Credit scores–also referred to as “FICO” or “beacon” scores–are used by financial institutions to gauge the level of risk they take on in prospective lending. They use this score in conjunction with your employment history and other factors (such as residential stability) to basically assess the likelihood that you will pay back a loan or credit obligation. The interest rate one receives on a loan or credit facility reflects the level of risk being taken on–with the rate being higher if one has a checkered history off paying their debt or is simply new to credit.
Who Keeps Record?
The two big credit-reporting agencies are Equifax and TransUnion. These are the companies that lenders use to gather credit bureau information on all of us. It is good practice to at least check your credit bureau once a year—not only to check-in on your credit standing, but to ensure there are no inaccuracies or fraud that is occurring on your file. Consumers are entitled to one free credit report per calendar year here in Canada.
How Credit Scores are Calculated
While it is true that many algorithms exist to calculate a score, meaning your actual credit score will vary depending on what model a company is using, there exists a consensus on how these numbers are calculated. Your credit score is broken down into these factors with accompanying weights:
Payment History accounts for 35% of your score.
This is the largest factor used in a credit score calculation. It reflects the details on a consumer’s adherence to a payment schedule for any type of credit or loan facility (mortgages, credit cards, vehicle loans, etc.). Late payments or delinquencies adversely impact your score. Models will also look at the frequency and severity of these overdue payments and relate them against all your open tradelines (debt). Late on the monthly payment? This will report as a 30-day late payment, which translates to an I2 or R2 on your bureau.
Utilized Credit vs. Available Credit accounts for 30% of your score.
A key factor involved in a credit score is what is referred to as a “credit utilization ratio.” In part, this will examine how much revolving, or installment debt balances you have. It also considers how much credit is available to you, even if you have no intention of using all of it (remember, lenders like to deal in potentialities). Take note that typically a lender will include 3% of the available limit on any tradeline when assessing your ability to accommodate a new payment. It is recommended to keep overall balances low and prune any credit you simply do not need to improve your score.
Credit History accounts for 15% of your score.
This will measure how long your accounts have been in existence. The idea is that a stable, long-enough track record of making payments decreases the odds that a consumer would pose a risk of defaulting on their debt. This is why anyone new to credit will need to establish a history before they are considered for prudent lending.
Public Records account for 10% of your score.
Public records include derogatory statements like a bankruptcy, consumer proposals, payment arrangements, or just plain collection issues. Generally, you want this section on your bureau to be a blank space.
Inquiries account for 10% of your score.
Representing a sizeable chunk of the calculation, inquiries are often an overlooked aspect of a credit score. Working in retail banking, I would come across a credit bureau that has a litany of inquiries from a car dealership seeking the best rate for financing, unbeknownst to the consumer. These are characterized as “hard hits” and should be avoided when possible as they do considerable damage to a credit score in a relatively short period of time. When the bank looks at a long list of inquiries, it could mean a credit applicant is habitually “credit-seeking” and represents a higher risk. Pre-approvals for credit cards or pulling your bureau for personal information are tasks that involve “soft hits,” which do not impact your credit score.