A brief history
American Express, Mastercard and Visa had a problem. They were in the business of issuing credit cards, but they didn’t want to issue them to just anyone. What good is a customer if they don’t pay their bills?
Enter FICO (Fair Isaac Credit Organization). In 1989, it released its first iteration of a credit scoring system. The idea was to create a formula that could synthesize a person’s credit worthiness down to a single number.
This provided the card issuing companies with a quick, easy way to determine someone’s credit worthiness. The three credit bureaus in the US quickly adopted this system and even today, Equifax, Transunion and Experian use some form of the FICO scoring system.
Canada followed a similar path with Transunion, Equifax and Experian quickly opening Canadian offices. In April 2009, Experian shut down their Canadian operations leaving just Transunion and Equifax.
What’s a score used for?
Your credit score is one of the first things that companies look when you apply for any sort of loan. This includes credit cards, mortgages and lines of credit.
If it’s a small loan (e.g. a credit card), the credit score may be all a computer considers to approve you. Your credit file becomes more important when a person looks at it.
How is your credit store calculated?
In Canada, credit scores can range from 300 to 900. In the US, the range is 300 to 850. A score of 300 means that you are either starting out or you made some financial mistakes.
If you’re in debt and struggling, there are lots of resources available to help you rebuild your credit. Please ask for help.
If you have a score over 700, the world is your oyster. It avails you to the best interest rates for loans and the highest limits for your cards. It’s just one factor though. When companies extend you credit, they look for three things:
- Character: Your reputation. Since your personal banker probably doesn’t know every detail about you, they’ll refer to your credit file and score.
- Capacity: How much credit you are seeking compared to your ability to repay the loan. If you want a $1 million mortgage with an income of $30k, you’re going to have problems.
- Capital: How much capital you have. If you have $1 million in capital and want a loan for $1 million, then the conversation changes.
How exact scores are calculated remain a secret. FICO releases the general components and their weightings, but not the exact formula.
Image source: MyFico
The components of your credit score in detail
The biggest factor in your score is your ability to pay your bills on time. Note that this doesn’t mean to pay off your bill completely each month (although you should for credit card bills). You only have to make your minimum payments.
Lenders typically use the North American Standard Account Ratings, AKA the “R” Ratings to communicate this information. Each account on your credit file will have one of four letters, “I”, “O”, “R” or “M” followed by a number from 1 to 9.
The first letter represents the type of account it is.
I stands for “installment” which represents loans made for a fixed amount that you pay back with regular installments. A car loan is an example of an installment loan.
O stands for “open credit” which typically represents lines of credit. You can borrow up to a certain limit and must make payments towards that limit. Some lines of credit and student loans will fall under this umbrella.
R stands for “revolving credit” which covers your credit cards.
M stands for “mortgage”.
The numbers describe how good you are at paying your bills. You want all your accounts to be rated at a 1. This means that you pay all your bills within 30 days of billing and you pay them as agreed upon.
You don’t want any numbers to be higher than 1 on your report. 9 is the worst possible number you can have as it means the lender has written off the amount or sent it to a collection agency.
|0||Your account is too new to rate.|
|1||You pay your bills on time.|
|2||You have a late payment that’s 31-59 days late.|
|3||You have a late payment that’s 60-89 days late.|
|4||You have a late payment that’s 90-119 days late.|
|5||Your payment is more than 120 days late, but the lender hasn’t written it off yet. There’s time hope.|
|7||You’re making regular payments under a consolidation order, Orderly Payment of Debts, consumer proposal or Debt Management Program with a credit counselling agency.|
|8||Repossession which typically means your car or other expensive item was repossessed.|
|9||The loan was written off, sent to a collection agency or you declared bankruptcy.|
Simply put, are you using lots of your available credit? Companies will differentiate based on the type of loan it is. Someone who has a mortgage which shows up as high utilization, will be a much lower risk than someone who has maxed out their revolving credit like credit cards.
Keeping your utilization to 35% or under on your revolving credit is the common advice that’s provided almost everywhere.
People who have a history of using credit responsibly are lower risks than people who don’t. It’s thus in your best interest to keep your oldest card and to keep accounts longer than you might think.
Types of credit used
The bureaus like to see a diversified mix. Some examples include student loans, auto loans, credit cards and mortgages.
When you apply for credit, a company access your credit file. This is called a hard pull. Too many hard pulls in a short period of time can look risky because you appear to be shopping for credit. Over time, the impact of hard pulls will diminish.
Visit the MyFico page to learn more in greater detail.
How to get your credit score
First things first. You should know that there is no such thing as a single credit score. There are multiple FICO models in use today that companies will use depending on the type of loan you’re applying for.
Someone looking at a mortgage will weight certain factors more heavily than if you were looking at an auto loan.
That’s why it’s important to not worry about minor fluctuations in your credit card. What you see on your screen might not even be what the lenders see. Instead, focus on being in the right general ballpark.
If you are comfortable selling your information to third-party companies, you can receive your credit score for free.
- Creditkarma.ca: CreditKarma is a well known American company. They use your information to sell your credit cards and other loan products. They pull from TransUnion and you can view all your accounts on your credit file too.
- Borrowell.com: Borrowell is a Canadian company in the business of making personal loans. They show your Equifax scores, but not your accounts on file.
- Mogo.ca: Mogo is a Canadian company that provides personal loans, mortgages and a prepaid card. They show your Equifax scores, but not your accounts on file.
If you’re rather deal with the credit agencies directly, both TransUnion and Equifax sell different types of monitoring services on their sites.
- Creditkarma.com: CreditKarma.com is the American parent company of CreditKarma.ca. This site can provide you with both your TransUnion and Equifax report and scores. Not that it uses VantageScore 3.0 instead of the more popular FICO.
- Credit.com: Credit.com is a competitor to CreditKarma and offers the same services, except with Experian data. Note that it provides two different types of calculations – Vantage Score 3.0 and Experian’s National Equivalency Score. Most lenders use FICO and none use Experian’s National Equivalency Score. It’s nice to know, but just not that important.
Maximizing your score
Credit scoring models are imperfect. With a little knowledge, you can manipulate them to increase your scores which means easier computer approvals. Here are some tips.
Pay your credit card throughout the month to keep your average utilization low. Better yet, apply for more credit cards. Your score is negatively impacted by the hard pull. That fades over time. Your score will be positively impacted by having more credit because it decreases your utilization.
Let’s use an example with hard numbers.
If you have a single credit card with a $4,000 limit and you use $3,000 every month, your utilization is 75%.
If you apply for a second credit card and receive a $6,000 limit on that card, your overall utilization drops to 30% ($3,000 utilization/$10,000 in limits) without doing anything!
Because utilization is a much larger component of your score than inquiries, getting additional cards will likely increase your score.
Get an unsecured line of credit
If you don’t already have one, get one. Every few months, use it to pay off a credit card and immediately pay off your line of credit. Better yet, overpay it and treat it like a chequing account. Free cheques and ATM withdrawals.
Your line of credit diversifies your product mix. It decreases your utilization. Over time, it increases your average age of accounts. You of course, will have perfect payment history.
Check for incorrect information
If you haven’t already, order your printed credit reports from Equifax and Transunion. You can order the report for free once a year. Your report will contain a list of your accounts and their status. Make sure everything is accurate. An auto lease that is improperly reported could drop your score by 200 points.
Even scarier, someone could have stolen your identity and opened accounts in your name. It’s annoying to clean up so it’s best that you catch it fast!
Your credit file might also have incorrect addresses on file which will give you grief when you apply for credit cards.
Learn about how to read your report here.
Keep accounts open for at least 6 months
R1 payment history on your report is great. It takes time for an R0 account to convert to R1. Keep your accounts for long enough so that they all report R1. Have a stern talking to yourself if anything on your credit file reports R2 or higher.
Keep your oldest accounts open. Use them once every few months to prevent account closure. Wait. The longer you wait, the more your score will go up.
If you’re going to apply for a mortgage or auto loan, chances are that you will apply to multiple places. Do it in a short span of time. The reporting agencies will combine the pulls into a single one because they know you are shopping for rates. This does not apply to credit cards (with some exceptions).
Your credit score is just one factor in getting approved for cards. It’s also one of the easiest things to manage so spend a little time to get it in order. A little time spent now getting things in order will yield plenty of benefits in the future.
Do you check your credit file on a regular basis? Why or why not? Leave a comment or drop me a line. I’m happy to help.