Without credit, our economy would come to a screeching halt. Are you curious about credit scores and how they are calculated? We will take a look behind the curtain and show you how to make the most of your credit score.
The top credit reporting agencies in Canada
There are two major credit reporting agencies in Canada, and the USA has three. The top agencies in Canada are TransUnion and Equifax. We will focus on Equifax for this conversation, but each agency has its unique approach to credit scoring.
Variables that influence credit scores
Credit scores are three digits that indicate how responsible a person is with their financial obligations. If you pay cash for everything, you would not have a credit score. That is not a good idea. Credit scores are signals to lenders and others that you are responsible with money.
Equifax has a scoring range of 300-850, where 300 is terrible, and 850 would be someone with perfect credit. However, the average Canadian has a score in the 660s, so you should keep tabs on your credit score. Arguably, the most influential variable that impacts credit scores is the repayment history.
The rationale is that past behaviour is an excellent indicator of future behaviour. Therefore a person who has always paid their debts on time will most likely continue to do so in the future. It is an assumption that lenders will make.
Another variable that impacts a credit score is the type of credit. There are two types of credit accounts:
- Credit cards and lines of credit are commonly referred to as revolving accounts or revolving lines of credit. A consumer would use these facilities then pay the balance when due. When the balance has been repaid, the consumer can use the funds again. This “revolving” is what gives the account this classification.
- Installment payments or installment accounts are car loans, furniture purchases, etc. The borrower makes regular payments at predetermined intervals, and with each payment, the balance outstanding is reduced.
Consumers who do not have both of these types of accounts will not have a high credit score.
Credit utilization ratio
The amount of debt that a consumer is carrying will impact their credit score. For example, if the total amount of credit available was $10,000 and the total balance outstanding was $5,000, the credit utilization ratio would be 50% which is relatively high. Industry experts recommend keeping your credit utilization ratio between 30% and 40%.
How credit scores are calculated
Each credit reporting agency has its unique scoring card. To make things even more complex, each lender will specify what type of credit profile they are looking for in prospective customers. This lack of standardization leads to scoring inconsistencies.
For example, a person could have a credit score of 680 when signing into their Equifax account, but the credit-granting establishment may only see a credit score of 650! What gives? What can you do about it? Since there are no standardized credit scoring models that are universally accepted, it truly is consumer beware. This can be problematic when a consumer has a borderline credit score and is applying for mortgages.
Real estate prices in Canada are at epic highs, and most Canadians do not have the 20% down payment needed for a mortgage. As a result, the only way most Canadians can buy a home is by qualifying for CMHC insurance. The minimum credit score needed to qualify for a CMHC insurable mortgage is 600.
Back to the lack of standardization. The majority of lenders look at credit reports from both Equifax and TransUnion. It is possible a borrower could have a 700 score with Equifax and a 600 with Transunion. These disparities are a cause for some financial anxiety because lenders make their decisions solely on these scores.
When applying for a credit, the lender will usually make an instant decision. Artificial intelligence is used to make a credit decision based on the information provided; it is unbiased and very cost-effective. The software will pull the credit report from the participating credit reporting agency, and if the borrower meets the requirements, credit is granted. Theoretically, a borrower could have an 850 credit score and still be declined.
How to access your Equifax credit report and score
This is a simple process; there will be an identity verification step. You will be prompted to answer questions that only you would know, like the last four digits on a credit account you currently have. Once you pass the identity verification step, you can order a copy of your credit report and score. The score you see on this report is not the same score that lenders will see, but it will give you insight into where you stand.
How to protect your credit score
Poor credit can make life more difficult, borrowing costs are higher, and there are some jobs that require a good credit score. This is why measures need to be taken in order to safeguard your credit score. Check your credit report and score at least once a month. Identity theft is a real issue, so never give out personal information to anyone you don’t know.
Suppose there are errors on your credit report, which can happen. You will need to follow the dispute process to have those mistakes removed. The law requires that all credit reporting agencies remove valid errors in a timely manner, but you need to bring the error to the reporting agency’s attention.
Should you have a low credit score, do not fall prey to companies that are selling credit repair services over the internet. These firms typically abuse the dispute process in the hopes of getting negative items removed from your credit report. Of course, when negative items are removed, your credit score will naturally rise, but these tactics could have long-term repercussions.
Now that you understand how credit scoring works, take pride in the fact that you have good credit. If your credit score could use a boost, there are steps you can take to remedy it. It takes time and concerted effort.
Credit allows us to have a better quality of life and helps make the economy function, just remember that credit is a tool and must be used responsibly. If you keep your debts under control, your credit score will soar, which will drive down borrowing costs whenever you need credit.