from rating agencies

The creditworthiness of companies and states is assessed by so-called rating agencies. Here, two different rating processes must be distinguished.

Mandated ratings: In this case a debtor, investor or creditor commissions a rating agency to assess the creditworthiness of a specific company. In addition to publicly available information, internal company data that the client provides can often be included. Examples of such internal data are information about the customer structure and financial plans.

Secondary ratings: These ratings take place without a direct mandate and only evaluate information that is publicly available. For this reason, secondary ratings are by no means as informative as mandated ratings.

Which factors are ultimately included and how they are weighted is not disclosed by a rating agency. This is their central business secret. The best-known rating agencies each use their own evaluation schemes. The largest and best-known rating agencies are Moody’s, Standard & Poor’s (S&P) and Fitch. They are also called the "Big Three" of rating agencies.

They all use a similar classification of creditworthiness levels. This results in over 20 different gradations of credit scores, from AAA down to C or D. Without going into all the fine nuances of the gradations, the following general assessments can be derived.

1. Highest creditworthiness; risk of default is negligible even long-term
2. Very secure debtor; almost no investment risk; somewhat harder to assess in the long term
3. Secure investment; low risk from unexpected events in the general economy or the sector
4. Average investment opportunity; economic deterioration could trigger payment problems
5. Speculative investment; if economic conditions worsen, defaults could occur
6. Highly speculative investment; defaults likely if economic conditions worsen
7. Only in very favourable developments are defaults unlikely
8. High probability of default or insolvency proceedings, but not yet in arrears
9. In arrears

Each rating level mentioned can, depending on the rating agency, have further sublevels. Investors use this classification to make investment decisions and banks to decide on loans. This credit assessment can be applied to both companies and government bonds.

When is a credit check carried out?

A credit check for private individuals is always important when it concerns whether a debtor can repay liabilities. It is not only about lending money, but also about the granting of services that are paid afterwards. The following examples show typical situations in which companies or other creditors carry out a credit assessment of debtors.

Loan approval by banks

Before a credit institution grants a consumer a loan, it needs information about the probability of default on the repayment. After all, it is essential for banks not to be left with uncollectible claims.

Opening a checking account

If you want to open a normal checking account, you generally do not have to provide asset and income information. However, a credit report on your previous payment behaviour is usually obtained. This is especially important for granting authorized overdraft and an overdraft facility. If you want to avoid this, you can open a pure deposit account (prepaid account), which can also be used as a garnishment protection account.

Signing a mobile phone or telephone contract

Since it is common in the telecommunications industry to bill services afterwards, providers need information about consumers' creditworthiness beforehand. For this reason, a SCHUFA report is usually obtained to determine previous payment behaviour.

Credit report by the landlord

Because a rental agreement in Germany entails strong legal obligations for landlords, they have a legitimate interest in information about potential tenants' creditworthiness. If rent payments fail, landlords face significant legal effort to collect outstanding claims and to evict the defaulting tenant. Landlords often do not obtain a credit report themselves but expect the tenant to provide one.

Instalment payments in mail-order companies

If you want to use instalment payments at a mail-order house or a large online retailer, you are effectively taking out a loan. As with other loans, the customer's creditworthiness is queried to determine the probability of default.

How does a credit check work?

When a consumer's creditworthiness is to be determined, the process of the credit check depends heavily on the type of contract. Since particularly thorough credit assessments are carried out before a credit decision, a more detailed description of the process follows:

Determining economic creditworthiness

As already described, the determination of economic creditworthiness assesses whether a borrower is economically able to pay the credit instalments properly. The borrower's cooperation is important here, because they must provide the following information.

1. Information about income

To regularly service loan instalments, a borrower must be able to show appropriate income. For this reason, the following questions must be answered:

How high is the regular income?

These questions already show in detail what the income information is about. The income should at least exceed the statutory garnishment exemption limits, since only income above these levels can be seized by banks as security in case of payment difficulties. Moreover, it must cover all expenses and still leave financial room for loan repayment.

Note: To prove the amount of their income, borrowers usually have to present current pay slips to a credit institution. Self-employed people are typically required to provide income tax assessment notices from recent years as proof of income.

How secure is the regular income?

Income security is closely linked to job security. For this reason, people with fixed-term employment or employees in a probationary period often do not obtain credit. Self-employed persons also sometimes find it difficult to obtain a loan. This is because neither employment nor the income of the self-employed is secure. Income fluctuates and a small business can disappear from the market at any time.

Note: To create a picture of general profitability despite fluctuating income, self-employed people often have to submit a business management report (BWA) as part of a creditworthiness assessment. This shows future economic prospects and outlines likely scenarios.

How is the income generated?

Lenders also want a clear statement about the borrower's employment situation. First the employment status is important:

• Employee
• Self-employed
• Civil servant
• Student
• Pensioner

In addition, the bank wants to know the employer for employees. Regular income can also come from other sources, such as rental income or income from capital assets.

2. Information about regular expenses

Another part of the economic credit assessment is information about regular expenses. These are costs that recur regularly and are thus relatively predictable:

• Rent
• Electricity/heating/ancillary housing costs
• Telecommunication costs (telephone, internet, smartphone)
• Insurance costs
• Living expenses (food, hygiene)
• Costs for clubs and associations
• Car costs (vehicle tax, insurance, fuel)
• Alimony payments

3. Information about assets

Assets can have a very positive effect on a borrower's creditworthiness and can especially serve as collateral for a loan. These include, among others:

• Real estate and land
• Savings balances
• Securities and fund shares
• Precious metals

4. Information about debts

The level of debt also influences a borrower's economic creditworthiness. Loans to be serviced bring additional regular interest costs. In addition, a borrower must be able to repay their debts within a foreseeable period. If the debt level rises too high, over-indebtedness threatens, which is likely to result in default.

5. The household budget calculation determines the possible loan instalment

Depending on the loan type, determining economic creditworthiness is more or less extensive. Especially for real estate financing, a household budget calculation is usually performed to determine the maximum possible loan instalment. Such a calculation could look like this:

Income

Net income 1st person in household: 2,200 euros per month

Net income 2nd person in household: 1,900 euros per month

Income from interest: 25 euros per month

Total income: 4,125 euros per month

Expenses

Rent (including heating): 690 euros per month

Electricity costs: 79 euros per month

Telecommunication costs (telephone and internet plus 2 mobile contracts): 100 euros per month

Living expenses: 750 euros per month

Insurance costs: 160 euros per month

Car costs: 250 euros per month

Costs for clubs, subscriptions and associations: 80 euros per month

Leisure budget: 150 euros per month

Contributions to capital investments: 150 euros per month

Safety reserve (replacements, repairs, travel costs): 300 euros per month

Total expenses: 2,709 euros per month

Possible loan instalment: 1,416 euros per month

The economic creditworthiness of the two borrowers would be very good in this case and a loan instalment of around 1,400 euros per month could be managed. This would also be a good basis for real estate financing.

Determining personal creditworthiness

A borrower's personal creditworthiness is nowadays mainly determined by obtaining a SCHUFA report or a credit report from other credit bureaus. This reflects the person's payment behaviour in recent years. Negative attributes typically result in a negative credit decision by the bank when taking out a loan. In addition, the bank's personal experience with a customer can influence creditworthiness. For example, if the bank customer regularly has chargebacks due to insufficient funds on their checking account, this can also negatively affect the bank's credit decision.

Scoring — the summary of all creditworthiness attributes

To make credit classifications practical, all credit attributes are summarized today in a scoring system. This way a specific score can be assigned to each debtor that expresses the probability of default and thus the ability to repay. A scoring system is not fixed and can be designed by each bank itself. There is leeway in weighting individual factors, so a person's credit rating can differ between credit institutions. As an example, a SCHUFA scoring system is shown to illustrate how such a system generally looks.

SCHUFA scoring system

Rating levels N, O and P include open negative attributes such as data from debtor registers. As can be seen, the scoring system defines a probability of default for the respective claim with the default rate. While rating level A corresponds to only 0.80% of defaults, level P corresponds to 96.08% of defaults. These average values ultimately help a bank with a lending decision.

Digression: Garnishment exemption limits in lending

As described, taking out a loan is only successful if the borrower's creditworthiness allows repayment. The amount of income plays an important role. This must be at least above the garnishment exemption limits so that the bank can actually seize parts of the income in case of payment difficulties. Depending on the size of the financing, banks often require an income significantly above these limits to ensure sufficient financial leeway. The garnishment exemption limits in Germany are as follows:

A mother with two children and no spouse therefore only needs to fear garnishment from a net income of more than 1,709.99 euros per month. And even then the garnishable amount increases only slowly. Thus taking out a loan may still be difficult with a net income of, for example, 1,800 euros per month.

How does a credit rating affect you?

A person's creditworthiness describes for a company the probability of default after concluding the contract. A prognosis about the likely course of the business relationship is therefore attempted. As a result of this credit assessment the following possibilities arise:

A contract is not concluded at all.

If a person's creditworthiness is rated negatively, a company may refuse to conclude a contract with the potential customer. This is especially the case with a negative SCHUFA or other credit bureau report. Negative payment behaviour in the past is regarded as serious by many companies, so they do not want to enter into a contract.

Terms depending on creditworthiness

Scoring values are particularly important for lending or instalment purchases, because not only the contract conclusion depends on the customer's creditworthiness. Economic creditworthiness also influences the terms of contracts. This is especially easy to observe with loan offers, as a typical description of terms shows. For an effective annual interest rate, for example, a range is often given instead of a concrete percentage.

Example: Effective annual interest rate - From 1.99% p.a. (1.99–10.99% p.a.)

The indicated interest range is the interest rate depending on the borrower's creditworthiness. It states that borrowers with top creditworthiness receive a loan at 1.99%, while those with poorer creditworthiness must pay up to 10.99% per year. To give loan customers a guideline where the bank places the average creditworthiness, the legislator prescribes in §6a Abs. 4 Preisangabenverordnung (PangV) that each bank must publish a representative example. The interest rate used there should be chosen so that it would be average for two-thirds of all potential customers. For the offer above the representative example could therefore look like this:

• Effective annual interest rate (for 2/3 of customers): 4.99% p.a.
• Loan amount: 10,000 euros
• Term: 84 months
• Total cost: 11,824.94 euros
• Monthly instalment: 140.77 euros

Contract types and the effects of creditworthiness

Depending on the contract type, a debtor's creditworthiness affects the respective contract differently. The following briefly explains the effects.

Loan agreements

If you want to take out a loan from a bank, you are doubly dependent on your creditworthiness. If there are negative attributes in the SCHUFA report, the contract may not be concluded at all. In addition, creditworthiness also affects the interest rate. The better the scoring, the lower the interest costs for the loan.

Checking account

For a checking account the credit check is limited to the SCHUFA report. If there are no negative attributes, the applicant can open the account. Otherwise, only a deposit account is possible.

Rental agreements

Landlords increasingly require a credit report before renting an apartment. This happens, among other reasons, to protect against so-called "rental nomads" and to avoid later legal disputes. The terms of the rental contract are not influenced by the tenant's creditworthiness. Also, the landlord usually does not obtain the report themselves but requests a corresponding self-disclosure from tenants.

Telephone and mobile contracts

For mobile and telephone contracts, the credit check is also limited to a SCHUFA report or a query at another credit bureau. Negative attributes mean a conventional telecommunications contract cannot be concluded. In such cases applicants must switch to prepaid tariffs where credit is paid in advance and then used by the user.

Instalment purchases in mail-order houses

Since a mail-order house effectively grants a loan for instalment payments, similar rules apply. A SCHUFA report with negative attributes can make instalment payment impossible. In addition, at least large mail-order companies now use scoring and often tie the interest conditions of instalment payments to the customer's creditworthiness.

Effect of creditworthiness on corporate and government bonds

Companies and especially states obtain borrowed capital by issuing bonds. Creditworthiness plays a very important role here too, although the connection is somewhat different:

1. A company sets up a bond with certain interest conditions and issues it on the capital market.
2. Investors check the company's creditworthiness and relate it to the interest conditions.
3. If the bond is attractive to investors it will be bought and its price rises. This in turn leads to falling yields.
4. If the bond is unattractive because interest is too low relative to default risk (creditworthiness), demand falls and thus the price. Falling prices lead to rising yields.

Thus a poor credit rating tends to be associated with higher borrowing costs for the company. In practice this may mean that the bond cannot be fully placed because no one is interested at the given terms. In such cases the company would have to improve the offer and increase interest or forgo part of the intended borrowed capital. States face similar situations, so their creditworthiness also significantly determines terms.

Credit bureaus and scoring agencies: Who provides information?

The terms creditworthiness and scoring have gained importance in recent years. For this reason there are now many credit bureaus dealing with consumer payment ability. Some well-known market participants are described below:

Schutzgemeinschaft für Allgemeine Kreditsicherung (SCHUFA)

SCHUFA is by far the best-known credit bureau for creditworthiness. It was founded in 1927 in Berlin and today has its headquarters in Wiesbaden. With data on over 67 million private individuals and 5.3 million companies, today's SCHUFA Holding AG can rely on a very broad data base and provide important information to over 9,000 contractual partners about potential customers and business partners.

• Data records: 813 million
• Natural persons with data at SCHUFA: 67.2 million
• Companies with data at SCHUFA: 5.3 million
• Contract partners: 9,000

Deltavista GmbH (now CRIF GmbH)

Deltavista GmbH was known in Germany mainly for its large database in the area of credit reports. In addition, its recognisable traffic-light system (green = all ok, yellow = soft negative attributes, red = hard negative attributes) is helpful to many creditors. The bureau has since been taken over by the global CRIF group from Italy, which now supplies 44,000 corporate customers in numerous countries with relevant data.

Bürgel Wirtschaftsinformationen GmbH & Co. KG

Bürgel was founded in 1885 in Berlin and is among the largest business credit agencies in Germany. The Italian CRIF group has taken over the bureau, enabling Bürgel to expand its international presence. Each year the company conveys around 6 million reports to its contract partners.

Arvato Infoscore

Arvato Financial Services belongs to Bertelsmann SE & Co. KGaA and can point to over 10,000 customers in Europe. With over 68 million credit checks per year, Arvato is clearly among the three largest credit bureaus in Europe. In addition to hard negative attributes, Infoscore — like Bürgel — also uses soft negative attributes in its credit reports when these arise from its own debt collection processes.

Boniversum (Creditreform)

Creditreform can look back on a long tradition, having been founded in 1879 in Mainz. Today the company has more than 155,000 members worldwide. From single reports to address validation and scoring, Creditreform Boniversum GmbH offers a wide range of services. It also provides classical debt collection services for companies.

What data do credit bureaus collect about consumers?

Credit bureau data should allow potential customers to form a picture of their customers' creditworthiness. Nevertheless, the data basis usually cannot provide a complete statement about a consumer's financial circumstances or willingness to pay. This is because banks and companies are by no means allowed to report everything to credit bureaus. Data protection therefore also plays a very important role. A credit report usually consists of positive and negative attributes and can be supplemented by scoring if necessary.

What are positive attributes?

Positive attributes in a credit report almost always consist of successful contract conclusions. If a consumer signs a mobile phone contract or opens a checking account, this is normally associated with the following steps:

• The company has successfully carried out a credit check.
• The consumer's economic circumstances appear sufficient to conclude such a contract.

Such entries help build trust in the person's ability to pay. They thus have a positive effect on a consumer's scoring.

What are negative attributes?

Negative attributes refer to all parts of the credit report that negatively affect the person's creditworthiness. This usually concerns the following aspects:

• Non-contractual payment behaviour
• Extraordinary contract terminations
• Entries in public debtor registers
• Personal insolvency proceedings

  

From these attributes companies can quickly see that there have been payment difficulties in the past or that the consumer is financially unable to meet obligations. Such negative attributes are usually deal-breakers when taking out a loan or signing a mobile phone contract.

Note: A company may not report an outstanding claim to a credit bureau without further ado. §28a of the Federal Data Protection Act (BDSG) specifies that certain criteria must be met for a report_

• Existence of an enforceable title
• Express acknowledgement of the claim by the debtor
• Two written reminders after the claim is due
• Four-week period between the first and second reminder
• Notification about the impending report to SCHUFA (in good time, but at the earliest with the first reminder)
• Immediate termination of the contract due to payment arrears

How do soft and hard negative attributes differ?

Some credit bureaus distinguish between hard and soft negative attributes in credit reports. Sometimes a three-way division into hard, medium and soft negative attributes is found. What does this mean? The following lists the individual attributes:

Hard negative attributes:

• Data from the debtor registers of local courts (affidavits of assets and arrest warrants to force an affidavit, entries pursuant to § 882c Abs. 1 Nr. 1-3 ZPO)
• Failure to provide an asset declaration
• Opening and dismissal of a personal insolvency proceeding
• Announcement, granting or refusal of discharge of residual debt

Soft and medium negative attributes:

• Due and adjudicated claims that were not properly paid (debt collection monitoring procedure) (medium)
• Debt collection procedures (soft)

The difference between hard and soft negative attributes mainly lies in the progress of the dunning procedure. A debt collection procedure typically involves the following aspects:

• A consumer did not pay an invoice on time and often ignored one or more reminders from the company.
• The claim was handed over to a debt collection agency, which now handles correspondence with the person concerned.

Such soft negative attributes are usually not or rarely mentioned in a SCHUFA report. Other credit bureaus include such soft reports when they originate from their own debt collection activities. An enforced debt collection procedure is normally based on an adjudicated claim. In that case the debt collection procedure was unsuccessful and an enforceable title was obtained from the court. Such claims are usually recorded as negative attributes by almost all credit bureaus.

Hard negative attributes arise when, despite an adjudicated claim, no agreement can be reached and affected debtors are required to provide an asset declaration. The final consequence can be a consumer insolvency procedure if assets are insufficient to pay an outstanding adjudicated claim via enforcement. Depending on the course of the insolvency proceedings, discharge of residual debt may be granted or refused.

How long are negative attributes stored?

Attributes in a credit report are not stored forever but are deleted after a certain period. The SCHUFA deletion periods for various types of entries are shown as examples below:

Is it possible to have negative entries deleted early?

Consumers do indeed have the option to have some entries removed from their credit report early. This is possible with SCHUFA for two types of entries, for example:

1. Data from the debtor registers of local courts

If a court bailiff has had entries made in public debtor registers due to an adjudicated claim, these can be deleted early if SCHUFA is provided with proof of deletion by the competent court. Normally such deletions are initiated when the claim has been settled.

2. Early deletion of claims from the SCHUFA report

SCHUFA also offers the possibility of early deletion in this case. However, certain conditions must be met:

• The claim must have been reported to SCHUFA for the first time before 01.07.2012.
• The claim must amount to a maximum of 2,000 euros.
• The claim must have been paid within 6 weeks and the creditor must have informed SCHUFA of the settlement.
• The claim must not be adjudicated (no enforcement order).

Tip: If completed incidents regarding outstanding claims are only a few months from deletion, credit bureaus may sometimes be accommodating. If a loan is imminent, the consumer could request deletion from the credit bureau. In individual cases this approach can be successful.

Who is allowed to request credit information?

For a company to request credit data about a person, it must declare a legitimate interest according to §29 Abs. 2 BDSG. A direct proof is not required. Credit bureaus only have to document how the legitimate interest was presented and check its correctness by random sampling. The law is intended to ensure that only companies that are actually about to enter into a business relationship obtain data about a consumer's creditworthiness.

Self-disclosure about your own creditworthiness — what matters

Even though credit bureaus try to keep consumers' data up to date, errors do occur. Unfortunately, false negative entries can have significant consequences for those affected, for example when mobile contracts can no longer be concluded or taking out a loan becomes almost impossible. For this reason it is important to regularly check your own data. Under §34 BDSG every consumer is entitled to request a data overview that contains the data and information stored about them. The conditions are also legally regulated:

• Once a year the data report must be provided free of charge in text form (§34 Abs. 8 BDSG)
• Further requests may be subject to fees, which may only cover the costs of producing the report.

If those affected find incorrect entries when checking their data, they can request deletion of these entries from the credit bureau. Normally the respective credit bureau will first examine a deletion request and only delete the entry if the examination supports it.

Our conclusion on the topic of creditworthiness

The concept of creditworthiness plays a very important role today. Whenever contracts with advance services or loan elements are concluded, the contracting party's creditworthiness is checked. This affects not only private individuals but also companies and states.

Consumers with poor creditworthiness and negative entries about their payment behaviour are likely to find it very difficult to conclude the contracts mentioned above. This in turn has a major impact on everyday financial life, because many transactions become extremely complicated without a checking account. Fortunately, deposit accounts provide suitable alternatives. Even taking out a loan is possible, with affected persons often turning to a loan without SCHUFA. Here the SCHUFA query is waived and later no report is made to the credit bureau.