Creditworthiness and credit rating

In everyday life, the term creditworthiness is now ubiquitous. When opening a current account, taking out a loan, signing a mobile phone contract or even a rental agreement, credit checks play an important role. But what does the term actually mean and what is the connection between creditworthiness and concluding a contract? This guide presents all important information about credit assessment and its effects in more detail.

What exactly is creditworthiness?

Fundamentally, creditworthiness (ability to pay) describes a debtor's ability to repay their debts. The term debtor is kept intentionally general, because depending on the situation it can come from very different areas.

Private individuals: There are many types of contracts where 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 credit rating

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 of creditworthiness?

Personal creditworthiness - willingness to pay

Personal creditworthiness covers the willingness and reliability of a debtor to pay. It is therefore about whether the borrower always does everything to meet their obligations. The payment behaviour of a person or a company plays an important role. The following questions are particularly important:

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

Economic creditworthiness - ability to repay

This sub-aspect, on the other hand, describes the economic means of a debtor. Thus the question is whether a borrower or an issuer is financially capable of fully meeting their obligations. The following questions play a particular role:

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

Creditworthiness of private individuals - cooperation between credit agencies and companies

When it comes to assessing the creditworthiness of private individuals, companies cooperate with so-called credit agencies. The process runs in two stages.

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

The credit assessment of private individuals is based on two different aspects. On the one hand, the so-called positive and negative attributes and on the other hand scoring of the probability of default.

Creditworthiness of companies and states - published ratings by rating agencies

The creditworthiness of companies and also states is assessed by so-called rating agencies. There are two different rating processes to distinguish.

Mandated ratings: In this case, a debtor, investor or creditor hires a rating agency to assess the creditworthiness of a specific company. In addition to publicly available information, company internal data 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 can be obtained publicly. For this reason, secondary ratings are by far not as informative as mandated ratings.

Which factors are ultimately included and how they are weighted is not disclosed by a rating agency. It is their central business secret. The best-known rating agencies use their own evaluation schemes for companies and states. 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 credit rating categories. This results in over 20 gradations of credit scores, from AAA down to C or D. Without going into all the fine nuances of the gradations, the following general evaluations emerge.

1. Highest rating; default risk can be neglected even in the long term
2. Very secure debtor; almost no investment risk; somewhat harder to assess long term
3. Secure investment; low risk from unexpected events in the economy or the sector
4. Average investment opportunity; deteriorations in the overall economy could cause payment problems
5. Speculative investment; if economic conditions worsen, payment defaults may occur
6. Highly speculative investment; payment defaults are likely if the economy worsens
7. No payment defaults expected only under very favorable developments
8. High probability of payment default or insolvency proceedings, but not yet in arrears
9. In arrears

Each rating category mentioned here can, depending on the agency, have further sub-steps. Investors make investments and banks make credit decisions based on these ratings. This credit assessment can be applied both to companies and to government bonds.

When is a credit check carried out?

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

Loan approval by banks

Before a credit institution grants a loan to an individual, it needs information about the probability of default. After all, it is essential for banks not to be left holding unpaid claims.

Opening a current account

Anyone who wants to open a normal current account does not have to provide asset and income information. However, a credit report on their past payment behaviour is usually obtained. This is especially important for granting tolerated overdrafts and a discretionary overdraft facility. Those who want to avoid this can maintain a pure credit balance account, which can also be used as a garnishment protection account without problems.

Conclusion of a mobile phone or telephone contract

Since it is common in the telecommunications industry to pay for services afterwards by invoice, providers require information about the creditworthiness of the consumers in advance. For this reason, a SCHUFA report is normally requested to determine past payment behaviour.

Credit report requested by the landlord

Because a rental agreement involves strong legal commitments for landlords under German law, they have a legitimate interest in information about the creditworthiness of potential tenants. If rent payments default, landlords face significant legal effort to collect outstanding debts and to evict the defaulting tenant. Landlords, however, often do not request a credit report themselves, but expect tenants to provide one.

Instalment payments at mail-order houses

Anyone who wants to use instalment payment at a mail-order company or a major online retailer essentially receives a loan. As with other loans, the customer's creditworthiness is queried to determine the probability of default.

How does a credit check proceed?

When determining a consumer's creditworthiness, the procedure of the credit check depends greatly on the type of contract. Since especially detailed credit assessments are carried out before a loan decision, the following gives a more precise description of the process:

Determining economic creditworthiness

As already described, determining economic creditworthiness assesses whether a borrower is economically able to pay loan installments properly. The borrower's cooperation is of course required in this area, as they must provide the following information.

1. Information about income

To regularly service loan repayments, a borrower must demonstrate corresponding 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 legal garnishment exemption thresholds in amount, as only then can banks accept it as security. Moreover, it must cover all expenses and still leave financial room for loan repayment.

Note: To prove the level of their income, borrowers usually have to present current pay slips to a credit institution. Self-employed persons, on the other hand, are often 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 temporary employment contracts or employees in probationary periods often do not obtain a loan. Furthermore, self-employed individuals sometimes find it very difficult to obtain a loan. This is because neither the job nor the income of self-employed people is secure. Earnings fluctuate and the small business can disappear from the market at any time.

Note: To get a picture of general profit situations despite fluctuating income, self-employed people often have to submit a business management evaluation (BWA) as part of a credit assessment. This shows future economic prospects and thus likely scenarios for the future.

How is the income generated?

Credit institutions also want a clear statement from a borrower about their employment situation. First, the employment status is important:

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

In addition, the bank wants to know the employer of the prospective borrower in the case of employees. Regular income can of course 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 assessment is information about regular expenses. These are costs that recur regularly and are therefore relatively predictable:

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

3. Information about assets

Assets can have a very positive effect on a borrower's creditworthiness and can serve as collateral 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 level of debt also influences a borrower's economic creditworthiness. Outstanding loans bring additional regular interest costs. Moreover, a borrower must be able to repay their debts within a foreseeable time. If the level of debt grows too high, over-indebtedness threatens, which with high probability ends in default.

5. The household budget calculation determines the possible loan installment

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

Income

Income person 1 in the household (net): 2,200 Euro per month

Income person 2 in the 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 (phone 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 (replacement purchases, repairs, travel costs): 300 Euro per month

Total expenses: 2,709 Euro per month

Possible loan installment: 1,416 Euro per month

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

Determining personal creditworthiness

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

Scoring - the summary of all creditworthiness attributes

To make the assignment of credit ratings to borrowers practicable, all creditworthiness attributes are today summarized in a scoring system. In this way, each debtor can be assigned a certain score that expresses the respective probability of default and thus the ability to repay. A scoring system is not fixed, but can be designed by each bank itself. There are also leeway in weighting individual factors, so a person's credit rating does not necessarily come out the same at every credit institution. As an example, a SCHUFA scoring system is shown to illustrate how such a system generally looks.

SCHUFA scoring system

For rating levels N, O and P there are open negative attributes such as entries from debt registers. As can be seen, the scoring system sets a probability of default for the respective claim with the risk rate. While rating level A only results in a default of 0.80% of all claims, it is 96.08% of all claims at level P. These average values ultimately help a bank with a loan decision.

Excursus: Garnishment exemption thresholds in lending

As already described, taking out a loan is only successful if the borrower's creditworthiness also enables repayment. The level of income plays an important role. It must be at least above the garnishment exemption thresholds so that the bank can actually garnish parts of the income in case of payment difficulties. Depending on the size of the financing, banks often require an income well above the thresholds to provide sufficient financial leeway. The garnishment exemption thresholds in Germany 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 still likely be difficult.

How does a credit rating affect things?

A person's creditworthiness indicates to a company the probability of default after the contract is concluded. An attempt is made to forecast the likely course of the business relationship. As a result of this credit assessment, the following possibilities arise:

A contract is not concluded at all.

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

Terms depending on creditworthiness

Scoring values are particularly important for lending or instalment purchases, because not only the conclusion of a contract depends on the customer's creditworthiness. Economic creditworthiness also affects the terms of the contracts. This can be seen particularly easily with loan offers, as a typical terms description shows. For example, an effective annual interest rate is often given as a range rather than a single 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 the borrower's creditworthiness. It indicates that borrowers with top creditworthiness receive a loan at an interest rate of 1.99%, while people with poorer creditworthiness may pay up to 10.99% per year. To give loan customers an indication of where the institution places average creditworthiness, the legislator requires in §6a para. 4 of the Price Indication Ordinance (PangV) that each bank publish a representative example. The interest rate used there should be chosen so that it could apply on average to two-thirds of all potential customers. For the above offer the representative example could look like this:

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

Types of contracts 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 take out a loan from a bank is doubly dependent on their creditworthiness. If there are negative attributes 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 attributes, the applicant can open the account. Otherwise, only a credit balance account can be opened.

Rental agreements

Landlords increasingly require a credit report before renting an apartment. This is done, among other things, to protect themselves from so-called "rental scammers" and to avoid later legal disputes. The tenant's creditworthiness does not, however, affect the terms of the rental contract. In addition, the landlord usually does not request the report himself but asks tenants to provide a corresponding self-disclosure.

Telephone and mobile contracts

For mobile and telephone contracts, the credit check is also limited to a SCHUFA report or an inquiry with another credit agency. Negative attributes prevent a conventional telecommunications contract from being concluded. In such cases, applicants must resort to prepaid tariffs, where a balance is first deposited that the user can later consume.

Instalment purchases at mail-order houses

Since a mail-order company effectively grants credit with instalment payment, similar regulations apply. Thus a SCHUFA report with negative attributes can prevent instalment payment. 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.

Impact of creditworthiness on corporate and government bonds

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

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 bond's interest conditions.
3. If the bond is attractive to investors, it is bought and its price rises. This, in turn, leads to falling yields.
4. If the bond is unattractive because the interest is too low compared to the default risk (creditworthiness), demand falls and so does the price. Falling prices lead to rising yields.

Thus, poor creditworthiness tends to be associated with rising interest rates for the company. In practice, this initially means that the entire bond may not be fully placed because no one is interested at the given terms. In such cases, the company would have to improve the offer by increasing interest rates or give up part of the intended debt capital. States face similar situations, so their creditworthiness also significantly influences terms.

Credit agencies and scoring providers: Who provides reports?

The terms creditworthiness and scoring have gained importance in recent years. For this reason, there are now quite a few credit agencies dealing with consumers' ability to pay. The following presents some well-known market players in more detail:

Schutzgemeinschaft für Allgemeine Kreditsicherung (SCHUFA)

SCHUFA is by far the best-known credit agency in matters of 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 large data base and thus provide important information to over 9,000 contractual partners about potential customers and business partners.

• Data records: 813 million
• Individuals with data at SCHUFA: 67.2 million
• Companies with data at SCHUFA: 5.3 million
• Contractual 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 memorable traffic-light scheme (green = all ok, yellow = soft negative attributes, red = hard negative attributes) is a great help for many creditors. The agency has since been acquired by the global 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 credit agencies in Germany. The Italian CRIF group has meanwhile taken over the agency, enabling Bürgel to expand its international presence. The company provides about 6 million reports to its contractual 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 credit checks per year, Arvato clearly ranks among the three largest credit agencies in Europe. In addition to hard negative attributes, Infoscore, like Bürgel, also uses soft negative attributes in its credit report when these come from its own debt collection processes.

Boniversum (Creditreform)

Creditreform can look back on a long tradition since it was founded in 1879 in Mainz. 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 performs classic debt collection services for companies.

What data do credit agencies collect about consumers?

The data of credit agencies should enable potential clients to get an impression of their customers' creditworthiness. Nevertheless, the data basis usually cannot provide a complete statement about a consumer's financial situation and willingness to pay. This is because banks and companies are by no means allowed to report everything to credit agencies. Data protection also plays a very important role. A credit report usually consists of positive and negative attributes and can be supplemented by scoring if required.

What are positive attributes?

Positive attributes in a credit report almost always consist of successful contract conclusions. When a consumer signs a mobile 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 are apparently sufficient to conclude such a contract.

Corresponding entries thus help build trust in the affected person's ability to pay. They positively influence a consumer's scoring.

What are negative attributes?

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

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

  

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

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

• Existence of a 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 time, but at the earliest with the first reminder)
• Extraordinary termination of the contract due to payment arrears

How do soft and hard negative attributes differ?

Some credit agencies distinguish between hard and soft negative attributes in a credit report. Sometimes a three-way division into hard, medium and soft negative attributes can even be found. But what does that mean? The following table outlines the individual attributes:

Hard negative attributes:

• Data from the debtor registers of local courts (sworn affidavits and arrest warrants to enforce a sworn affidavit, entries according to § 882c para. 1 no. 1-3 ZPO)
• Failure to submit an asset declaration
• Opening and dismissal of a personal insolvency procedure
• Announcement, granting or denial of discharge of residual debt

Soft and medium negative attributes:

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

The difference between hard and soft negative attributes lies mainly in the progress of the reminder procedure. A debt collection procedure generally 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 conducts the written communication with the affected person.

Such soft negative attributes are normally not or rarely mentioned in a SCHUFA report. Other credit agencies include such soft reports whenever they stem from their own debt collection operations. A debt collection monitoring procedure, on the other hand, usually has a judicated claim as its basis. In this 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 agencies.

Hard negative attributes occur when, despite a judicated claim, no agreement could be reached and the affected debtor is requested to submit an asset declaration. The final consequence in this case is a consumer insolvency procedure, which is opened when assets are insufficient to pay an outstanding and judicated claim in the context of enforcement. Depending on the course of the insolvency proceedings, a discharge of residual debt may be granted or denied.

How long are negative attributes stored?

Attributes in a credit report do not remain forever, but are deleted after a certain time. The following table illustrates SCHUFA's deletion periods for different types of entries:

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. For SCHUFA, this is possible in two cases:

1. Data from the debtor registers of local courts

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

2. Early deletion of claims from the SCHUFA report

SCHUFA also provides the option of early deletion for this case. However, several conditions must be met:

• The claim was first reported to SCHUFA before 01.07.2012.
• The claim may amount to a maximum of 2,000 Euro.
• The claim was settled within 6 weeks and the creditor notified SCHUFA of the settlement.
• The claim is not judicated (no enforcement order).

Tip: If resolved incidents about outstanding claims are only a few months away from deletion, credit agencies can sometimes be lenient. If, for example, a loan application is imminent, the affected consumer could ask the credit agency for deletion. In individual cases this approach can be successful.

Who is allowed to request credit information?

For a company to query credit data about a person, it must declare a legitimate interest according to §29 para. 2 BDSG. A direct proof is not required, however. Credit agencies must merely document the manner in which the legitimate interest is presented and check its correctness by random sampling. The law is intended to ensure that only companies with which business is being initiated obtain data on the creditworthiness of certain consumers.

Self-disclosure about your own creditworthiness - this is important

Even though credit agencies strive to keep consumers' data up to date, errors still occur. Unfortunately, false negative entries can have significant consequences for those affected if mobile 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 may request a data overview that contains the data and information stored about them. The conditions are also regulated by law:

• once a year the data disclosure must be provided free of charge in text form (§34 para. 8 BDSG)
• further requests may be subject to fees, which may only cover the costs of preparing the disclosure.

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

Our conclusion on the topic of creditworthiness

The term creditworthiness plays a very significant role today. Whenever contracts with advance services or credit elements are concluded, the creditworthiness of the contracting party is checked. This concerns 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 in turn has a major impact on everyday finances, because without a current account many transactions become extremely complicated. Fortunately, suitable alternatives are offered with a credit balance account. Even taking out a loan is possible, whereby affected persons may orient themselves toward a loan without SCHUFA. In such cases the SCHUFA inquiry is omitted and no notification to the credit agency is made later.