Your credit score affects things like getting credit cards, loans, mortgages or renting an apartment. But how does a credit score work?
How does a credit score work?
A credit score is a number calculated using information from your credit report that indicates how likely you are to repay credit. In Canada, this score is a three-digit number between 300 and 900.
A high credit score means you can borrow more money and get the best rates for loans, credit cards and mortgages. If you use credit responsibly, you will earn points. If you don’t, you will lose points.
How a credit score is calculated
According to Equifax, your credit score is calculated from:
- Payment history: 35%
- Credit utilization ratio: 30%
- Length of credit history: 15%
- Public records: 10%
- Credit inquiries: 10%
What’s important to note here is that other factors alongside your credit score determine your creditworthiness, such as your income.
Remember that Canada’s major credit bureaus, Equifax and TransUnion, have different ways of calculating your score, meaning they will differ slightly.
What lowers a credit score?
Your credit score is lowered by actions relating to your finances, which are recorded on your credit report.
Your credit report allows lenders to gauge how responsible you are when managing credit. This lets them decide whether to risk lending money or accept your rental application.
Your credit report records the following:
- Any open lines of credit that you use and their balances.
- Defaulted or closed lines of credit, known as bad debts.
- Payment history, including missed or late payments to creditors.
- Non-sufficient funds payments or bad cheques.
- Debts sent to collection agencies.
- Court decisions relating to your credit and bankruptcies.
- Inquiries from lenders who have requested your credit report within the past three years.
- Registered items (like as a lien on your house or car).
These actions are recorded as part of your credit history, which, in turn, can impact your credit score.
How does a low credit score affect you?
A low credit score tells lenders that you cannot manage money sensibly, resulting in you being deemed high risk refused when you apply for credit. Even if you are accepted, lenders will be cautious by charging higher interest rates on credit cards and lines of credit.
In some industries, your credit history can affect your job prospects or ability to rent if an employer or landlord performs a credit check.
How many years does information stay on my credit report?
Late payments, bad debts and other adverse financial decisions appear on your credit report for at least six years.
Here’s how different types of negative information appear on your credit report:
- Late payments stay on your credit report for six years from the date reported.
- A debt collection action stays on your credit report for six years from the date of your last payment.
- Bankruptcy stays on your credit report for six to seven years, depending on the credit bureau.
- Judgments (debts from court action) stay on your credit report for six years.
- A tax lien stays on your credit report for six years after it’s been paid.
- Charged-off accounts stay on your credit report for up to six years from the date of the first missed or late payment on the account.
- Banking items, such as cheques returned for insufficient funds, stay on your credit report for six years from the date reported.
- A consumer proposal remains on your credit report for at least three years after completion.
- Closed accounts paid as agreed remain on your credit report for up to 10 years after they are reported as closed.
How do late payments affect my credit score?
On Canadian credit reports, late payments are sent from the lender to the credit bureau through a series of codes.
These codes include a letter and a number, which refer to the type of credit and the regularity of payments. This credit rating system is used on every credit account, and higher number codes damage your credit.
Failure to make timely payments will result in a higher number code, harming your credit.
Late payments on credit cards
Here are some examples of how late credit card payments are reported on your credit report:
- If you pay your credit card balance on time, it is reported as R1, the best possible credit rating.
- If you don’t pay your credit card bill and it’s over 120 days late, it is reported as an R5.
- If a collection agency contacts you regarding your credit card bill, it is reported as R9, the worst possible rating.
So it’s easy to see that late payments and debts in collections can damage your credit rating, with the damage appearing there for six to seven years. Consequently, this will lower your credit score.
Do credit report mistakes affect my credit score?
Any mistakes on your credit report are most likely causing your credit score to drop. Common mistakes include:
- Incorrect personal information.
- Misspellings of your name or address.
- Accounts that do not belong to you.
- Unfamiliar accounts or credit inquiries.
- Payments recorded as late but were made on time.
- Inaccurate credit limits.
- Accounts attached to debt collection agencies.
- Closed accounts reported as open.
Check your credit report online or request a copy of your credit report to ensure all the information is accurate.
How do I increase my credit score?
Making payments on time is essential for building a good credit score, but other factors contribute to an excellent score.
Follow the tips below to improve your credit score in as little as 60 days:
- Pay your bills on time
- Make payments twice a month
- Keep a low credit utilization ratio
- Add new lines of credit and use them responsibly
- Keep old credit accounts active
- Don’t make too many credit applications
- Keep a good debt-to-income ratio
- Don’t rely on credit cards
- Try getting a secured credit card
A good credit score gives you better borrowing power and access to the best interest rates, helping you reach financial goals like owning a home or car.
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