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Many people are at a loss when it comes to understanding how credit scores work. Yet that score can have a huge impact on any credit application they might make.
Not only do financial institutions check credit scores; so do employers, landlords, insurance companies, and mobile serve providers. They all want to know who they are dealing with because the higher the score, the less risk they need to take on. Hence, the better the deal they can offer.
"Here are some credit score basics and tips on how to improve your score.
CREDIT REPORTS AND CREDIT SCORES
It’s important to distinguish between credit reports and credit scores. “Credit reports act as a historical record of the loans and other credit products you have had and how well you managed them,” says Stacy Yanchuk-Olesky, CEO of Credit Counselling Canada. “They show past patterns, whereas credit scores are forward looking. They show, for example, how likely you are to pay off your debt. A strong score is built on a strong credit history.”
It’s easy to assess the strength of your credit score, because it comes in the form of a three-digit number between 300 to 900. And that score will have a significant impact on the interest rate offered by a lender, says André Bolduc, CPA, BDO’s licensed insolvency trustee.
"For example, say you want to borrow $15,000 and pay it off in 60 months," says Bolduc. "As BDO points out, if you have a score of more than 675, you will pay 6.9 per cent in interest, or $2,760. If your score is between 501 and 550, you will pay 15.9% interest, or $5,760."
As Bolduc explains, a low credit score can put you at a great disadvantage if you want to buy property. “You may need to go to an alternative lender that offers rates of 9 per cent or 10 per cent,” says Bolduc.
FACTORS THAT AFFECT YOUR SCORE
There are at least five factors that can have an impact on your score.
Your payment habits (35 per cent). By making frequent payments and paying before the due date, you can improve your score. But, contrary to what some banks suggest, don’t just pay the minimum, says Yanchuk-Olesky. “If possible, pay off the balance each month. You’ll sleep better at night.”
- Your credit usage (30 per cent). Do not use more than a third (up to 50 per cent at most) of your available credit. “If your card has a $6,000 limit, don’t spend more than $3,000,” explains Yanchuk-Olesky.
- Age of accounts (15 per cent). The older the account, the better idea lenders will have of your payment patterns. So, it can be helpful to keep a card that you’ve had for 20 years as long as there is no fee attached to it. Just make sure to maintain some activity on the card or other account—even if it’s just an automatic payment that is made every month. It’s also a good idea to make a withdrawal (on a line of credit, for example) every few months, even if you pay the money back right away. If you don’t make any transactions on these types of accounts, they’ll become inactive, usually within three to six months.
- Number and type of accounts receivable (10 per cent). It’s better to have a credit card, a mortgage, and a line of credit than to have three credit cards.
- Number of applications made (10 per cent). Be careful not to apply for credit too often because every time you apply, your score goes down—even if the application doesn’t go through. “If your application is denied and your score isn’t very high, ask a credit counsellor in a not-for-profit organization or a broker to guide you, rather than going from one financial institution to another,” says Yanchuk-Olesky.
FOLLOW SOME KEY RULES OF THUMB
It’s also important to follow a few simple practices.
- Check your credit report regularly with the two main credit bureaus in Canada, TransUnion and Equifax. The service is free and is often available directly through your online bank. You can also order your credit report by mail, online or by phone. Plus, you can check your score and find tips on how to improve it through apps such as Borrowell or Credit Karma (which work with Equifax or TransUnion). (Note that by checking your report and score on a regular basis you can reduce the likelihood of falling victim to fraud.)
Make sure your file is error-free. If you find errors in your file, contact the bureau and they will correct it. This can take time, so it’s better to do it before you apply for credit. Also note that not all lenders work with both credit bureaus, so it is best to check with each one.
- Have a credit card with your name on it. If you share a card with someone else, it won’t help you build a credit history. If things go wrong, it also means that only the owner is responsible.
- Get a second credit card. As Bolduc explains, this second card should have a fairly high credit limit. Even if you just use it to pay for one small item each month, it will help you improve your score if you pay the balance each month, he says.
- Beware of points cards. Canadians are big fans of rewards programs, and because of this they tend to ring a lot of expenses on their cards. But this could get risky if they are unable to pay off their cards, says Yanchuk-Olesky. “This is especially true when you consider that the interest rate on some cards is 25 per cent,” she says. You are better off getting a low-rate card.”
- Don’t miss a payment. If you miss a payment date or make a late payment on your credit card even just once, it could affect your credit score. And if you miss two minimum payments in a row over a 12-month period, it could lead to an increase in the annual interest rate on your unsecured credit cards and lines of credit.
While it’s important to follow the rules, you don’t need to be obsessed with your score, says Bolduc. “A score of 750 is considered ‘excellent,’ so if you reach that level you shouldn’t worry too much—especially since your score changes all the time, depending on the transactions and refunds you make,” he says.
Even so, always remember to use credit wisely. Financial institutions are always coming up with new types of cards and credit products, but that doesn’t mean you should accept every new offer that comes your way. “Credit is convenient, but there is always a price to pay,” says Yanchuk-Olesky.
WAYS TO AVOID DEBT
Listen to Season 7 of the Mastering Money podcast, which features episodes on topics such as debt in Canada and pitfalls to avoid. Plus, find out how to how to stay out of debt and avoid bankruptcy and check out CPA Canada’s financial literacy resources.