Creditworthiness and credit rating

In everyday life, the term creditworthiness is now ubiquitous. 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 is the connection between creditworthiness and concluding a contract? This guide presents all the important information about credit assessment and its effects in more detail.

What exactly is creditworthiness?

In principle, creditworthiness (ability to pay) describes a debtor's ability to repay their debts. Debtors are deliberately kept general here, because depending on the situation they 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 the customer's 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 out loans. Rating agencies also evaluate 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 differentiates these two types of creditworthiness?

Personal creditworthiness - willingness to pay

Personal creditworthiness concerns a debtor's willingness and reliability to pay. It is therefore about whether the borrower always does everything possible to settle their obligations. A person's or company's payment behavior plays an important role. The following questions are particularly important:

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

Economic creditworthiness - ability to repay

This aspect, on the other hand, describes a debtor's economic ability. It therefore asks whether a borrower or issuer is financially able to fully meet their economic obligations. The following questions are particularly important:

• 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 companies

When it comes to rating 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 conclusion.

The credit assessment of private individuals is based on two different aspects: on the one hand so-called positive and negative characteristics 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 states, on the other hand, is assessed by so-called rating agencies. Two different rating processes must be distinguished.

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

Secondary ratings: These ratings are carried out 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. This is their central trade 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" rating agencies.

They all use a similar classification of credit rating categories. This results in more than 20 subdivisions of credit scores, descending from AAA to C or D. Without going into all the fine nuances of the gradations, the following ratings can be summarized.

1. Highest credit rating; default risk is negligible 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 overall economy or the sector
4. Average investment opportunity; deterioration in the overall economy could trigger payment problems
5. Speculative investment; if the economic situation worsens, payment defaults could occur
6. Highly speculative investment; payment defaults are likely if the economic situation worsens
7. No payment defaults expected except under very favorable developments
8. High probability of a default or insolvency proceedings, but not yet in arrears
9. In arrears

Each rating level mentioned here may, depending on the rating agency, have further subdivisions. Investors use this classification to make investment decisions and banks use it for credit decisions. This credit rating 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 meet obligations. It is not only relevant for lending, but also for services that are paid afterwards. The following examples show typical situations in which companies or other creditors perform a credit assessment of debtors.

Loans by banks

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

Opening a checking account

If you want to open a normal checking account, you do not have to provide information on assets and income. However, a credit report on your past payment behavior is usually obtained. This is particularly important for granting authorized overdrafts and overdraft facilities. Those who wish to avoid this can use a simple prepaid account, which can also be used as a protected account against garnishment.

Concluding a mobile phone or telephone contract

Because it is common in the telecommunications industry to bill services afterwards on invoice, providers need information about consumers' creditworthiness beforehand. For this reason, a SCHUFA report is usually obtained to determine past payment behavior.

Credit report by the landlord

Since a rental agreement in Germany implies strong legal obligations for landlords, they have a legitimate interest in information about the creditworthiness of prospective tenants. If rental payments fail, landlords face considerable legal effort to collect outstanding claims and to move out a defaulting tenant. Landlords often do not obtain a credit report themselves, but expect tenants to provide one.

Installment payments at mail-order houses

If you want to use an installment payment option at a mail-order company or a large online retailer, you are essentially taking out a loan. As with other loans, the customer's creditworthiness is checked to determine the probability of a payment default.

How does a credit check work?

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

Determining economic creditworthiness

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

1. Information about income

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

How high is the regular income?

These questions already indicate in detail what the income disclosure is about. The income should at least exceed the statutory garnishment exemption thresholds, as banks will only accept it as collateral to that extent. Furthermore, it must cover all expenses and still leave some financial leeway for loan repayment.

Note: To prove their income, borrowers usually have to submit recent pay slips to a financial institution. Self-employed persons are typically required to provide income tax assessments for the past 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 or employees in probationary periods often do not receive credit. Self-employed people also sometimes find it very difficult to obtain a loan because neither their job nor their income is secure. Income fluctuates and the small business itself can disappear from the market at any time.

Note: To get a picture of the general profit situation despite fluctuating income, self-employed persons 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.

In what way is the income earned?

Banks also want clear information about a borrower's employment situation. The employment status is initially important:

• Employees
• Self-employed
• Civil servants
• Students
• Pensioners

In addition, banks want to know who the employer of a potential borrower is. 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 assessment is information about regular expenses. These include recurring costs that are 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 (taxes, 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 when taking out a loan. These include, for example:

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

4. Information about debts

The level of debt also affects a borrower's economic creditworthiness. Outstanding loans generate additional regular interest costs. Furthermore, 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 lead to a payment default.

5. The household budget calculates the possible loan installment

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

Income

Income 1st person in household (net): 2,200 euros per month

Income 2nd person in household (net): 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 costs: 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 (replacement purchases, repairs, travel costs): 300 euros per month

Total expenses: 2,709 euros per month

Possible loan installment: 1,416 euros per month

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

Determining personal creditworthiness

A borrower's personal creditworthiness is now mainly determined by obtaining a SCHUFA report or a credit report from other credit bureaus. This reflects the person's payment behavior in recent years. Negative characteristics usually lead to a negative credit decision by the bank when taking out a loan. Personal experiences of the bank with a customer can also influence creditworthiness. For example, if a bank customer regularly has chargebacks due to insufficient funds in their checking account, this can also negatively affect the bank's credit decision.

Scoring - the summary of all creditworthiness characteristics

To make credit rating practicable, all creditworthiness characteristics are summarized today in a scoring system. This way each debtor can be assigned a specific score 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 also leeway in weighting individual factors, so a person's credit rating is not the same at every financial institution. As an example, a SCHUFA scoring system shows how something like this generally looks.

SCHUFA scoring system

For rating categories N, O and P, open negative characteristics such as data from debtor registers are present. As can be seen, the scoring system with the risk rate specifies a probability of default for the respective claim. While rating category A implies only a 0.80% default of all claims, it is 96.08% in category P. These average values ultimately help a bank make a credit decision.

Aside: Garnishment exemption thresholds in lending

As already described, taking out a loan is only successful if the borrower's creditworthiness allows 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 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 significantly above the thresholds to provide sufficient financial leeway. Garnishment exemption thresholds in this country are as follows:

A mother with two children and no spouse therefore only has to fear garnishment starting at a net income of more than 1,709.99 euros per month. Even then, the garnishable amount increases only slowly. Thus, taking out a loan with an income of, for example, 1,800 euros per month may still prove difficult.

How does a credit rating affect you?

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

A contract may not be concluded at all.

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

Terms depending on creditworthiness

Scoring values are especially important for lending or installment purchases, because not only does the conclusion of the contract depend on the customer's creditworthiness, but economic creditworthiness also influences the terms of such contracts. This is easy to observe with loan offers, as a typical terms description shows. For an effective annual interest rate, for example, no single percentage is given but a range.

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

The stated interest rate range depends on a borrower's creditworthiness. It indicates that debtors with top creditworthiness receive a loan at 1.99%, while people with poorer creditworthiness may pay up to 10.99% per year. To give borrowers an indication of where the bank places 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 applies on average to two-thirds of all potential customers. For the example above, the representative example might therefore look like this:

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

Contract types and the effects of creditworthiness

Depending on the type of contract, a debtor's creditworthiness has different effects on the respective contract. The following briefly explains the impacts.

Loan agreements

If you want to take out a loan from a bank, you are doubly dependent on your creditworthiness. If negative characteristics appear in the SCHUFA report, a contract conclusion may not even take place. In addition, creditworthiness also affects the interest rate level. 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 characteristics, the applicant can open the account. Otherwise, only a prepaid account can be opened.

Rental agreements

Landlords increasingly require a credit report before renting an apartment. This is done, among other reasons, to protect themselves from problem tenants and to avoid later legal disputes. The terms of the rental agreement, however, are not affected by the tenant's creditworthiness. Also, landlords normally do not obtain the report themselves but request that tenants 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 at another credit bureau. Negative characteristics mean a conventional telecommunications contract cannot be concluded. In such cases, applicants must resort to prepaid tariffs, where a credit balance is deposited in advance and later consumed by the user.

Installment purchases at mail-order companies

Because a mail-order company essentially grants a loan for installment payments, similar rules apply. A SCHUFA report showing negative characteristics can prevent installment payment options. Furthermore, at least large mail-order companies today use scoring and often tie the interest conditions of installment payments to the customer's creditworthiness.

Impact of creditworthiness on corporate and government bonds

Companies and especially states obtain external capital by issuing bonds. Here creditworthiness also plays a very important role, but 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 compare it with the interest conditions.
3. If the bond is attractive to investors, it will be purchased and its price will rise. 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 a poor credit rating tends to be associated with rising interest costs for the company. In practice, this may mean that the entire bond cannot be placed because no one is interested at the given terms. In such cases, the company would have to improve the offer by raising interest rates or give up part of the intended external financing. States face similar situations, so their creditworthiness also significantly influences 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 quite a few credit bureaus that deal with consumers' ability to pay. Some well-known players in the market are presented in more detail below:

Schutzgemeinschaft für Allgemeine Kreditsicherung (SCHUFA)

SCHUFA is clearly 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 more than 9,000 contractual partners.

• Data records: 813 million
• Natural persons 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 field of credit reports. The memorable traffic-light scheme (green = everything ok, yellow = soft negative characteristics, red = hard negative characteristics) has been a great help to many creditors. The bureau has since been taken over by the globally operating CRIF group from Italy, which now supplies around 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 economic credit bureaus in Germany. The Italian CRIF group has now taken over the bureau, allowing Bürgel to expand its international presence. The company provides approximately 6 million reports annually to its contractual partners.

Arvato Infoscore

Arvato Financial Services belongs to Bertelsmann Se & CO. KGaA and can point to over 10,000 customers in Europe. With more than 68 million credit checks per year, Arvato is clearly among the three largest credit bureaus in Europe. In addition to hard negative characteristics, Infoscore, like Bürgel, also uses soft negative characteristics in its credit reports when these originate from its own collection procedures.

Boniversum (Creditreform)

Creditreform can look back on a long tradition, having been founded in 1879 in Mainz. The company now has more than 155,000 members worldwide. From individual reports to address validation and scoring, Creditreform Boniversum GmbH offers numerous services. It also takes on traditional debt collection services for companies.

What data do credit bureaus collect about consumers?

The data held by credit bureaus should enable potential clients to form a picture of their customers' creditworthiness. Nevertheless, the database can usually not give a complete statement about a consumer's financial circumstances and willingness to pay. This is because banks and companies are by no means 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 characteristics and can be supplemented by scoring if required.

What are positive characteristics?

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

• The company has successfully performed a credit check.
• The consumer's economic circumstances are apparently sufficient to conclude such a contract.

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

What are negative characteristics?

Negative characteristics denote all parts of the credit report that affect the person's creditworthiness adversely. They typically include the following aspects:

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

From these characteristics companies can quickly see that there have been payment difficulties in the past or that the consumer is even financially unable to meet obligations. Such negative characteristics are usually deal-breakers when taking out a loan or concluding 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) stipulates that certain criteria must be met for a report to be made:

• Existence of a title of debt
• Express acknowledgement of the claim by the debtor
• Two written reminders after the due date
• A period of 4 weeks between the first and second reminder
• Notification about the impending report to SCHUFA (in a timely manner, but at the earliest with the first reminder)
• Immediate contract termination due to payment arrears

How do soft and hard negative characteristics differ?

Some credit bureaus distinguish between hard and soft negative characteristics in a credit report. There can even be a threefold distinction of hard, medium and soft negative characteristics. What does this mean? The following shows the individual characteristics:

Hard negative characteristics:

• Data from debtor registers of district courts (sworn affidavits and arrest warrants to enforce a sworn affidavit, entries under § 882c para. 1 nos. 1-3 ZPO)
• Failure to submit an asset declaration
• Opening and rejection of a personal insolvency proceeding
• Announcement, granting or denial of discharge of residual debt

Soft and medium negative characteristics:

• Due and titled claims that were not properly paid (collection monitoring procedures) (medium)
• Collection procedures (soft)

The difference between hard and soft negative characteristics mainly lies in the progress of the dunning procedure. A collection procedure typically 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 collection agency, which now handles correspondence with the affected person.

Such soft negative characteristics are usually not or only rarely mentioned in a SCHUFA report. Other credit bureaus include such soft entries when they originate from their own collection activities. It is different with a collection monitoring procedure, which is usually based on a titled claim. In this case the collection procedure was fruitless and an enforceable title was obtained from the court. Such claims are usually classified as negative characteristics by almost all credit bureaus.

Hard negative characteristics arise when, despite a titled claim, no agreement can be reached and debtors are required to submit an asset declaration. The final consequence may be the opening of personal insolvency proceedings if assets are insufficient to settle an outstanding titled claim through enforcement. Depending on the course of the insolvency proceedings, discharge of residual debt may be granted or denied.

How long are negative characteristics stored?

Entries in a credit report do not remain forever but are deleted after a certain period. Below are the SCHUFA deletion periods for various types of entries:

Is it possible to have negative entries deleted early?

Consumers do have the option to have some entries removed from their credit report early. With SCHUFA, this is possible in two types of cases:

1. Data from debtor registers of district courts

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

2. Early deletion of claims from the SCHUFA report

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

• The claim must have been communicated to SCHUFA for the first time before 01.07.2012.
• The claim must not exceed 2,000 euros.
• The claim was settled within 6 weeks and the creditor informed SCHUFA of the settlement.
• The claim is not titled (no enforcement order).

Tip: If resolved incidents relating to outstanding claims are only a few months away from deletion, credit bureaus can sometimes be lenient. If a loan is imminent, the affected consumer could request deletion from the credit bureau. In individual cases this approach can be successful.

Who may request credit information?

For a company to query credit data about a person, it must declare a legitimate interest under §29 para. 2 BDSG. Direct proof is not required. Credit bureaus must merely document how the legitimate interest is presented and check its correctness through random checks. The law is intended to ensure that only companies that have a business initiation with the consumer obtain credit data.

Self-disclosure about your own creditworthiness - this is important

Even though credit bureaus strive to keep consumers' data up to date, errors still occur. Unfortunately, false negative entries can have significant consequences for the affected persons, such as suddenly being unable to conclude mobile phone contracts or finding it almost impossible to obtain a loan. For this reason, it is important to regularly check your own data. Under §34 BDSG every consumer is therefore allowed to request a data overview containing the data and information stored about them. The conditions for this 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 inquiries may be subject to fees, which may only cover the cost of preparing the disclosure

If consumers discover incorrect entries when reviewing their data, they can request deletion of these entries from the credit bureau. The respective credit bureau will usually check a deletion request first and only delete entries if the check supports the deletion.

Our conclusion on creditworthiness

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

Consumers with poor creditworthiness and negative entries regarding their payment behavior will likely find it very difficult to conclude the aforementioned contracts. This has a major impact on everyday financial life, because many transactions become very complicated without a checking account. Fortunately, a prepaid account offers an alternative. It is even possible to obtain a loan, although affected persons may have to look for a loan without SCHUFA. In such cases a SCHUFA inquiry is waived and no report to the credit bureau is made later.