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 concluding a rental agreement, a credit check plays an important role. But what exactly does the term mean and what is the connection between creditworthiness and the conclusion of a contract? This guide presents all the important information about credit assessments and their effects in more detail.

Fundamentally, creditworthiness (ability to repay) describes a debtor's ability to repay their debts. The term "debtor" is kept deliberately general because, depending on the situation, it 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 long-term 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: personal creditworthiness and economic creditworthiness. But what distinguishes these two types?

Personal creditworthiness — willingness to pay

Personal creditworthiness deals with a debtor's willingness and reliability to pay. It asks whether the borrower consistently does everything to meet their obligations. The payment behavior 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 liabilities always been fully repaid in the past?
• Were there payment difficulties and long delays?

Economic creditworthiness — ability to repay

This aspect describes the debtor's economic capacity. The question is whether a borrower or an issuer is financially able to fully meet their 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 expenditure situation look like?
• How will these situations change in the future?

Creditworthiness of private individuals — cooperation between credit bureaus and companies

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

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

The credit assessment of private individuals is based on two different aspects: positive and negative indicators on the one hand, and scoring of the probability of default on the other.

Creditworthiness of companies and states — published ratings by rating agencies

The creditworthiness of companies and states is assessed by rating agencies. Two different rating processes are distinguished.

• Mandated ratings: In this case, a debtor, investor or creditor commissions a rating agency to assess the creditworthiness of a specific company. In addition to publicly available information, company-internal data provided by the client is often included, such as customer structure and financial plans.
• Secondary ratings: These ratings are performed without a mandate and only evaluate publicly available information. For this reason, secondary ratings are far less informative than mandated ratings.

Which factors are included and how they are weighted is not disclosed by rating agencies — it is their business secret. The best-known rating agencies each use their own rating schemes. The biggest and most well-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. There are over 20 gradations of credit scores, from AAA down to C or D. Without going into all the fine nuances, the following general assessments result.

1. Highest credit rating; default risk is negligible even in the long term
2. Very secure debtor; virtually no investment risk; somewhat harder to assess in the long term
3. Safe investment; low risk from unexpected events in the overall economy or industry
4. Average investment opportunity; economic downturns could trigger payment problems
5. Speculative investment; if the economic situation worsens, defaults could occur
6. Highly speculative investment; payment defaults likely if economic conditions deteriorate
7. No defaults expected only under very favorable developments
8. High probability of default or insolvency proceedings, but not yet in arrears
9. In arrears

Each rating level may have further sublevels depending on the rating agency. Investors use these ratings to make investment decisions and banks use them for credit decisions. These ratings apply to both companies and government bonds.

When is a credit check carried out?

A credit check for private individuals is important whenever there is a question of whether a debtor can repay liabilities. This not only applies to lending, but also to services that are paid for afterward. The following examples show typical situations in which companies or other creditors assess a debtor's creditworthiness.

Loan issuance by banks

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

Opening a current account

When opening a normal current account, you normally do not have to provide information about assets and income. However, a credit report regarding your previous payment behavior is usually requested. This is particularly important for allowing an authorized overdraft and granting a discretionary overdraft facility. If you want to avoid this, you can open a pure credit balance account, which can also be used as a protected account against garnishment.

Concluding a mobile or telephone contract

Since it is common in the telecommunications industry to pay for services afterward by invoice, providers require information about consumers' creditworthiness in advance. For this reason, a SCHUFA report is usually requested to determine previous payment behavior.

Credit check by the landlord

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

Instalment payment in mail-order houses

When taking out instalment payments with a mail-order company or a large online retailer, you are receiving credit. As with other loans, the customer's creditworthiness is checked to determine the likelihood of default.

How does a credit check work?

When a consumer's creditworthiness is to be determined, the procedure depends largely on the type of contract. Because extensive credit assessments are carried out especially before a lending decision, a more detailed sequence is described below:

Determining economic creditworthiness

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

1. Information about income

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

How high is the regular income?

These questions already make clear what information about income is needed. Income should at least exceed the statutory garnishment exemption thresholds, as banks only accept it as collateral to that extent. In addition, it must cover all expenses and still leave financial leeway for loan repayment.

Note: To prove income to a bank, employees usually need to provide recent payslips. Self-employed people are generally required to submit income tax assessments from recent years as proof of income.

How secure is the regular income?

Income security is closely tied to job security. For this reason, people with fixed-term employment or employees still in probationary periods often do not receive a loan. Self-employed persons may also find it difficult to obtain a loan because neither their job nor their income is guaranteed. Income fluctuates and a small business can disappear from the market.

Note: To create a picture of overall earnings despite fluctuating income, self-employed persons are often required to submit a business management report (BWA) during a credit check. This shows future business prospects and likely scenarios.

How is the income earned?

Banks also want clear information about the employment situation. The employment status is important, for example:

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

Banks also want to know the employer of salaried applicants. Regular income can also come from other sources, such as rental income or income from capital investments.

2. Information about regular expenses

Another part of the economic creditworthiness check is information about regular expenses. These are the recurring costs that are relatively predictable:

• Rent
• Electricity/heating/other housing costs
• Telecommunications costs (phone, internet, smartphone)
• Insurance costs
• Living expenses (food, hygiene)
• Costs for clubs and associations
• Vehicle costs (tax, insurance, fuel)
• Maintenance payments

3. Information about assets

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

• 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 bring additional regular interest costs. Moreover, a borrower must be able to repay debts within a foreseeable period. If debt increases to too high a level, over-indebtedness threatens, which is likely to result in default.

5. The household budget calculation determines the possible loan instalment

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

Income

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

Income of 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

Telecommunications costs (phone and internet plus 2 mobile contracts): 100 Euro per month

Living expenses: 750 Euro per month

Insurance costs: 160 Euro per month

Vehicle 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 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 around 1,400 Euro per month could be managed. This would also serve as a good basis for mortgage financing.

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 behavior in recent years. Negative indicators typically lead to a negative lending decision by the bank. Personal experiences of the bank with a customer can also influence creditworthiness. For example, regular returned direct debits due to insufficient funds can negatively affect the bank's decision.

Scoring — the summary of all creditworthiness indicators

To make credit ratings practical, all creditworthiness indicators are summarized 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. There is room for different weightings of factors, so a person's credit rating may not be the same at every bank. The following example shows a SCHUFA scoring system to illustrate the concept.

SCHUFA scoring system

Rating categories N, O and P indicate open negative entries such as data from debtor registers. As you can see, the scoring system sets a probability of default with the risk rate. While category A corresponds to a default rate of only 0.80% of all claims, category P corresponds to 96.08% of all claims. These average values help a bank make a lending decision.

Note: Garnishment exemption limits when lending

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

A mother with two children and no partner would therefore only need to fear garnishment from a net income of more than 1.709,99 Euro per month. Even then, the garnishable amount only increases slowly. Thus, taking out a loan with, for example, 1.800 Euro per month may still be difficult.

How does a credit rating affect you?

A person's creditworthiness indicates to a company the probability of default after concluding a contract. It attempts to forecast the likely course of the business relationship. As a result of this credit assessment, the following outcomes are possible:

A contract is not concluded.

If a person's creditworthiness is rated negatively, a company may refuse to enter into a contract with the potential customer. This is particularly the case if there is a negative SCHUFA or other credit bureau report. Past negative payment behavior is seen as serious by many companies, so they may decline to contract.

Terms depending on creditworthiness

Scoring values are especially important for lending or instalment purchases, because not only does contract conclusion depend on creditworthiness, but the terms of the contract do as well. Economic creditworthiness affects contract conditions. 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 quoted interest range depends on the borrower's creditworthiness. It indicates that borrowers with top creditworthiness receive a loan at 1.99%, while those with poorer creditworthiness may pay up to 10.99% per year. To give customers an idea of where the bank places average creditworthiness, the legislator requires banks to publish a representative example under §6a para. 4 of the Price Indication Ordinance (PangV). 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 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 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 agreement differently. The following explains the effects briefly.

Loan agreements

Anyone seeking a loan from a bank is doubly dependent on their creditworthiness. If negative indicators appear in the SCHUFA report, the contract may not be concluded. Moreover, creditworthiness also influences the interest rate. The better the score, the lower the interest costs.

Current account

For a current account, the credit check is limited to the SCHUFA report. If there are no negative indicators, 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 out a flat. This is done to protect against tenants who do not pay and to avoid later legal disputes. The tenant's creditworthiness does not affect the terms of the lease. Usually, the landlord does not obtain the report himself but requires the tenant to provide a self-disclosure.

Telephone and mobile contracts

For mobile and telephone contracts, the credit check is limited to a SCHUFA report or an inquiry with another credit bureau. Negative indicators can prevent a normal telecommunications contract from being concluded. In such cases, applicants must resort to prepaid tariffs where credit is paid in advance and used later.

Instalment purchases in mail-order houses

Since a mail-order company is effectively granting credit for instalment payments, similar rules apply. A SCHUFA report with negative indicators can mean instalment payments are not possible. Large mail-order companies increasingly use scoring and often link instalment purchase interest rates to a customer's creditworthiness.

Effect of creditworthiness on corporate and sovereign bonds

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

1. A company issues a bond with specific interest conditions on the capital market.
2. Investors assess the company's creditworthiness and compare it to the interest offered.
3. If the bond is attractive to investors, it is bought and its price rises, which in turn lowers yields.
4. If the bond is unattractive because the interest is too low compared to 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 can mean that the bond cannot be fully placed because no one is willing to buy it at the given terms. The issuer would then have to increase interest or accept less capital. States face similar dynamics, so their creditworthiness also strongly influences financing conditions.

Credit bureaus and scoring agencies: Who provides information?

The terms creditworthiness and scoring have become more important in recent years. As a result, there are many credit bureaus that compile information about consumers' ability to pay. Some well-known providers are described below:

Schutzgemeinschaft für Allgemeine Kreditsicherung (SCHUFA)

SCHUFA is by far the best-known credit bureau for creditworthiness. It was founded in 1927 in Berlin and today has its headquarters in Wiesbaden. With data on over 67 million private individuals and 5.3 million companies, SCHUFA Holding AG has a broad data base and provides important information to over 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
• Contract partners: 9,000

Deltavista GmbH (now CRIF GmbH)

Deltavista GmbH was known in Germany for its large credit database. Its distinctive traffic-light system (green = all ok, yellow = soft negative indicators, red = hard negative indicators) is helpful for many creditors. The credit bureau was taken over by the global CRIF group from Italy, which now serves 44,000 corporate customers in many countries.

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 since acquired Bürgel, expanding its international presence. The company provides about 6 million credit reports to its contractual partners annually.

Arvato Infoscore

Arvato Financial Services is part of Bertelsmann SE & Co. KGaA and serves over 10,000 customers in Europe. With over 68 million credit queries per year, Arvato is one of the three largest credit bureaus in Europe. In addition to hard negative indicators, Infoscore — like Bürgel — also uses soft negative indicators in its credit reports when they come from its own debt collection activities.

Boniversum (Creditreform)

Creditreform has a long tradition, having been 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 many services. It also provides classic debt collection services for companies.

What data do credit bureaus collect about consumers?

Credit bureau data is intended to give potential customers a picture of their clients' creditworthiness. Still, the data base usually cannot provide a complete picture of a consumer's finances and willingness to pay. Banks and companies are not allowed to report everything to credit bureaus; data protection also plays an important role. A credit report usually consists of positive and negative indicators and can be supplemented by scoring.

What are positive indicators?

Positive indicators in a credit report almost always consist of successful contract conclusions. If a consumer concludes a mobile contract or opens a current account, this is normally associated with the following:

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

Such entries build trust in the person's ability to pay and positively affect their scoring.

What are negative indicators?

Negative indicators denote elements of the credit report that negatively affect the person's creditworthiness. Typically, these include:

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

  

From these indicators, companies can quickly see that there were payment difficulties in the past or that the consumer may be financially unable to meet obligations. Such negative indicators are usually knockout criteria for lending or concluding a phone contract.

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

• Existence of a court-ordered title
• Explicit acknowledgment of the claim by the debtor
• Two written reminders after the claim became due
• A period of 4 weeks between the first and second reminder
• Notification of the impending report to SCHUFA (in good time, but no earlier than the first reminder)
• Immediate termination of the contract due to payment arrears

How do soft and hard negative indicators differ?

Some bureaus distinguish between hard and soft negative indicators in credit reports. Sometimes a three-part distinction (hard, medium, soft) is used. What does this mean? The following describes the different indicators:

Hard negative indicators:

• Data from debtor registers of local courts (affidavits of assets and arrest warrants to enforce an affidavit, entries under § 882c para. 1 no. 1-3 ZPO)
• Failure to submit asset disclosure
• Opening and rejection of personal insolvency proceedings
• Announcement, granting, or refusal of discharge from residual debt

Soft and medium negative indicators:

• Due and titled claims that have not been properly paid (debt collection monitoring procedures) (medium)
• Debt collection procedures (soft)

The difference between hard and soft negative indicators lies mainly in the progress of the reminder and enforcement process. A debt collection procedure typically involves:

• A consumer failed to pay an invoice on time and often ignored one or more reminders.
• The claim was handed over to a collection agency, which now handles communication with the consumer.

In a SCHUFA report, such soft negative indicators are usually not or rarely mentioned. Other credit bureaus include soft entries when they originate from their own collection activities. A debt collection monitoring procedure is usually based on a titled claim. In that case, collection proceedings were unsuccessful and an enforceable court title was obtained. Such claims are generally recorded as negative indicators by almost all credit bureaus.

Hard negative indicators arise when, despite a titled claim, no agreement can be reached and debtors are required to submit an asset disclosure. The ultimate consequence may be consumer insolvency proceedings if assets are insufficient to satisfy an enforceable claim. Depending on the course of the insolvency proceedings, discharge of residual debt may be granted or refused.

How long are negative indicators stored?

Indicators in a credit report are not stored forever but are deleted after a certain time. The following table shows SCHUFA deletion periods for various types of entries:

Is there a possibility to have negative entries deleted early?

Consumers do have the possibility to have certain entries deleted from their credit report early. For SCHUFA, this is possible for two types of entries:

1. Data from debtor registers of local courts

If a bailiff has entered information into public debtor registers due to a titled claim, these can be deleted early if SCHUFA is provided with proof of deletion by the competent court. In most cases, such deletions are arranged when the claim has been settled.

2. Early deletion of claims from the SCHUFA report

SCHUFA also allows for early deletion in this case, but certain conditions must be met:

• The claim must have been reported to SCHUFA for the first time before 01.07.2012.
• The claim must not exceed 2.000 Euro.
• The claim must have been settled within 6 weeks and the creditor must have notified SCHUFA of the settlement.
• The claim is not titled (no enforcement order).

Tip: If only a few months remain until deletion for settled incidents, 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 request credit information?

For a company to request credit data about a person, it must declare a legitimate interest according to §29 para. 2 BDSG. Direct proof is not required. Credit bureaus only have to document how the legitimate interest was presented and periodically check its accuracy. The law is intended to ensure that only companies that are about to start business relations can obtain data about certain consumers.

Self-disclosure about your own creditworthiness — this is important

Even though credit bureaus strive to keep consumers' data up to date, errors still occur. Incorrect negative entries can have significant consequences if suddenly mobile contracts cannot be concluded or taking out a loan becomes nearly impossible. For this reason, it is important to check your own data regularly. Under §34 BDSG, every consumer may 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 para. 8 BDSG)
• Further requests may be charged a fee, which may only cover the cost of preparing the report.

If errors are found when reviewing the data, consumers can demand deletion of these entries from the credit bureau. The bureau will normally check a deletion request and only carry out the deletion if the check supports it.

Our conclusion on creditworthiness

The concept of creditworthiness plays a very important role today. Whenever contracts with advance services or credit elements are concluded, the counterparty'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 contracts described above. This has a significant impact on everyday financial life because many transactions are very complicated without a current account. Fortunately, credit-balance accounts provide an alternative. Even taking out a loan is possible, but affected consumers may have to look for a loan without SCHUFA. In such cases, no SCHUFA inquiry is made and the credit bureau is not notified later.