Your credit score may feel like a mystery or, in some cases, a burden. But the first step toward improving your credit is understanding the components in your credit score, what events affect it, and how it does-and does not-influence your ability to secure a loan.
In short, your credit score is a quick way for any lender to estimate the likelihood of your repayment of a loan, whether that's a line of credit through a credit card, an auto loan, or a home mortgage.
Credit reporting agencies compile and report your credit score. There are two main agencies in Canada-Equifax and TransUnion-that both draw on the same information from your credit report. These agencies use complex algorithms (mathematical equations) to balance each factor in your credit report and provide the most accurate assessment possible to a potential lender.
In Canada, credit scores range from 300 to 900. A higher credit score, one of at least 700, gives you the best chance to receive the lowest offered rates, which may be as low as 0.00%. A score in the middle range, the 600s, means you will pay a slightly higher interest rate. A score of 500 or below will result in a notably higher interest rate, and may affect your chance of approval.
Still, credit agencies do not provide a numerical cutoff for loan approval. And that's an important qualification, especially for those with a rocky credit history. Your credit score gives your potential lender an idea of where you fall along the spectrum of borrowers-it does not pass a yes-or-no judgment on approval. Getting to that final answer requires much more information than what your credit report contains.
Consumers are entitled to one free credit report each year. This can help you monitor your credit and know more about how your credit score may impact a loan application before you begin the process. Because you get one score from each of the three agencies, you can spread those three reports throughout the year to keep a close eye on your credit.
That covers the basics. To become fully informed, here's what you need to know:
The components of a credit score
Payment history. Your on-time payment of bills is the single largest factor in your credit report, but it still accounts for a minority of your score. A late bill payment may stay in your credit score for up to seven years, but not all late payments are the same. Were you thirty days late on a payment? Sixty days? Ninety days? Did this late payment occur last month, last year, or five years ago?
These nuances are all taken into account when calculating your score. Not surprisingly, being thirty days late on a single payment in 2013 is not as damaging to your credit score as having multiple payments ninety days past due this calendar year.
Amount you owe. Your credit score is a snapshot of the current state of your finances, which is why your score can change significantly from month to month as your checking account balance grows or credit card debt declines. The second most important factor, this component looks at your debt-to-income ratio. Your debt-to-income ratio compares outstanding debt to present income and should stay below 20% to win the highest rating in your credit score.
The focus of your debt-to-income ratio is your “revolving credit,” mainly credit cards. Lenders are interested in seeing not just how much you owe but how close you are to maxing out your line or lines of revolving credit. Even if your debt-to-income ratio falls within an acceptable range, having all your credit cards near their limit every month signals to a lender that you're operating at the fringes of your creditworthiness.
Length of credit history. In short, longer is better. Just as you trust a long-time friend more than a recently met acquaintance, lenders take comfort in seeing a long, stable credit history. This is why many financial experts recommend hanging on to your oldest credit account-it provides the most complete picture of your credit history.
Being new to the credit world is not a black mark, but the absence of a long credit history makes it difficult for a potential lender to reward your track record. Borrowers often fret over negative factors, but your credit score is equal parts reward for a positive credit history and negative marks for credit issues. If you're just starting out, you shouldn't expect to have a high credit score. It takes time to accumulate a solid history of repayment through various credit channels to earn the top rating.
New lines of credit. Everyone expects to open or close lines of credit from time to time. Credit agencies become wary only when they see closely timed, repeated “hard inquiries” on your credit report. Why? Because to the credit agency, it suggests a borrower that's overly anxious to increase their debt, which may be a sign that they're spending too much or haven't demonstrated sufficient restraint to take on-and pay back-more debt.
Checking your own credit or other “soft” credit inquiries will not negatively impact this portion of your credit score. Still, apply for new credit only when you need it.
Types of credit. Many potential red flags in your credit report relate to taking on too much debt. But one positive factor is having active accounts across several types of credit. A diverse array of well-managed credit accounts demonstrates to lenders that you have experience managing credit and are more likely to pay back additional loans. It's a case when something is definitely better than nothing.
A good credit mix might include a credit card (revolving), a home loan (secured), and a student loan (installment)-all with strong payment histories and, in the case of the charge cards, moderate balances.
What affects your credit score
We've already touched on some elements that may impact your credit score, but there are also cases when credit issues extend beyond high balances and late payments. These more serious credit challenges may result in collections, charge offs, lawsuits, or even bankruptcies.
Potential lenders are able to see the specific details of these more serious credit issues, which can help add clarity, and exemplifies why your ability to secure a loan depends on more than just a number. For auto loans, the most important factor a lender considers is whether you've had a previous repossession of a vehicle. Since the focus of the auto lender is repayment on your car-not a home entertainment system or, given the financial crisis of the late 2000s, even mortgage payments-seeing a successfully repaid vehicle in your credit history is one of the strongest signs for those with less-than-perfect credit.
If you're emerging from bankruptcy, you will start with the lowest possible credit rating. A note in your credit report about the bankruptcy stays in place for about six or seven years following your first bankruptcy. Additional bankruptcies may stay on file for up to fourteen years. While a bankruptcy in your credit report presents a challenge to securing additional credit, it's not an impassible hurdle and highlights the importance of other factors in determining your eligibility.
What is not part of your credit score
Your credit worthiness is about more than just a number. The five primary factors your credit score considers leave out important information. After all, the purpose of the score is to help a lender determine whether you're likely to pay back a loan, and your credit past is not the only variable.
For example, your credit report does not include your income or current employment status. Nor does it report the interest rate on your credit card, or whether you've completed courses to learn more about financial planning or credit management. (Alternatively, it doesn't include information about additional financial obligations, like alimony, either.)
By law, your credit report cannot contain information about your race, religion, national origin, gender, or marital status, or report on any public assistance you may be receiving or have received in the past. Some credit reports may include information about your age, but that information cannot be used to discriminate against the elderly.
This is why connecting with a lender personally gives both parties the opportunity to create a fuller picture of your credit situation-you are more than your credit score.
Let's work toward a credit solution together. Start by filling out our fast-and-easy online credit application today!
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