You’ve most likely heard the term “credit score” in conversations about debt or borrowing and understand that it has an effect on our ability to take out loans and get a mortgage and that it’s important to maintain good credit. Do you know how your credit score is calculated or how to ensure your credit information is accurate? If you don’t know, you’re not alone. Your credit score is a judgment about your financial health at a specific point in time. There are many ways to calculate your credit score, but the most common method is called the FICO Score. The FICO score was developed by the Fair Isaac Corporation, which uses statistics to measure the risk of someone defaulting by taking into account different factors in a person’s financial history. Your credit score falls on a scale of 300 – 900. The higher your number, the better your credit score. This method is used by TransUnion, one of the major credit-reporting agencies in Canada. Equifax Canada uses a similar method called the Beacon Score. Whether or not you are just starting to establish your credit or you have a long credit history, your credit score should always remain a priority.
Reviewing your credit annually ensure that all of the information is accurate and that there are no unauthorized discrepancies. In some cases you can have a message added to your credit bureau for fraud prevention that ensures any credit applications presented need to be phone verified. This diligence on your part could actually save you thousands of dollars.
Understanding how your credit score is calculated will also help you maintain a good rating for when you may need to go to a lender and ask for a mortgage or loan. Though the true calculation of the FICO score is a secret and probably far too complex for most to understand, here are the elements we do know:
Payment History – 35%
Your ability to pay off your debt, like credit cards and phone bills, plays a big role in your credit score. It’s important to always pay at least the minimum payment before or on the due date. If you ever get to see your credit score, you may see a list of letters and numbers like R1, O2, or I1, which are your credit ratings. The letter indicates the type of credit you are using (R=revolving credit, I=installments, O=open credit). The number ranges from 1-9. 1 meaning you pay within 30 days of payment due date, 9 meaning your credit’s been placed for collection or bankruptcy.
Credit Utilization – 30%
Credit utilization is the ratio between the amount you owe and the credit limit you have (on all accounts). If you are over your limit this will have a significant impact on your score, or alternately using 90% of your approved limit will also have a negative effect.
Length of Credit History – 15%
According to the Financial Consumer Agency of Canada, research shows that consumers with longer credit histories have lower repayment risk than those with shorter credit histories. It’s a good idea to keep some credit cards you’ve had for a long time. Closing long standing credit cards may inadvertently affect your score.
Inquiries – 10%
Ensure that you are not applying for credit cards or credit products that you have no intention of using. Having too many credit inquiries (any time you apply for a loan or credit card) can hurt your credit rating as it infers you are a large credit seeker. Your score does not lower with every credit inquiry. How inquiries affect your score will depend on other factors like your payment and credit history.
Credit Mix – 10%
Having various types of credit shows your ability to manage a variety of credit. A mortgage, secured car loans and unsecured credit are considered good debt, debt that was incurred for something that will increase in value (mortgage for a home) or contribute to your overall financial health (student loan). Bad debt is anything that may lead to an unhealthy financial situation, like payday loans and any form of cash advances.
As I mentioned, the cost of bad credit can be significant. Take for example: you’re applying for a mortgage and your FICO score is less than 600, there is a chance you will not be approved for credit from an A lender (major lenders, like banks). You will then have to consider making you application with what is known as an alternative lender (B lender). The rates are higher (likely 1.5% higher than posted rates) based on the possible credit risk that you have been assessed at. That’s thousands of dollars of interest that you would not have to pay if you had a good credit score! Making sure you have a good credit score is very important, but there are many factors that go into getting you a mortgage.