How Credit Scores Are Calculated

Your credit score is used by financial institutions to determine how risky it is to give you a loan, and it can have a large impact on your life. Those with high credit scores are seen favourably by lenders and enjoy low interest rates and an easy time getting approved for loans. Those with low scores often have a hard time getting approved at all and will pay much higher interest rates if they do get approved. Understanding how your score is calculated and taking the proper steps to ensure you have a high score is crucial to your financial health.

Your credit score in Canada is calculated using a proprietary formula with data collected by two credit bureaus, Equifax and TransUnion. Scores fall between 300 and 850.

How is your Score Calculated?

Several factors go into determining your score. It is important to know that your score can fluctuate daily as different lenders are constantly updating the data they are sending to the credit bureaus. Small changes typically are nothing to worry about, as lenders lump together consumers based on ranges of the scores. Similarly, it is not important to try to get a perfect 850 score. A 850 score realistically cannot be obtained without opening dozens of accounts that you most likely will never use, and a 850 score will not get you any better loan terms than an 800 as both scores are considered excellent.

Even though the exact formula is secret, the bureaus do publish the five factors that go into calculating a score and the respective weights each factor contributes to your score.

Payment History

The largest factor is your payment history which accounts for 35% of your score. Anytime you get a loan, the lender reports whether or not they received the payment on time on a monthly basis. If it is more than 30 days late, it will be reported as such.

Lenders can report 30, 60 or 90 days late, or they can report a “charge off.” A charge-off is when the lender assumes they will not ever see the loan paid off and consider it a loss. Often when a lender charges off a loan, they sell it to a collection agency for pennies on the dollar, and the loan then becomes due to the collection agency.

Late payments stay on your report for seven years and will have an enormous negative impact on your score. It is imperative to pay your bills on time. Payments within a 30 day grace period will not be reported as late, but anything after 30 days can be. Even if you catch back up, the late payment will stay on your credit report.

Credit Utilization

The second most important factor in your credit report is credit utilization. On revolving accounts, such as credit cards, credit utilization is the percentage of your credit limit that you are using. For example, if you have a $5,000 credit limit, and you carry a $2,000 balance, that is a credit utilization of 40%. On instalment loans, credit utilization is the amount of the loan that has yet to be paid off. If you take out a car loan for $20,000 and you still owe $15,000, that would be considered 75% credit utilization.

For the highest score, keeping your credit utilization under 35% is recommended. On instalment loans, that typically is much harder to control, but for revolving credit, a best practice is to keep the balances low.

Credit History

The next factor is credit history, contributing 15% to your score. Credit history is the length of time your accounts have been open. Both the average age of your accounts and the oldest account contribute to your score.

Lenders want to see borrowers with a long history of paying their bills on time. Opening a large number of accounts at once can have a big impact on lowering your score because all of those new accounts will bring your average age way down. Likewise, older accounts will bring up your average age, so it can be a good idea to keep older revolving accounts open even if you do not use them anymore, as closing them will cause the average age of your accounts to decrease, thus lowering your score.

Sometimes credit cards come with an annual fee, and keeping an old account open and paying the fee just to keep your average age of accounts high may not be worth it however. Remember scores are judged in ranges, so it is unlikely closing one old account will bump you down to the next range, especially for a long time, so that is something to keep in mind if you are thinking of closing an old account.

Credit Mix

Your credit mix, or types of credit, accounts for 10% of your score. Lenders want to see several different types of accounts on your report. If you only have credit cards, for example, your score will be lower than if you also had an instalment loan, such as a car loan, on your report.

There are three main types of accounts, revolving accounts, such as credit cards, instalment accounts, such as car loans or student loans, and mortgage accounts, which are tied to an asset like real estate. Younger consumers will have a hard time getting all three types of loans on their report, but keep in mind that it is a relatively small factor, and paying your bills on time is much more important than making sure you have one of each type of account.

Inquiries

The fifth factor that goes into your credit score is the number of inquiries you have on your credit report. Anytime a lender checks your report, that inquiry stays on for two years. There are two types of inquiries, hard and soft. Soft inquiries are usually done for marketing purposes and do not contribute at all to your score. Hard inquiries are when you actually apply for a loan. These types of inquiries do affect your score. Both types of inquiries stay on your credit report for two years, but the hard inquiries only lower your score for one year.

As a general rule, it is advisable to only apply for credit when you need it. Having many hard inquiries in a short period of time is seen as risky by lenders, as it may indicate the consumer is under financial stress. It is the smallest and least important factor in your score, however, so it is okay to apply for credit when you need it, so long as you do not overdo it.

Best Practices to Maximize Your Score

So now that we know the factors that contribute to your score, let us take a deeper look into how to put that into practice. Keep in mind that your score changes daily as lenders are constantly updating the information they are sending to the credit bureaus. In addition, the exact formula that the bureaus use is also being updated periodically, as they are constantly looking for ways to improve the value that they provide to the lenders.

Since payment history is the most important factor, it is crucial to pay your bills on time. This is simply the most effective way to make sure you will have a good enough score to get approved for loans when you need them.

Let’s say you do fall behind though; all hope is not lost. Even though the effects of late payments have a huge impact on your score for a long time, you can take steps to minimize the impact. Having a 30 day late payment is not as bad as 60 or 90 day late payment. In addition, the sooner the lender stops reporting your account as being late, the sooner you can be back on track. While the late payment will stay on your report for seven years, the negative impact it has does lessen over time.

Keeping your balances low is also important if you want a high score. Maxed out cards will lower your score by a considerable margin. Showing banks you are a responsible borrower by living within your means is one of the most important ways to keep your credit score in a respectable range.

You can also increase your score if you avoid closing old accounts and avoid unnecessarily opening new ones. This will keep your credit age at the best level. Many consumers try to open many accounts hoping it will give them an extremely high credit score. While it may eventually cause the score to rise in the long term, it does lower the score in the short term.

Having many open credit accounts can also be tempting for an inexperienced consumer, and many young people have fallen into the trap of trying to raise their score by opening many accounts only to get themselves into trouble by using them irresponsibly. Again, it can be advisable to keep an old account open provided it does not have an annual fee.

Opening more than one type of account can also be a good strategy to raise your score, provided you can do it responsibly. Most borrowers typically open a credit card as their first tradeline. Adding a small instalment loan may be a good idea as well.

Say you are considering buying a used car and you are planning on paying cash. Getting a small loan with a large down payment can raise your score in a way that might be helpful later. Yes, you might pay a little bit in interest now, but if you can show the banks you are a reliable borrower, it will more than pay off later when you need a larger loan.

The last thing you can do is avoid excessive inquiries. Remember inquiries have a negative effect on your score. If you need credit, apply for it, but applying for or opening many unnecessary accounts will do more harm than good.

Credit Repair

If you have made some mistakes, there are some concrete steps you can take to put yourself in a better position. First, get caught up and make both a commitment and a plan to stay caught up.

If any accounts have gone into collection, consider paying them off as well. While it is true that a paid collection account can hurt your score just as much as an unpaid account, there are reasons to pay it off.

In addition to your score, some lenders use manual underwriting when deciding on a loan application. Manual underwriting is when the lender considers the person behind the report instead of just the data. Let’s say you have had some credit issues and after a couple of years decide to apply for a car loan. You may get automatically denied at first due to your credit score, but a car dealer who wants to sell a car will have an incentive to get you approved so they may be more lenient. If they manually underwrite the loan, and you can explain to them in a sincere and authentic way that you had some financial issues, but then tried to fix it in an honourable way and took steps to keep your current bills up to date, they may be very likely to issue a loan even with bad credit.

Once you have your credit accounts caught up, you can dispute any negative tradelines that are still being reported. While you cannot get accurate information removed, what is being reported must be accurate and verified. Write letters to both the credit bureaus and the lenders and ask them to make sure the information they are reporting is correct and verified, if they cannot do that, the negative information must be removed.

Understanding how credit works is crucial to your financial health. Those who understand it and put practices in place to responsibly use credit will never have a problem getting loans approved when they want them and will end up paying much less in interest.