Island Savings

Understanding Your Credit Score and Why It Matters



According to an Ipsos survey, more than half of all Canadians have never checked their credit score and 7 in 10 don’t know their current score. Those numbers should give us pause, especially considering that consumer debt levels in Canada continue to climb. But perhaps the most telling statistic of that study is that of those who don’t check their score, 40% would rather not know it.

A large part of achieving financial wellness is understanding your credit score, what it means, how it’s calculated and learning practical strategies to improve it.

Understanding debt utilization ratio and the difference between hard checks and soft checks or between revolving credit and installment credit are just a small part of the story when it comes to seeing the full picture of your credit.

“We find that the biggest issue members are facing today is that they are over-utilized on revolving credit, so that means lines of credit and credit cards,” says Barbara Fabian, Assistant Branch Manager at Mayfair. “Another common issue we see is cell phone bills. Many people don’t realize that cell phone companies report to their credit bureau and they report often. It just takes a couple of missed cell phone payments to damage your score.”

Fabian says there are simple steps people can take to improve their credit score but before we explore some of those strategies, we’re going to look at what makes a good score, how it’s calculated, where you can check yours, and why it all matters.

So let’s give credit where credit is due and start there.

What is a good credit score?

Your credit score is used by lenders to determine what kind of borrower you are. It can affect your eligibility for certain loans or credit cards as well as the interest rate you get.

In Canada, your credit score ranges from 300 to 900, 900 being a perfect score.

If you have a score between 780 and 900, that’s excellent.

If your score is between 700 and 780, that’s considered a strong score and you shouldn’t have too much trouble getting approved for the loans you need with a great rate.

When you start hitting 625 and below, your score is getting low and you’ll start finding it more and more difficult to qualify for a loan.

What does a low credit score mean?

A low credit score doesn’t mean you’ll never be able to borrow. Some places might still lend you money, although at a higher interest rate.

This is one of the ways you’ll find your credit score really matters: the better your score, the less you pay on interest.

In other words, a good credit score helps you save money.

How is your credit score calculated?

Your credit score is calculated using five factors: payment history (35%), debt utilization ratio (30%), credit history (15%), credit application frequency (10%) and credit diversity (10%).

Most of the information is automatically removed after 6-7 years (although not purged) so that student loan payment you missed 20 years ago won’t be haunting your score today.

1. What’s your payment history like?

This is obviously the most important factor affecting your credit score. Prospective creditors want to know that you are going to pay them back. Your payment history covers all of your consumer debt: credit cards, lines of credit, student loans, car loans, cell phone payments on contract, etc.


CREDITORS WANT TO KNOW

  • Do you pay your bills on time?
  • How frequently do you miss a payment?
  • How many times have you missed a payment?
  • How old are your missed payments?

Find out what happens if you’ve missed a credit card payment.

2. How much do you currently owe?

When creditors look at how much you owe, they’re trying to determine whether or not you are able to take on more debt. Are you able to manage with more?

Besides looking at the amount of debt that you currently have, lenders will look at what’s called debt utilization ratio: that’s the amount of credit you’re using compared to the amount that’s available to you.

For example, if you have a credit card limit of $5,000 and you’re constantly hovering at $3,600, then you’re using 75% your available credit on an ongoing basis. To a creditor, that indicates that you’re struggling to pay off your existing debt.

Creditors will also look at how much outstanding debt you have compared to how much was available to you.


CREDITORS WANT TO KNOW

  • How much in total do you currently owe?
  • How much are your payments?
  • How much of your available credit do you use on an ongoing basis?

3. How long is your credit history?

Creditors want to see a long established history of managing credit. There’s nothing more frightening to them than somebody walking out of the woods without any credit history.

That’s what this 23 year old who had an $80,000-a-year job, no debts and enough money for a 20 percent down payment on a $400,000 home found out when he tried to get a mortgage.

“When you have a credit history, lenders know what to expect from you,” Fabian explains. “They know your behaviours and what kind of borrower you are.”

A good credit history is built over time. That’s something you can’t lifehack.


CREDITORS WANT TO KNOW

  • How long has it been since you first obtained credit?
  • How long you’ve had each account for?
  • Are you actively using credit now?

4. How frequently are you applying for new sources of credit?

Frequently applying for credit is a flag for creditors. It tends to signal financial difficulty rather than stability. If you frequently sign up for new credit cards, loans or other forms of credit, lenders may conclude that you're not able to manage your money.

There are two kinds of credit checks: hard checks and soft checks.

Soft checks are when you or a third party are reviewing your credit for non-lending purposes (eg. prospective employer, etc.). Soft checks don’t affect your credit score.

A hard check happens when you’re looking for credit. If you’re applying for a new loan, a new credit card, looking to finance your new computer, negotiating your new cell phone plan...the lender will check your credit by initiating a hard check. Hard checks hurt your credit rating.


CREDITORS WANT TO KNOW

  • How many times did you request a hard credit check in the last 5 years?
  • How many credit accounts have you opened recently?
  • How much time has passed since you last opened a new account?
  • How long ago was your most recent inquiry?

5. What kind of credit have you used?

The kinds of credit you use can say a lot about how you handle your finances. There are two kinds of credit: revolving credit and installment credit.

Installment credit comes in the form of a loan that you pay back regularly (once a month, bi-weekly, whatever it may be). The amount of the loan is set when you are approved and the sum that you borrow doesn’t change.

Revolving credit on the other hand is not a predetermined amount. You will have a credit limit that sets how much you can borrow up to, but you can pay it off and spend it again indefinitely.

Having high levels of revolving credit is not the same as having equal levels of installment credit. The latter is considered more secure.


CREDITORS WANT TO KNOW

  • Do you have high levels of revolving credit?
  • Do you use deferred interest or payment plans to pay for large purchases?
  • Do you resort to loan consolidation services?
  • Do you access payday loans or other unsecured loans?

How do you check your credit score?

Nearly half of Canadians (47%) don’t know where to check their credit scores.

In Canada, your credit score is calculated by two different credit bureaus: Equifax and TransUnion. You can request a free copy of your credit report by mail at any time from both (see instructions from TransUnion and for Equifax) though your credit score is not included on the reports.

To see your credit score, you have to pay for the online report (Equifax charges $23.95, Transunion bills $19.95 a month for Credit Monitoring that you can cancel at any time).

Recently some companies such as Mogo, Borrowell and Credit Karma have offered to give you your credit score “for free.” In exchange, you do have to give them the most valuable currency in the digital age: your personal information.

How do you improve your credit score?

When you understand how your credit score is calculated, it’s immediately easier to see how you can improve it. That’s the good news: no matter how bruised your score is, there are a few relatively easy ways that you can change your behaviours and improve it.

Make regular payments

One of the easiest ways to improve your credit score or to build it from the ground up is to make consistent, regular payments on time over time. These are things that potential lenders love to see: consistency, dependability, regularity and history.

When it comes to credit cards, the best financial advice is always to pay it off every month (or twice a month) so you’re never running a balance.

This is one of the best habits to get into because you’re always paying down your debt.



Close your newer accounts

If you have several credit cards and you’re thinking about closing one (or several) of them to help you manage your debt a little better, it’s more advantageous for your credit score to close the most recent one. That way you can maintain the history with an older account.

There may be better reasons to close your older accounts (higher interest rate, annual fee, etc.) in which case just consider your timing: if you know you’re going to buy a new car in a couple months or get a new cell phone contract or a line of credit for whatever reason, wait to close that older account until after so you can go in with your credit looking as good as possible.

However you do it though, canceling a credit card will always have an immediate negative impact on your credit score because you are reducing the amount of available credit and usually increasing your debt utilization ratio.

Accept an increase on your credit limit

Improving your debt utilization ratio is one of the fastest ways to build up your credit and you could see your score go up 30-50 points within 30 days.

The ideal debt utilization ratio is 30%, but it’s best to keep it below 10%.

The best way to do that is obviously to pay down the balance. You can also accept offers to increase your credit limit.

If you’re calling in to ask for your credit limit to be increased, that’s a little bit different as you’ll initiate a hard credit check and that will hit your credit score. But credit card companies will often offer their customers an increased limit.

Use different kinds of credit when possible

Remember that revolving credit is considered to be less secure than installment credit.

Which do you think a lender would rather see on your credit report: a credit card or a student loan? A line of credit or an RRSP loan?

If improving your credit score is your goal then you want to diversify your sources. It doesn’t have to be a lot. A small loan that you pay off within 12 months will go a long way. Just think outside of the credit card box (or consider a secured credit card).

“Especially if you are just starting out with no credit, an RRSP loan is one of the best tools at your disposal,” says Fabian. “It’s a big win as it helps you build a great credit history while starting your RRSP savings.”

Find out if an RRSP loan is right for you.

Why your credit score matters

Improving your credit score is not a waste of time. When you understand your credit score, how it’s calculated, you start to think a little more deeply about the debt you might be considering.

Not only that, but working to improve your credit score is not a pointless exercise to game the system. It’s about developing strong financial habits that will help you as you continue your journey towards financial wellbeing.

When it comes to credit, the most important rule is this: don’t bite off more than you can chew. If you are concerned about taking on more debt, or if you know that you struggle to pay down your credit cards and that a credit limit increase might be more harmful than beneficial, those are valuable flags that you ought to pay attention.

If you are struggling with debt and are concerned that your only options to dig your way out seem to be to take on more debt, visit us in branch and talk to an expert. We are here to help educate you about the options that are available to you, to help you make the best decision possible and make a plan to pay it off.

 

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