Your credit score informs lenders of your credit worthiness. Otherwise known as the likelihood of you paying back your debts. The credit score is a tool to determine a pattern of behaviour for any given borrower. So, naturally, if you are in the market for a new home, you may be interested in knowing not just what your credit score is, but how your credit score is calculated. Many Canadians don’t know that this one number determines what financial opportunities are available to them. This leads to the question; How is my credit score calculated?
There are five main categories to determine your score:
- Payment History (35%)
- Credit Utilization (30%)
- Credit History Length (15%)
- New Credit Requests (10%)
- Credit Mix (10%)
These five aspects together will paint a complete picture for lenders. This picture will determine their choice in whether or not to lend to you. As well as the terms you may be offered.
Payment History (35%)
Your payment history makes up the vast majority of your credit score. Every payment you make toward your debts, such as mobile phone bills, credit cards, student loans, and mortgage payments are reflected on your credit report. This means that your credit history is not only the most influential factor of your credit score, but that it is both the easiest to damage or maintain. Unfortunately, it’s also the hardest to improve. If you have a history of delinquent payments it could take several years to restore your credit. It should also be said that not all hope is lost if you, like many Canadians, do have a history of delinquent payments. Getting your credit score back on track requires consistency and time.
How long does this history affect my score?
It depends on the activity. Positive information may stay on your credit report indefinitely. Negative information typically sticks around for 6-years. This shows that it’s often easier to maintain your credit score than trying to repair it after the fact. Over time you will rebuild your reputation through paying bills on time and keeping the other factors listed here in mind.
The reason your payment history weighs so heavily on your report is that it paints a picture of your money habits. A discerning creditor can look at your payment history and determine if delinquent payments are a pattern of behaviour or simply clustered among a particularly bad period of time. The narrative is especially helped if there is a return to normal activity after a period of delinquent payments. Your history establishes a pattern of behaviour for better or worse and will ultimately determine your financial future. A lender wants to be confident that you will repay your debt. The less confident they are increases the perceived risk and often will lead to being approved for lower amounts or higher interest rates.
Credit Utilization (30%)
The second weightiest item on your credit score is how much you currently owe relative to available credit. This ratio of debt to availability is called your credit utilization ratio. This includes everything you owe from a retail rewards credit card to your student loans. Just like your history tells the lender about your patterns of behaviour, the amount you currently owe informs the lender if you currently owe within or above your means.
This follows common sense on part of the lender. If you are living above your means, you will have a harder time paying off your debt. This might lead you to use more than an acceptable amount of the credit you have available. For reference, you should try to keep your credit utilization to less than 50% of your available credit. This shows that you can responsibly manage your credit and are not living beyond your means.
Credit History Length (15%)
The reason this is weighed is to speak to the habits of a borrower. Unfortunately, those who have no credit history may find their score suffer due to this. Alternatively, if your credit history stretches back a decade or more, it will give lenders a very good picture of your money habits. Lenders assess risk by understanding your short-term and long-term financial habits and this will help them understand your risk. As mentioned above, most negative activity will disappear after six years. However, sustaining a positive relationship with lenders for that time or even longer will reflect well in your credit report. If you are considering closing a credit product, always be sure to keep your oldest credit line active. This will ensure you have a strong history of repayment and this will increase lender confidence.
New Credit Requests (10%)
When you submit a request for new credit, sometimes in the form of an increased limit or a new form of credit, this can trigger a “hard pull”. This type of request will have a short term negative impact on your credit score. Shopping for credit is a concern for lenders. If you were to apply for several different forms of credit in a very short time period it signals to them that there may be something wrong. This might lead a lender to believe that you do not have a good handle on your financial needs, increasing your risk to the lender. New credit requests, otherwise known as hard inquiries, can stay on your credit report for up to 3-years.
Credit Mix (10%)
Your credit mix makes up the final 10% of your credit score. Your credit mix is the types of credit you currently have. Variety in your credit mix shows that you can manage different types of credit responsibly. When it comes to applying for a mortgage, lenders will like to see a history of instalment accounts as they are similar to what you will expect with a mortgage payment.
Some examples of credit accounts are:
Revolving Accounts: Revolving accounts include things like credit cards and lines of credit. These have broad repayment requirements and once you make a repayment, the credit limit is available to use again in the future.
Instalment Accounts: These types of accounts include student loans, fixed term loans, and mortgages. There is a specific number of payments over a specific period of time and you do not have access to the original credit amount once a payment on principal has been made.
Open Accounts: These accounts do not have a fixed limit or interest rate applied directly. These can include things like charge cards and phone bills where you are expected to pay the balance owing in full.
Managing your credit score and understanding how you can improve it will open many doors for you financially. This can include getting you that mortgage for your dream home! If you have any questions about your credit you can receive your credit report for free, without impacting your score, from Equifax or TransUnion. Though the educational tools on that website are quite robust, there is no substitute for a financial professional. If you are looking to get your credit in order for a mortgage, give me a call at (705) 333-4338 or get in touch with me here!