Credit is something many of us take for granted.
If you have good credit, you should have no problem borrowing money at the best interest rates with the most favourable terms and conditions. If you’re able to pay for your home, car and other assets in cash, you may not care about your credit score, but for everyone else, building a good credit score is important.
A good credit score isn’t just for bragging rights. It comes with many benefits. A mortgage is the single biggest debt of most people’s lifetime. If you have a good credit score, you’re more likely to qualify for the mortgage with the most favourable terms and conditions and the lowest interest rate, helping you keep more of your hard-earned money.
Let’s take a closer look at your credit and why it matters. After that, we’ll look at what’s a credit rating and the various credit ratings.
What is credit and why does it matter?
Your credit consists of three parts: your credit history, credit report and credit score. Your credit history is a summary of your borrowing history. It’s a recap of each and every time you’ve borrowed funds. This includes your car lease and it may include the credit card you forgot to pay in university. Meanwhile, your credit report is a recap of your credit history in a more consumer-friendly format.
Last, but not least, is your credit score. Your credit score is the figure that lenders care so much about. Lenders use your credit score to help decide whether your loan application goes into the approve or reject pile. The higher your credit score, the more likely you are to get the lowest interest rates. Credit scores typically fall between 300 and 900.
There are two major credit reporting agencies in Canada—Equifax and Transunion. Equifax and Transunion are firms that calculate and keep track of your credit history, credit report and credit score. If you want instant access to your credit score, you’re required to pay; otherwise, you can request a copy of your credit report for free, once per year. To do that, you must download and fill out the credit report request forms from the Equifax and Transunion websites. (And before you ask, no, it won’t lower your credit score to request a copy of your own credit report.)
Reviewing your credit report at least once a year is a good practice. If you’re planning to make a major purchase, such as a home, it’s also a good idea to review your credit report. If you see a blemish on your credit report, it’ll give you time to correct it. (It sometimes takes a while due to a delay on lenders reporting your credit history.) Likewise, if your credit score is lower than you thought, you’ll have the time to take the steps necessary to improve it.
The Five Factors of Your Credit Score
There are five main factors that impact your credit score. By understanding the five factors, you can help maximize your credit score.
The first factor is your payment history, which affects your credit score the most. Your payment history relays whether you’ve made your payments on time. The following can negatively affect your payment history:
- Making payments late
- Missing payments
- Your debts go to collections
- You file for bankruptcy
To maintain a good credit score, always aim to pay your accounts by the due date. If you can’t afford to pay off the full amount, at least make the minimum payment.
The second most important factor in your credit score is your credit utilization. Credit utilization is just a fancy word for how much of your total available credit you’re currently using. To calculate your credit utilization, take your credit limit and subtract your current outstanding balance from it. Ideally, you want an overall credit utilization of less than 35 percent. If you must go over, make sure you never use more than 70 percent of your available credit. It can adversely affect your credit score. Lenders will get concerned that you’re getting close to being maxed out.
How Many Credit Inquiries
Only apply for credit if you really need it. Having too many credit inquiries within a short timespan can negatively impact your credit score. Each time you apply for credit, it counts as a credit inquiry. A credit inquiry means that the lender is requesting a copy of your credit report for borrowing purposes. If a lender see a lot of credit inquiries, it may hesitate to lend to you, since it will draw the conclusion that you’re applying after being turned down by other lenders, when that may or may not be the case.
Length of Credit History
Lenders like to see that you have a history of consistently making your payments on time. The longer you have a credit account open, the better it is for your credit score. Closing an old account can lead to your credit score dropping.
If you have just one type of credit, it can hurt your credit score. Try to mix it up with credit cards, loans and lines of credit (just make sure you use your credit responsibly).
What is a credit rating?
Credit ratings are a system by the credit reporting agencies about how and when you make your payments. Credit reporting agencies like Equifax and Transunion aren’t the only ones who use credit ratings. Lenders may use them as well when reporting information to the credit reporting agencies.
A letter and a number make up a credit rating. For example, you might have a credit rating of R1 on your credit card, indicating that you’ve paid your credit card on time throughout its history. Bravo!
The letter in your credit rating stands for credit type you’re using.
- “I” stands for “Installment” credit: When you borrow money for a specific time period and you regularly pay it back in fixed amounts until the loan is fully repaid. An example of installment credit is a car loan.
- “O” stands for “Open” status credit: When you borrow money as needed, up to your credit limit. An example of open status credit is a line of credit.
- “R” stands for “Revolving or recurring” credit: When you’re able to borrow money up to a certain limit on a regular basis. You can make payments in different amounts depending on your account’s outstanding balance. This is the most common credit type. An example of revolving or recurring credit is a credit card.
- “M” stands for “Mortgage” loan: If you have a mortgage on a property, it may appear on your credit report.
There will also be a number in your credit rating. The number will be between 1 and 9.
The number “1” is the best rating you can get. You want to aim for this credit rating on all your accounts. It indicates that you pay your accounts on time (within 30 days of the billing date). The more accounts with a credit rating of 1 that appear on your credit report, the better. It will go a long way in helping you achieve a good credit score.
Any number above 1 is likely to have a negative impact on your credit score. The worst credit rating you can get is 9. It usually indicates the lender has written off the debt or the debt has been sent to collections.
- “0” means the account is too new and you lack the credit history for it to be rated or it has been approved, but you haven’t used it yet.
- “1” means the account has been paid as agreed upon within 30 days of billing. The payment is considered on time. You have a history of making your payments on time throughout the account’s history. You should strive for this credit rating with all your accounts. The more 1 ratings on your credit report, the higher your credit score is likely to be.
- “2” means you’ve made a payment that’s between 31 and 59 days late. This essentially means that you’ve missed a payment. On its own it’s not terrible, but it can lead to lenders coming up with their own negative opinion on you.
- “3” means you’ve made a payment that’s between 60 and 89 days late. This means that you missed two payments in a row. This credit rating is likely to grab the attention of lenders. You may have difficulty opening credit with this rating.
- “4” means you’ve made a payment that’s between 90 and 119 days late.
- “5” means you’ve made a payment that’s more than 120 days late, but doesn’t yet have a rating of “9.”
- “6” isn’t used by the credit reporting agencies.
- “7” means that you’re making payments under a consumer proposal, consolidation order, orderly of debts or a debt management program with a credit counselling firm.
- “8” means that the lender is attempting to repossess your assets to recover the money you owe.
- “9” means that the debt has been written off as “bad debt,” it has been sent to collections or you’ve filed for bankruptcy.
All of the debts that appear on your credit report should have a credit rating. The codes will differ depending on the credit type and whether you make your payment on time. For example, if you have a credit card and you pay it on time, it will have an “R1” rating on your credit report. If you have a car loan and you missed a payment by 45 days, an “I2” rating would appear on your credit report.
In this article we took an in-depth look at credit. We looked at what is credit and why does it matter, the five factors of your credit score and what is a credit rating. After reading this article, you should have a much better understanding of your credit report and how to read it.
If you need help making sense of your credit report, contact us today.