Understanding Credit

How your credit score is calculated, and what you can do to improve it!

When you apply for a mortgage, there are three factors that are extremely important in the lender's decision to approve your file: credit, income, and equity (down payment).

Your credit score is extremely important as it is a quick way for lenders to decide how well you are managing the credit that has been extended to you. It provides potential creditors with information on every credit card, loan payment and late payment you've made- as well as any bankruptcies, or orderly-payment-of-debts that you have undergone. The higher your credit score, the better. Scores typically range between 400-900. Anything over 680 is considered to be "good". Mortgage default insurers (if you are purchasing a home with less than 20% down) have a minimum credit score guideline of 600 so your score will need to be higher than this if you have less than 20% down, and many mortgage lenders have a minimum required credit score of 620. Generally speaking, the higher your credit score, the lower the likelihood that you will default on your credit obligations.

There are two credit reporting agencies in Canada, Equifax, and TransUnion. These are independent companies that make money by collecting information regarding your credit history and providing it to other businesses, for a fee. Companies that you deal with report information on a monthly basis to the credit reporting agencies; this information forms your unique credit report. The information reported to your credit report includes information on your payment history as well as the balance outstanding and limit of your accounts.

The bureau monitors the activity on your report and assigns a credit score to you.

So, how is your credit score calculated and what can you do to increase it?

While each credit reporting agency (Equifax & TransUnion) is different, both rely on similar methods to calculate your credit score. Here is an approximate breakdown of the factors determining your credit score:

• Payment History (35%): It goes without saying if you pay your bills on time, as agreed, your score will be higher than if you do not. If you have a poor payment history, meaning you've missed a bill payment, had an account with a collection agency, or declared bankruptcy, or arranged an orderly-payment-of-debts; you will likely have a low credit score. The more time that passes from the negative event, the better. Your score will increase as time moves on.
• Current Debt (30%): How you manage the credit that has been extended to you, affects your credit score in a big way. It's very important not to utilize the full credit limit that has been extended to you on a credit card or revolving line of credit. The closer your outstanding balance is to the limit, the lower your credit score will be. TransUnion recommends that you keep your credit card/unsecured line of credit balance under 50% of your limit.
• Length of Credit History (15%): The longer you've had a positive history with the credit bureau, the better your credit score will be. Someone without a lengthy credit history will likely have a lower score than someone with an excellent track record for years.
• New Credit (10%): If you have a large number of inquiries (companies checking your credit reports) in a short period of time, your credit score will be lowered. Regardless of the reasons for the large amount of credit checks, the bureaus view a large number of credit checks negatively and will lower your score. It's important to not have too many credit checks in a given year. I always recommend that my clients keep their number of credit checks to 3-5 per year.
• Types of Credit (10%): Part of your credit score involves the types of credit and loans you have reporting on your credit report. A healthy mix of credit cards, retail accounts, installment loans, mortgages and consumer finance accounts is best.

So, now you know how your score is determined, what steps can you take to ensure your score is as high as possible?

• Pay your bills on time: Ensure you make at least the minimum payment, on time, every month. Every missed payment reflects negatively on your report!
• Don't max out any revolving credit accounts: As soon as you are at your limit, or close to it, your credit score will drop significantly. Try not to max out any credit card or personal line of credit accounts.
• Choose credit wisely: Limit your credit checks and don't apply for too many accounts in a year. Try to limit all credit checks to accounts you genuinely need.
• Keep an eye on your credit report: I recommend checking your credit report once a year to ensure the information contained in the report is accurate and that there aren't any errors or fraudulent accounts. You can order a free copy of your report through Equifax and TransUnion.
• Be patient: It can take a while to repair your credit report after experiencing issues. Follow the above recommendations and you will eventually be rewarded with an increased credit score!