Understanding credit and all the factors that go into it can be complicated. Yet still, credit is something almost all of us come into contact with at some point. Whether it be applying for your first credit card, financing a car purchase or applying for a mortgage – you will establish, and likely need to borrow using, credit in your lifetime.
Just because credit is common, doesn't mean it's easy to understand. So for all the credit questions you have, but are too afraid (or embarrassed) to ask; we've got your answers.
What's a credit report?
A credit report is a summary of your credit and payment activities with financial institutions and other organizations. How long have you had credit? Do you pay your bills on time? Have you missed payments? How much do you owe?
Your credit report may contain:
Your personal information such as name, birth date, Social Insurance Number (SIN) and employment information.
Your credit history including your record of paying bills and making debt payments on time.
Public record information such as registered liens for secured loans, court judgments or bankruptcies.
Your involvement with collection agencies trying to collect on your debts.
Your past credit inquiries from organizations or individuals who've inquired about your credit in the past three years.
Life hack: review your credit report at least once a year. This will help you catch errors, fraud or identity theft that could affect your ability to obtain credit.
What's a credit score and how is it calculated?
You've definitely heard the term "credit score" referenced a lot. But what is it and where does it come from? Based on your credit report, your credit score is calculated using a mathematical formula and allows a potential lender to quickly evaluate your credit behaviour. A high score indicates a lower credit risk.
Your credit score will go up or down based on five factors, which combine to calculate your credit score. Depending on who reports your credit, these factors may be weighted slightly differently, but they are:
Your payment history
This is an important factor in your score. Your history reflects all the payments you've made towards your consumer debts. This will also show whether your debts have ever gone into collections, or if you've ever filed bankruptcy.
How much you owe
Your debt load really matters to lenders because it shows whether you have the financial capacity to handle the additional payments that would come along with more credit. Another aspect that impacts this factor is something called "credit utilization", which is how regularly you're using a large percentage of your available credit. It's best to limit your credit utilization to 30% of your overall credit because some credit scoring models may penalize you for exceeding this percentage1. For example, if you had a credit limit of $5,000 you should aim to keep your total balance under $1,500.
Length of your credit history
How long have you had credit available to you? The longer you've had access to and used credit, the easier it is for lenders to judge whether or not you use it responsibly. If you're a first-time applicant, you won’t have much for a lender to go off of, but you'll build a history over time as you use your credit.
New credit applications
At first, new applications will count against your credit score, but by using them and paying them down on-time, you can improve your credit rating.
Types of credit used
This is not a significant factor, unless you don't have a lot of other information on your credit report. Different types of credit give lenders insight into how you manage your money overall.
How do I find my credit score?
There are several services that let you check your credit score and review your credit report. In Canada, the two largest are:
Each of these services typically offers a free check of your credit score and report once a year.
Is my credit score "good"?
Now that you know what a credit score is and how you can access it, you're probably wondering how does your score stack up? In Canada, a credit score can range from 300 (just starting out) to 900 (credit ninja) points.
How can I raise my credit score?
Good news! If you're not happy with your score, you have the power to change it. It's possible to positively influence your score by making responsible credit choices:
Pay your bills every month and pay them on time.
Don’t carry high balances on your credit cards, even if you’re making the minimum payments every month. Outstanding debt influences your credit score.
Avoid applying for retail cards just to save 20% on your purchase (unless you plan on using the card regularly and paying down the balance). Every inquiry for credit is kept on your credit report, and too many can cause a potential lender to wonder why you suddenly need so much credit.
Open a credit account and keep it open to establish a history of credit use. Create a pattern of making your payments on time. Remember that it takes time to establish a credit history.
Review your credit report at least once a year. This will help you catch errors, fraud or identity theft that could affect your credit score and ultimately your ability to obtain credit.
Why does credit matter?
Financial institutions use this information to decide whether they should give you additional credit (whether that's a credit card or a loan). Your credit report gives them information about how you've repaid borrowed money in the past. A prospective employer or landlord may also run a credit check as part of your application process, so your credit can also impact your job opportunities and/or your living arrangements.
Whether you're applying for a loan or mortgage, even a job, there are several factors that will impact your qualification. We call these the five Cs of credit:
- Credit history shows the lender a snapshot of what the borrower’s repayment history has been over a period of time. This is the only way a lender can predict the borrower’s propensity to make future payments.
- Character is the impression you make on the lender about your stability and willingness to repay the loan. Your character is also determined by your credit history and your history with the particular financial institution.
- Capacity is your ability to repay the money you borrow, which is determined by looking at your debt ratio. A lender calculates your debt ratio by dividing your monthly debt by your monthly income (before taxes). If your percentage of debt compared to your income is too high, it may be difficult for you to manage the payments of a mortgage or another loan.
- Capital refers to your net worth and is the value of your assets minus your liabilities. Having good capital decreases your chance of defaulting on the loan.
- Collateral is property or large assets you own that can be used to help to secure the loan. For an asset to be considered collateral it must have an account or serial number of some type and the lender must be able to assign value to it and register a lien against it.
There's another associated factor (a 6th C, if you will) that impacts your borrowing qualifications – the conditions. Conditions of the loan, such as its interest rate and amount of principal, influence a lender's decision to extend a loan. Conditions also include how you (the borrower) intend to use the money. If you apply for a car loan or a home improvement loan, you're more likely to be approved because of the specific purpose, rather than an unsecured personal loan that could be used for anything. Additionally, lenders may consider conditions that are outside of your control, such as the state of the economy, industry trends or pending legislative changes.
Now that you understand more about credit, how you build it and how it affects you, it's important to remember to check-in on your credit. You should make it a habit to look at your credit report and credit score regularly, much in the same way you monitor other aspects of your finances. Healthy credit habits play a big role in your overall financial health.