You know you have a credit score, you may have even checked it once or twice, but do you know how your credit score is calculated? Do you know how lenders use your credit score?
Credit scores are a valuable way to show lenders that you are a responsible consumer. For example, when you go to purchase a home and require a mortgage, your credit score can be a significant factor in your approval. However, there is quite a lot that goes into this mysterious number that helps lenders identify your credit worthiness as a customer.
What is a credit score?
Credit scores can range from 300 to 900 points. A low score could mean that you are just beginning to build your credit – for example, when just getting your first-ever credit card. It could also mean that you’re not paying your bills on time. Higher scores demonstrate a better capacity to manage debt in the eyes of a lender. You can check your credit score for free on a few Canadian sites, such as Credit Karma, Borrowell, RateHub and Mogo.
The companies that monitor your credit are Equifax and TransUnion. Known as credit bureaus, they also calculate your score based on a few specific factors:
● Your payment history - do you pay your bills on time?
● Debt levels - how much do you owe, and how much credit are you using?
● Your history of credit - how long have you had credit?
● Public records - have you ever filed for bankruptcy?
● The number of inquiries into your credit file - how many times have you applied for credit?
What do the numbers mean?
A number of factors are used to determine your credit score. Your payment history is worth 35% of your score, and this includes information about credit card repayments, the types of credit you currently hold, and whether you’ve made your payments on time. Credit bureaus will consider if you tend to be late making your payments, how much you currently owe, and how often you miss payments. These are identified as delinquencies on your credit report.
Credit utilization – or how much credit you use versus how much is available – is worth 30% of your credit score. The credit bureaus see you as less of a risk if you hold less than 30% of your available credit. Therefore, if you have a credit card with a $1,000 limit, you need to keep your balance below $300. If you hold a surplus above the 30% threshold, your credit score is at risk.
Your credit history, which keeps track of how long you’ve held credit, is worth 15% of your credit score. Credit bureaus will include your oldest credit card which shows lenders that you’ve been able to manage and maintain credit for an extended period. Therefore, if you were to cancel your oldest credit card, your credit score may drop for a short period.
Another factor that helps to determine your credit score are public records, and this information is worth 10% of your credit score. If you’ve ever filed for bankruptcy or had a file go to a collections agency, this will negatively impact your credit score.
The final factor that affects your credit score is credit inquiries, and this is worth 10% of your credit score. Credit bureaus monitor every time someone accesses your credit report for review. They track this activity because it may mean that you are applying for more credit or another loan. Some credit checks are soft, which means they do not impact your overall credit score, whereas other credit checks are hard, which means that they will affect your overall score.
Why does your credit score matter?
Now that you know what your credit score is and how credit bureaus calculate the magic number, you’re probably wondering why it even matters? We don’t blame you. It can seem quite tedious to have your financial life limited to a three-digit number based on your credit card and borrowing habits — however, your credit score matters for a few reasons.
If you have a low credit score, the rates lenders offer you may be higher than you would expect, or it may be difficult to secure a loan at all. If you plan to buy a home or acquire a new vehicle anytime soon, you need to take care of your credit score. The higher your score, the more likely you will be an attractive borrower in the eyes of the lenders.