Creditworthiness and Credit Rating

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

Fundamentally, creditworthiness describes a debtor's ability to repay their debts. "Debtor" is intentionally kept general, because depending on the situation this can come from very different areas.

Private individuals: There are many types of contracts in which the provider grants the customer credit 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 on debt. Rating agencies also assess the creditworthiness of states.

Personal and economic creditworthiness - the two components of creditworthiness

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 concerns a debtor's willingness and reliability to pay. It is about whether the borrower consistently does everything to pay their obligations. 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 paid off in full in the past?
• Were there payment difficulties and long delays?

Economic creditworthiness - ability to repay

This sub-aspect describes the debtor's economic capacity. The question here is whether a borrower or an issuer is financially able to fully meet their economic obligations. The following questions are particularly relevant:

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

Creditworthiness of private individuals - cooperation between credit bureaus and businesses

When it comes to assessing the creditworthiness of private individuals, companies work with so-called credit bureaus. The process takes place in two stages.

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

The creditworthiness classification of private persons is based on two different aspects: on the one hand so-called positive and negative features and on the other hand scoring for the probability of default of claims.

Creditworthiness of companies and states - published ratings by rating agencies

The creditworthiness of companies and states, on the other hand, is evaluated by rating agencies. Two different rating processes are distinguished here.

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, company-internal information provided by the client can often be included. Examples of such internal information are details 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 far not as informative as mandated ratings.

Which factors are included and how they are weighted is not disclosed by a rating agency. This is the central trade secret. The most well-known rating agencies — Moody’s, Standard & Poor’s (S&P) and Fitch — each use their own assessment schemes for companies and states. They are often called the "Big Three" rating agencies.

They all use a similar classification of creditworthiness levels. There are typically more than 20 different gradations of credit scores, from AAA down to C or D. Without going into all the fine nuances, the following ratings roughly correspond to the classifications:

1. Highest creditworthiness; default risk is negligible even in the long term
2. Very secure debtor; almost no investment risk; a bit harder to assess in the long term
3. Safe investment; low risk from unexpected events in the overall economy or the sector
4. Average investment opportunity; deteriorations in the overall economy could trigger payment problems
5. Speculative investment; if economic conditions worsen, defaults could occur
6. Highly speculative investment; payment defaults are likely in case of economic deterioration
7. No defaults expected only under very favourable developments
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 sub-levels. Investors and banks make decisions based on these ratings. This credit assessment can be applied to both companies and government bonds.

When is a creditworthiness check performed?

A creditworthiness check for private individuals is always important when it comes to whether a debtor can repay obligations. It is not only relevant for lending, but also for the provision of services that are paid afterwards. The following examples show typical situations in which companies or other creditors carry out a creditworthiness assessment.

Loan issuance by banks

Before a bank grants a loan to a private person, it needs information about the probability of default. After all, it is essential for banks not to be left with unpaid claims.

Opening a current account

When opening a normal current account, you generally do not have to provide asset and income information. However, a credit report on your past payment behaviour is obtained. This is especially important for allowing an authorised overdraft and granting a discretionary overdraft facility. Those who want to avoid this can open a pure prepaid account, which can also be used as a protected account (Pfändungsschutzkonto).

Concluding a mobile phone or telephone contract

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

Creditworthiness report by the landlord

Because a tenancy agreement creates strong legal obligations for landlords under German law, they have a legitimate interest in information about the creditworthiness of potential tenants. If rent payments fail, it involves significant legal effort for landlords to collect outstanding claims and to evict the defaulting tenant. Landlords, however, often do not obtain a credit report themselves but expect tenants to provide one.

Instalment payments at mail-order companies

If you want to use an instalment payment option at a mail-order company or a large online retailer, you are essentially receiving credit. As with other loans, the customer's creditworthiness is queried to ultimately determine the probability of default.

How does a creditworthiness check work?

When a consumer's creditworthiness is to be determined, the course of the creditworthiness check depends largely on the type of contract. Because detailed creditworthiness assessments are particularly carried out before a lending decision, a more detailed description of the procedure follows:

Determining economic creditworthiness

As already described, determining economic creditworthiness assesses whether a borrower is economically able to properly pay the loan installments. The borrower must, of course, assist in this area by providing the following information.

1. Information about income

To regularly service loan payments, a borrower must have corresponding income. For this reason, the following questions need to be answered:

How high is the regular income?

These questions already show in detail what the information about income is about. The income should at least exceed the statutory garnishment exemption limits, as banks can only accept it as security. Furthermore, it must cover all expenses and still leave financial leeway for loan repayment.

Note: To prove their income, borrowers usually have to present recent payslips to a lending institution. Self-employed persons, on the other hand, are generally required to provide income tax assessments from recent years as proof of income.

How secure is the regular income?

The security of income is closely linked to the security of the respective job. For this reason, people with fixed-term employment contracts or employees in a probationary period often do not receive a loan. Self-employed people also sometimes find it difficult to obtain a loan. This is due to the fact that neither the job nor the income of the self-employed is secure. Earnings fluctuate and a small business can disappear from the market at any time.

Note: To get an impression of the general profit situation despite fluctuating income, self-employed people are often required to provide a profit and loss statement (BWA) as part of a creditworthiness check. This shows the future economic perspective and thus probable scenarios for the future.

How is the income earned?

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

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

In addition, banks want to know the borrower’s 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 creditworthiness check consists of information about regular expenses. These include recurring and therefore relatively predictable costs:

• Rent
• Electricity/heating/ancillary housing costs
• Telecommunication costs (telephone, internet, smartphone)
• Insurance costs
• Living expenses (food, personal care)
• Costs for clubs and associations
• Car costs (vehicle tax, insurance, fuel)
• Maintenance payments to be paid

3. Information about assets

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

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

4. Information about debts

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

5. The household budget calculation determines the possible loan instalment

Depending on the type of loan, the assessment of economic creditworthiness can be more or less extensive. Especially when financing real estate, a household budget calculation is often carried out to determine the maximum possible loan instalment. Such a calculation might look like this:

Income

Income 1st person in household (net): 2.200 Euro per month

Income 2nd person in household (net): 1.900 Euro per month

Income from interest: 25 Euro per month

Total income: 4.125 Euro per month

Expenses

Rent (including heating): 690 Euro per month

Electricity costs: 79 Euro per month

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

Living expenses: 750 Euro per month

Insurance costs: 160 Euro per month

Car costs: 250 Euro per month

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

Leisure budget: 150 Euro per month

Contributions to capital investments: 150 Euro per month

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

Total expenses: 2.709 Euro per month

Possible loan instalment: 1.416 Euro per month

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

Determining personal creditworthiness

A borrower's personal creditworthiness is mainly determined today by obtaining a SCHUFA report or a credit report from other credit bureaus. This reflects the person's payment behaviour over recent years. Negative entries usually lead to a negative lending decision by the bank. In addition, a bank's personal experience with a customer can also influence creditworthiness. For example, if a bank customer regularly has payment reversals due to insufficient funds on their current account, this can also negatively affect the bank's lending decision.

Scoring - the summary of all creditworthiness features

To make creditworthiness classification of borrowers practical, all creditworthiness features are summarised in a scoring system. In this way, each debtor can be assigned a specific score that expresses the respective probability of default and thus the ability to repay. A scoring system is not fixed and can be designed by the respective bank. There are also leeways in weighting individual factors, so the creditworthiness rating of a person does not have to be the same at every lending institution. The following example shows a SCHUFA scoring system to illustrate how such a system can look in principle.

Scoring system of the SCHUFA

For rating levels N, O and P, open negative features such as data from debtors' registers are present. As can be seen, the scoring system establishes a probability of default for the respective claim with the risk quota. While rating level A implies only a 0,80% default rate of all claims, it is 96,08% for level P. These average values ultimately help a bank make a lending decision.

Excursus: garnishment exemption limits in lending

As already described, taking out a loan is only successful if the borrower's creditworthiness allows repayment. Income level plays an important role. It must be at least above the garnishment exemption limits so that the bank can actually seize parts of the income in the event of payment difficulties. Depending on the size of the financing, banks often even require an income that is well above the limits to provide sufficient financial leeway. The garnishment exemption limits in this country are as follows:

A mother with 2 children and no spouse therefore only has to fear garnishment from an income of more than 1.709,99 Euro net per month. Even then, the garnishable amount increases only slowly. Thus, taking out a loan with an income of, for example, 1,800 Euro per month would likely still be difficult.

How does a creditworthiness rating affect you?

A person's creditworthiness describes for a company the probability of default after the contract is concluded. The aim is to make a forecast about the likely course of the business relationship. As a result of this credit assessment, the following options are possible:

A contract conclusion does not take place.

If a person's creditworthiness is assessed negatively, a company may refuse to conclude a contract with the potential customer. This is especially the case with a negative credit report from SCHUFA or other credit bureaus. Past negative payment behaviour is considered serious by many companies, so they may not want to enter into a contract.

Conditions 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 the contract. This is particularly visible in loan offers where an interest rate is often given as a range rather than a specific percentage.

Example: Effective annual interest rate - From 1,99% p.a. (1,99-10,99% p.a.)

The stated interest range is the interest rate depending on a borrower's creditworthiness. It indicates that debtors with top creditworthiness receive a loan at 1,99% while those with poorer creditworthiness may pay up to 10,99% per year. To give loan customers a reference point for where the respective bank places average creditworthiness, the legislator prescribes in §6a Abs. 4 Preisangabenverordnung (PangV) that every bank must publish a representative example. The interest rate used there should be chosen so that it applies on average to two-thirds of potential customers. For the above offer the representative example could look like this:

• Effective annual interest rate (for 2/3 of all customers): 4,99% p.a.
• Loan amount: 10.000 Euro
• Term: 84 months
• Total costs: 11.824,94 Euro
• Monthly instalment: 140,77 Euro

Contract types and the effects of creditworthiness

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

Loan agreements

Anyone who wants to borrow money from a bank is doubly dependent on their creditworthiness. If there are negative entries in the SCHUFA report, a contract may not be concluded at all. In addition, creditworthiness influences the interest rate. The better the scoring, the lower the interest costs for the loan.

Current account

For a current account, the credit check is limited to the SCHUFA report. If there are no negative entries, the applicant can open the account. Otherwise, only opening a prepaid account is possible.

Tenancy agreements

Landlords increasingly require a credit report before renting an apartment. This is partly to protect against "rental nomads" and to avoid later legal disputes. The terms of the tenancy agreement are not affected by the tenant's creditworthiness. The landlord usually requests a self-disclosure from tenants rather than obtaining the report himself.

Telephone and mobile phone contracts

For mobile and telephone contracts, the credit check is generally limited to a SCHUFA report or an inquiry with another credit bureau. Negative entries can mean that a conventional telecommunications contract cannot be concluded. In such cases, applicants must switch to prepaid tariffs, where credit is paid in advance and then consumed.

Instalment purchases in mail-order houses

Since a mail-order company effectively grants credit when offering instalment payments, similar rules apply. A SCHUFA report with negative entries can prevent instalment payments. In addition, at least large mail-order companies today use scoring and often link the interest conditions of instalment payments to the customer's creditworthiness.

Effect of creditworthiness on bonds of companies and states

Companies and especially states raise debt capital by issuing bonds. Creditworthiness plays an important role here as well, although the relationship works somewhat differently:

1. A company issues a bond with certain interest conditions 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 is bought and its price rises. This leads to decreasing yields.
4. If the bond is unattractive because the interest is too low compared to the default risk (creditworthiness), demand falls and the price drops. Falling prices lead to rising yields.

Thus, poor creditworthiness tends to be associated with higher interest costs for the company. In practice, this may mean that the entire bond cannot be placed because nobody is interested at the given terms. In such cases, the company would have to increase the interest or forgo part of the targeted debt capital. States face similar situations, so their creditworthiness also significantly influences conditions.

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 quite a few credit bureaus dealing with consumers' ability to pay. Some well-known market players 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 now 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 basis and provide important information on potential customers and business partners to over 9,000 contract 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 primarily for its large credit database. In addition, the distinctive traffic-light system (green = all ok, yellow = soft negative features, red = hard negative features) is a great help for many creditors. The bureau has since been acquired by the globally active CRIF group from Italy, which now supplies 44,000 corporate customers in numerous countries with corresponding data.

Bürgel Wirtschaftsinformationen GmbH & Co. KG

Bürgel was founded in 1885 in Berlin and is among the largest business information bureaus in Germany. The Italian CRIF group has now taken over the bureau, enabling Bürgel to expand its international presence. The company transmits about 6 million credit reports to its contract partners annually.

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 creditworthiness queries per year, Arvato is one of the three largest credit bureaus in Europe. In addition to hard negative features, Infoscore—like Bürgel—also uses soft negative features in its credit reports when these originate from its own debt collection proceedings.

Boniversum (Creditreform)

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

What data do credit bureaus collect about consumers?

Credit bureau data should give potential customers the opportunity to form an opinion about the creditworthiness of their clients. Nevertheless, the data basis can usually not make a complete statement about a consumer's financial circumstances and willingness to pay. This is due to the fact that banks and companies are not allowed to report everything to the credit bureaus. Data protection also plays a very important role. A credit report usually consists of positive and negative features and can be supplemented by scoring if required.

What are positive features?

Positive features in a credit report almost always consist of successful contract conclusions. If a consumer signs a mobile phone contract or opens a current account, this is usually 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 features?

Negative features denote all parts of the credit report that negatively affect the person's creditworthiness. This typically involves the following aspects:

• Non-contractual behaviour in payments
• Extraordinary terminations of contracts
• Entries in public debtors' registers
• Personal insolvency proceedings

  

Based on these features, companies can quickly see that there were payment difficulties in the past or that the consumer may not be financially able to meet their obligations. Such negative features are usually deal-breakers when applying for 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) states that certain criteria must be met for a report to be made_

• Existence of a court-ordered title
• Explicit acknowledgement of the claim by the debtor
• Two written reminders after the claim has become due
• A period of 4 weeks between the first and second reminder
• Notification of the impending report to SCHUFA (in good time, but at the earliest with the first reminder)
• Termination of the contract without notice due to payment arrears

How do soft and hard negative features differ?

Some credit bureaus distinguish between hard and soft negative features in credit reports. In some cases, a three-tier differentiation of hard, medium and soft negative features can be found. What does this mean? The following table shows the individual features:

Hard negative features:

• Data from the debtors' registers of local courts (affidavits and arrest warrants to enforce an affidavit, entries under § 882c Abs. 1 Nr. 1-3 ZPO)
• Refusal to submit an asset declaration
• Opening and rejection of a personal insolvency proceeding
• Announcement, granting or refusal of debt relief

Soft and medium negative features:

• Due and judicially recognised claims that were not duly paid (debt collection monitoring procedures) (medium)
• Debt collection procedures (soft)

The difference between hard and soft negative features mainly lies in the stage of the dunning procedure. A debt collection procedure usually involves the following aspects:

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

Such soft negative features are usually not or rarely mentioned in a SCHUFA report. Other credit bureaus include such soft notifications if they originate from their own collection activities. An inkassoüberwachungsverfahren (debt collection monitoring procedure), on the other hand, normally has a judicially enforceable title as its basis. In this case, the debt collection procedure was fruitless and an enforceable title was obtained from the court. Such claims are usually recorded as negative features by almost all credit bureaus.

Hard negative features arise when, despite a judicially recognised claim, no agreement can be reached and the debtor is asked to provide an asset declaration. The final consequence can be a consumer insolvency proceeding if the assets are insufficient to pay an outstanding and judicially recognised claim within the enforcement process. Depending on the course of the insolvency proceedings, debt relief (Restschuldbefreiung) may be granted or denied.

How long are negative features stored?

Features in a credit report do not remain forever but are deleted after a certain period. The following table shows SCHUFA deletion periods for various types of entries:

Is it possible to have negative entries deleted early?

Consumers do have the possibility to have some entries removed from their credit report early. This is possible at SCHUFA for two types of entries:

1. Data from the debtors' registers of local courts

If a bailiff has made entries in public debtors' registers due to a judicially recognised claim, these can be deleted early if proof of deletion by the competent court is provided to SCHUFA. As a rule, such deletions are initiated when the claim has been settled.

2. Early deletion of claims from the SCHUFA report

SCHUFA also allows early deletion for this case. However, some conditions must be met:

• The claim must have been first reported to SCHUFA before 01.07.2012.
• The claim must not exceed 2.000 Euro.
• The claim was settled within 6 weeks and the creditor informed SCHUFA about the settlement.
• The claim is not judicially recognised (no enforcement order).

Tip: If completed incidents for outstanding claims will only be deleted in a few months, credit bureaus can sometimes be lenient. If, for example, a loan application is pending, the affected consumer could request deletion from the credit bureau. In individual cases, this approach can be successful.

Who is allowed to query credit information?

For a company to query credit data about a person, it must declare a legitimate interest according to §29 Abs. 2 BDSG. Direct proof is not required. Credit bureaus only have to document how the legitimate interest was presented and check its correctness by means of random samples. The law is intended to ensure that only companies that are about to enter into a business relationship obtain credit data about certain consumers.

Self-disclosure of your own creditworthiness - what matters

Although credit bureaus strive to keep consumers' data up to date, errors still occur. Unfortunately, incorrect negative entries can have significant consequences for those affected if, for example, mobile phone contracts can no longer be concluded or taking out a loan becomes nearly impossible. For this reason it is important to regularly check your own data. Under §34 BDSG, every consumer is entitled to request an overview of the data 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)
• additional requests may be subject to fees, which may only cover the costs of producing the report

If those affected notice incorrect entries when checking their data, they can request deletion of these entries from the credit bureau. As a rule, the respective credit bureau will examine a deletion request and only carry out the deletion if the examination justifies it.

Our conclusion on creditworthiness

The term creditworthiness plays a very significant role today. Whenever contracts involving advance services or credit elements are concluded, the counterpart'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 will find it very difficult to conclude the contracts mentioned above. This has a major impact on everyday financial life, because without a current account many transactions become extremely complicated. Fortunately, prepaid accounts offer suitable alternatives. Even taking out a loan is possible, whereby those affected must look for a loan without SCHUFA. Here, the SCHUFA query is waived and no report is later made to the credit bureau.