Credit Score 101
How to Get & Maintain a Healthy Credit Score
Your credit score is the most important number to manage in the financial aspect of your life.
If a blood test is a good indicator of how healthy you are, your credit score is the most critical indicator of your financial health and well-being. Your credit score needs to meet a certain threshold for you to be considered financially healthy by financial institutions.
What Is A Credit Score?
A credit score is a three-digit number, ranging from 300 to 900, indicating your creditworthiness, i.e. how good you are at returning the money you borrowed from financial institutions. The higher your score, the better.
In Canada, two main credit bureaus keep track of your credit score - Equifax and TransUnion. The way you build your credit score is simple. Every time you apply for a credit/loan at a financial institution, this information is recorded by the financial institution and sent back to these two credit bureaus. The financial institution keeps track of how you utilize your credit and if you pay them back on time and keeps forwarding this info to Equifax and TransUnion, who then use this information to calculate your credit score. Your score increases for any good financial behaviour (paying back your credit, utilities and debt on time). Your score gets downgraded for any “bad” financial behaviour (late payments, taking out more and more credit, defaulting on your payments).
Here are the credit score ranges utilized by Equifax and TransUnion:
- 300-579
- 580-669
- 670-739
- 740-799
- 800-900
Generally speaking, a credit score below 670 (so credit scores categorized as “Poor” and “Fair”) is considered to be below average. Individuals in this category often face challenges obtaining credit and loans from financial institutions. Even if they can get a credit line, they have to pay sky-high interest rates on their debt as financial institutions deem them high-risk, i.e., they consider them very likely not to pay their balance on time and fully.
Thus, the higher your credit score, the better the conditions under which you can take out a credit or loan in your name.
Unfortunately, often, individuals won’t pay enough attention to their credit score until they have to apply for a larger loan, like a car loan or mortgage. While managing your credit score seems extremely challenging, once you understand the credit score do’s and don’ts, you’ll be better equipped to take the first steps towards (re)building it.
What Affects My Credit Score?
Equifax and TransUnion have developed proprietary algorithms for measuring credit scores. These algorithms are not public, but generally speaking, these are the things that have the biggest impact on your credit score:
1. Your payment history
Your payment history has the most significant impact on your credit score. On-time payments on your credit, loans, and utilities boost your score. Missed or late payments or accounts sent to collections negatively affect your score.
2. Credit utilization
Credit utilization, or your credit utilization ratio, is a percentage showing how much of the credit you’ve been approved for you’re actually utilizing. You calculate it by dividing your total credit balance by your total credit limit and then multiplying it by 100 to get a percentage.
The lower this number, the better. Your goal is to keep it below 30%, but ideally, you’d want it to be below 10%
For example, let’s assume you have the following three credit accounts:
- Credit Card #1: Limit $7,000, Balance $1,000
- Credit Card #2: Limit $2,000, Balance $500
- Line of Credit #1: Limit $35,000, Balance $7,000
- Line of Credit #2: Limit $10,000, Balance $1,500
Your total credit balance is equal to $1,000+$500+$7,000+$1500=$10,000. Your total credit limit is equal to $7,000+$2,000+$35,000+$10,000=$54,000. Your credit utilization, in this case, is equal to ($10,000/$54,000)*100=18,52%
3. Credit history length
Generally speaking, the longer your credit accounts have been open, the better. Credit bureaus look at the age of your latest credit account, as well as at the average of all your existing credit accounts. A longer history of responsible credit account utilization without late or missed payments), positively reflects on your credit score.
Also, be vary of the fact that closing old credit accounts can cause a temporary dip in your credit score, as closing such an account can affect your credit utilization percentage.
4. Your credit mix (10%)
The more different types of credit you have taken out (for example, credit cards, car loans, mortgages) and been able to repay without late or missed payments, the better this reflects on your credit. This shows you can handle multiple lines of credit in a financially responsible way.
5. New credit inquiries
Beware of making too many new credit inquiries in a short period of time, as this may indicate that you are experiencing financial troubles and can temporarily lower your credit score.
How Can I Improve My Credit Score?
The good news is that your credit score and report are working documents, and you can rebuild them with some financial discipline. Thousands of Canadians successfully rebuild their credit scores with responsible financial planning.
Here are some tips to improve your credit score and keep it healthy:
- Pay your bills on time every month. To facilitate this, set up automatic payments or a reminder on your calendar to pay your bills on time.
- Irresponsible credit card utilization is the top reason so many Canadians struggle with maintaining healthy credit scores. Keep your credit card balances below 30% of your credit limit. Regularly clean your balance to avoid late and missed payment fees. Avoid maxing out your credit cards.
- If you’re struggling with too much debt, focus on paying off debt with the highest interest rates first. These are typically credit card interest rates. Also, consider whether transferring your existing credit card balances to a card with a lower interest rate would pay off. Keep in mind that fees apply for every transfer, so carefully calculate how much this would benefit you.
- Check your credit report regularly. You can actually request your credit report from Equifax and TransUnion once a year. Carefully check for errors on your credit report, as these can hurt your score. Dispute any errors you find.
- If you have a short credit history or are entirely new to credit, consider getting a secured credit card. With a secured card, you'll need to make a deposit upfront, which is collateral for your credit limit. Regularly paying with a secured card can help build your credit history and improve your score.
Conclusion
Understanding your credit score, how it’s calculated, and how you can (re)build it is the crucial first step toward maintaining healthy finances. Remember always to be careful when utilizing credit and ensure you earn enough income to avoid late or missed payments or defaults.
Remember, the higher your credit score, the better the conditions under which you can take out your next loan. This is especially important if you’re considering a mortgage to finance your home purchase. Mortgages are long-term financial commitments, and having an above-average credit score will get you lower interest rates and better terms, resulting in a more stable financial situation in the long run.
