Credit scores are a way for a lender to assess how well you handle debt. To be able to set a credit score, the credit bureaus need information about credit use. This leads to a strange principle behind credit scores: the more access to available credit you have, the better your credit score will be. While that’s good for your credit score, is that actually good for you financially? Are we too addicted to credit scores? The techniques needed to build a higher credit score can be surprisingly harmful to you. Sometimes having a bad credit score can actually be better.
On today’s show, my guest Ted Michalos helps us understand just how much credit we should really be using and why having a less than stellar credit score may actually be good for you.
According to the two credit bureaus in Canada – Equifax and TransUnion – the higher the score you have, the better. Their ranking system even reinforces this concept.
|300-560 = Poor||300-599 = Very Poor|
|560-659 = Fair||600-699 = Poor|
|660-724 = Good||700-749 = Fair|
|729-759 = Very Good||750-800 = Good|
|760-900 = Excellent||801-900 = Very Good|
A good score is considered to be between 660 and 724; over 729 is very good. A poor credit score is in the 500s.
There are 6 factors that influence credit scores:
- Your payment history – Did you make your required payments every month? Your credit score deteriorates if you don’t make the payments
- Credit utilization – How much credit do you have available to use and are you bumping up against it? Someone with very little credit doesn’t have as good a score as somebody with a lot of credit that uses it regularly.
- Length of credit – How long have you had your credit? If you’ve only had it for a very short time, you won’t have a lot of history, so your score won’t be as high.
- Stability – How long you have lived at your current address and how long you have worked for your current employer. Does your financial picture today look like what it looked like yesterday?
- Type of credit – Do you have a mortgage, a car loan, and a credit card? Or do you have six credit cards, a line of credit, or a combination? The types of credit you have will affect what your score looks like.
- Credit inquiries – How often are people doing credit inquiries against your score? When a bank or lender does a hard inquiry against you, it’s recorded in your credit report.
But that doesn’t mean you have to ‘improve’ all these factors.
If you’re planning on purchasing a car, applying for a mortgage or a bank loan, then a better credit score is good for you. It means you’ll get better terms, lower interest. It’ll ensure that you’re not only approved for the loan but you can get a better rate.
If you are applying for a consolidation loan with bad credit, then your score could mean your only option is with a subprime lender. This is when you may want to work on improving your credit score first.
If you have a credit card with a low enough limit that you can pay off the balance in full and you work towards saving for the next car, you may not be borrowing any new loans or applying for any new credit in the near future.
If you are afraid that filing a consumer proposal or bankruptcy will lower you credit for a while, remember, you are eliminating debts that are driving up your utilization rate today. And in all likelihood the reason you think you need credit is because you are using credit to pay for credit.
How can a lower credit score be good for you?
It’s important to pay your credit cards in full each month in order to have a healthy credit rating. You should only have access to a limited amount of credit, regardless of the fact that a higher credit utilization will give you a better score. Since having a higher credit utilization makes your score better, Ted believes that is one of the reasons why people face trouble with credit debt:
The risk is always there if you have access to credit that you’ll actually spend it…one of the common things I say to people who come in and see us is how many credit cards do you have in your wallet? I think, ideally you have two. You might make an argument for three, you need one for personal expenses, maybe you need one for business. If you have any more than that then you just run the risk of well, this one’s full, I’ll use the next one.
He recommends limiting your access to credit, even if it means a lower score. Not everyone needs a good credit score.
Credit repair companies lead to more debt
You may see advertisements on television from companies claiming to be able to repair your credit by monitoring it for you. These are misleading. You can only repair your credit by paying your bills each month and paying down your debt in time:
They’ve got people now paying monthly fees to monitor your credit and they’re telling you can get your credit score free online. It’s not the credit score that the credit reporting agencies use and the only way to repair your credit is to pay down your debt in time. I mean anything else is just somebody selling you a bill of goods.
There is no quick solution to repairing your credit. It takes time and consistent effort.
Ultimately, Ted suggests worrying less about your credit score and instead focusing on being able to manage your monthly payments:
I wish people wouldn’t get so hung up on the whole credit scoring system. It’s for the benefit of lenders; it’s not for the benefit of individuals like you and me. It’s about getting you to borrow more money as opposed to less money. I mean my recommendation is you only borrow what you need.
Resources Mentioned in the Show
FULL TRANSCRIPT – Show 195 Is a Bad Credit Score Good for You?
Doug: Last week on Debt Free in 30 my guest was Meg Penstone, we talked about what’s on your credit report, why are credit reports important? Because the information on your credit report is used to calculate your credit score and your credit score impacts whether or not you can get a loan and the interest rate the bank will charge you.
That all makes sense but today I want to make the case that it’s possible that a bad credit score could be good for you. More specifically chasing a high credit score and ignoring all other aspects of your financial life, is never a good idea. You don’t need the highest credit score possible. In fact sometimes a less than perfect credit score means that you are managing your debt and your finances wisely.
To discuss this I am joined by my Hoyes Michalos co-founder and partner, Ted Michalos. Ted, are you ready to bust some myths around credit scores?
Ted: Happy to help.
Doug: Excellent. So let’s start with the basics. What is considered to be a good credit score?
Ted: There are two major credit reporting companies in Canada and they use a scoring system that gives you a between 300 and 900 points.
Doug: So you’re talking about Equifax and TransUnion.
Ted: That’s exactly right. Now there are actually more credit scoring companies but nobody uses them so we don’t need to talk about them. According to the credit bureaus, the higher the score you have the better. So a 300 would be very, very bad, a 900 would be perfect. A credit score of 500 is considered poor and may indicate you’re not managing your debt very well. Equifax tells us that they consider a score between 660 and 724 to be good, over 729, very good.
Doug: And nobody ever gets to 900, it’s just not possible.
Ted: I checked my own credit score recently and because I don’t use a lot of credit my score’s pretty bad.
Doug: Well as we’re going to talk about today a bad credit score may be good for you. And that’s an excellent point. We’re going to talk about why your credit score is bad because it’s not using your system. Okay, so what credit score is good enough then? I mean is a 660 good enough, do I have to shoot for 720, do I got to shoot for 800? Where’s the limit here?
Ted: Before you can figure out what’s good you need to understand what you’re looking at. So, where are you at financially and are you going to be applying for credit in the near future? That’s probably the first question. The second is what types of debt have you already got? So what kind of debt behaviours do credit bureaus reward? So what can you do to make your score better? What have you done in the past that may have made your score worse?
So if you’re planning on purchasing a car, applying for a mortgage or a bank loan, then a better credit score is good for you. It means you’ll get better terms, lower interest. It’ll ensure that you’re not only approved for the loan but you can get a better rate. If you have a credit card and you’re working towards paying down your debt saving for the next car, borrowing or whatever, you may not be borrowing any new loans or applying for any new credit in the near future. This is especially true for older Canadians. In this case there’s probably no reason for you to worry about a high credit score.
Doug: Okay, so let’s back up there then. So, at the start of the show I said there can be a difference between what’s good for you and what’s good for your credit scores. So why don’t you kind of refresh everyone’s memory as to what influences your credit score.
Ted: Alright, so there’s six factors they’re looking at. The first is your payment history. And that one’s pretty obvious. So when the credit reporting agencies are tracking your history, they simply keep track of did you make your required payments every month? If you don’t make the payments your credit score starts to deteriorate.
Doug: Makes sense, that’s easy.
Ted: The next one is credit utilization. So, how much credit do you have available to use and are you bumping up against it? So, someone with very little credit, which is the problem I’m running into, doesn’t have as good a score as somebody with a lot of credit that uses it regularly. How long have you had your credit? So if you’ve only had credit for a very little while, so maybe you’re a young person or you’re new to Canada or maybe you’re an older person, you’ve just never used credit cards in your life and now you need one. If you haven’t had them for a long time you don’t have a lot of history so your score won’t be as good.
Stability, so we’re talking about how long have you lived at your current address, how long have you worked at your current employer, does your financial picture today look like what it looked like yesterday? Is it going to look like that tomorrow? Do they think that you are stable?
Next biggie is the types of credit that you have. So if you’ve got a mortgage, a car loan and a credit card or if you’ve got six credit cards, a line of credit and a bunch of bad stuff like that, the mix of the types of credit that you have will affect what your score looks like.
And the final one is a little – it’s not one that people usually think of. How often are people doing credit inquiries against your score? The reason that’s important is because when a bank or a lender does a hard inquiry against you, it’s recorded on your credit report. And they’re looking to see are you applying for credit all over the place at the same time? A general rule, and it’s got nothing to do with today’s show, is if you apply for credit at two different places and you’re turned down, do not try a third one for at least three, four, five months because it looks like you’re trying to amass a lot of credit quickly and that will really hurt your score.
Doug: Yeah it’s being turned down that’s the problem. I mean if I’m shopping for a new car I may go look at three different places and apply at three different places at once. If I’m approved at all of them it’s fine but if I’m turned down I got a problem. Okay, so there’s six things that affect your credit score, payment history, credit utilization, length of credit, stability, type of credit and then how many credit inquires you’ve had against you.
Okay, so now we’re getting to the key point here. So, obviously the first one, you know, paying your bills on time is good for you and it’s good for your credit score so where possible pay your bills on time. I mean that obviously makes sense. It’s going to save you money on interest and late payment fees too so that one’s an easy. But let’s talk about credit utilization because you already kind of hit on this. So, you know, it’s here where I think there can be a difference between what’s good for you and what’s considered good for your credit score.
So Ted you and I are going to play a little game of let’s pretend here. That’s what the listeners always like. So, let’s pretend that I have one credit card with nothing owing on it and a $2,000 credit limit and let’s pretend that you have five credit cards, each with a $10,000 credit limit and you carry a balance of $2,000 on each of them so which of us is going to have a better credit score?
Ted: Obviously I have the better credit score because I have higher credit limits. I’ve got good utilization. I’m using them all and I’m making my payments.
Doug: So, is having five credit cards and carrying a balance on each of them actually good for you?
Ted: Well, okay so let’s stop pretending. I think that’s very bad for you.
Doug: Okay. So it’s good for your credit score but it’s not good for you. Okay, now that was kind of a bad example.
Ted: I think that’s a pretty good example because a lot of people that we see think they’ve got great credit because they’ve got all these different cards and they’re making their payments every month and so they don’t understand why they can’t get new credit when they apply for it. Why are they talking to me, they’ve got such great credit. Well, they don’t.
Doug: Yeah, you don’t that’s the point. Okay so obviously neither you nor I are carrying balances on our credit cards and, you know, I think everyone listening understands that you know, carrying a balance on your credit card and paying interest every month is not a good plan.
So, let me run a different scenario by you then. So let’s say that you have one credit card with a $10,000 limit. Let’s say that I have one credit card with a limit of $3,000. Now let’s say that we both charge a couple of grand a month to our credit cards, you know, for groceries and gas and other living expenses and, you know, office supplies all that stuff.
Doug: Pizza, a lot of pizza. Now we’re both smart guys, well we like to think so.
Ted: We like to think we’re smart.
Doug: Yeah, absolutely. Definitely good looking but yes, smart as well. We pay off our credit cards in full each month so we’re not paying any interest. We both earn the same points on our cards and whatever because we’re both spending the same amount. So financially we are even, but who has the higher credit score in this example?
Ted: I do and the reason for that is while we’re both spending the exact same amount I’m using less of my credit facilities than you are. Remember you gave me a $10,000 limit and you gave yourself a $3,000 limit. I only use 20% of my limit every month, I’ve got lots of access to additional credit if I want to. You’re using two thirds of your limit every month so it looks like you’re closer to the edge than I am.
Doug: Yeah that makes sense. You’ve got lots of wiggle room, I don’t I guess is –
Ted: Right, that’s a good way to say it.
Doug: Okay, so I got two comments on this then. So, now first, you and I don’t exactly know how Equifax and TransUnion calculates our credit scores. We don’t know if the perfect utilization rate is 20% or 30% or some other number. You know, we think that anything more than 30% is probably a negative but we don’t know for sure because of course if they told us, then everyone would game the system right exactly where they needed to be.
In the example I gave above where we’re paying off our credit cards in full each month so you could argue that we aren’t really utilizing any of our credit but let’s keep it simple and assume that we’re utilizing some of our available credit.
So, now my second point. You have a better credit score because you have more available credit but is that really good for you personally? So again is having more access to more credit wise?
Ted: Well, so it doesn’t cost me anything to have access to that extra credit. I mean they’re charging me a bill for my credit limit but there’s always risk associated with this and we see it all the time. If you keep a low credit limit, then you can’t ever get into a lot of trouble. So just because you’ve got – well, the example we just had, I have a $10,000 limit and I spend $2,000 a month. If something goes wrong in one month and I suddenly spend a lot more on it, well the difficulty is maybe I can’t pay the card off that month and so now I’m carrying a balance. If I have two cards, I’ve used one. Well now maybe I don’t ever use the second one, something’s gone wrong, I run it up and now I’m using it as well.
So the risk is always there if you have access to credit that you’re actually spend it. Remember, credit is good debt is bad. As soon as you use your credit becomes debt, debt is bad.
Doug: And so your advice is what?
Ted: Limit the amount of credit that you have access to. I mean one of the common things I say to people who come in and see us is how many credit cards do you have in your wallet? I think, ideally you have two. You might make an argument for three, you need one for personal expenses, maybe you need one for business. If you have any more than that then you just run the risk of well this one’s full, I’ll use the next one.
It’s better to plan your purchases ahead of time, make sure you can pay down any expenses you put on your credit cards every month than it is to actually use credit cards and those sorts of tools as the way to finance your life. We used to say years ago, you were famous for saying, credit cards are a replacement for cash, they’re not a replacement for lending because they’re just too damn expensive.
Doug: Yeah, if you’ve got the cash in your bank then there’s no problem with using the credit card, you can go and pay it off, it’s a convenience so you’re not carrying wad of cash when you go to the store.
Ted: You get in trouble when you use the cash and the credit card and then you start using the second credit card.
Doug: And that’s a huge risk and I think that’s an example of where trying to get a higher credit score is actually bad for you. So, now one of the other factors that you listed off at the start there that determines your credit score is how long you’ve had a loan. So the credit bureaus assume that the longer you’ve used credit, the better you are at managing credit, you know, assuming you’re paying your bills on time obviously. So in other words experience matters. So that makes sense but that can also lead to bad behaviour for you personally. So, do you agree or disagree with that?
Ted: No, I mean I fully agree. Let’s say you’ve got a couple of credit cards, you switch to a new one because the new card offers you a reward program or just a better rate. If you cancel your old credit card, the credit bureau’s going to hit you, you take a hit to your credit score because you’ve cancelled an old one and you’ve switched to something new. If you keep the accounts open you don’t take the hit but now you’ve got the risks that we just talked about. So it’s – there’s no good way out of any of this expect to limit how much you use any of these things.
Doug: Yeah they want you to keep having more and more and more and that’s – and so when you do the right thing and switch, oh that’s a new card, you don’t have the same history so that’s a bad thing. Okay, so I think we’ve made the point that what’s good for your credit score may not be good for you personally but of course we like to keep bashing away at it so let’s talk about one more area, that it impacts your credit score and that is the type of credit that you carry and you alluded to this earlier. So, if you have just high interest credit cards, your credit score will tend to be lower than someone who has, you know, a nice mix, like a term loan, a bank loan and some other things. So, should you go out and get a loan to improve your credit score?
Ted: No. You never borrow just for the sake of borrowing. If you don’t have a specific need or purpose in mind it just doesn’t make sense. You’re always going to use credit for what’s right for you and going to the bank and getting a loan right now doesn’t sound like it’s right. If you don’t need the money for a car, if you don’t need the money for a specific purpose, then I mean if – it doesn’t make sense just to go out and borrow just to try to improve your credit score. That’s the short answer.
Doug: And that makes sense. If guess if you know you’re going to be buying a house in two years then maybe it’s slightly different because okay, I have to start building up my credit but otherwise you’re saying nope, just don’t do it.
So, okay now this is a bit of a tangent but I like to get you wound up on at least once every show and we’re not going to talk about payday loans today so I can’t use that.
Ted: I wondered how you were going to work that in actually.
Doug: Well, okay so what do you think of credit repair companies then?
Ted: I think they are one of the largest boondoggles on the planet right now. And I think the credit reporting agencies are as much to blame as these credit repair companies. They’ve got people now paying monthly fees to monitor your credit and they’re telling you can get your credit score free online. It’s not the credit score that the credit reporting agencies use and the only way to repair your credit is to pay down your debt in time. I mean anything else is just somebody selling you a bill of goods.
Doug: Yeah and they like to, you know, here we’ll set you up with this high interest loan which will report to the credit bureau and that’ll improve your credit. But like you said, you’re paying massive fees.
Ted: It just doesn’t make any sense.
Doug: No, it doesn’t.
Ted: You don’t destroy your credit overnight. I mean what goes wrong is you accumulate more, you can’t deal with it and that takes time. To fix the problem it takes time.
Doug: There’s no quick solution. And I actually wrote a blog post on one of those companies, I’ll put a link to it in the show notes, paying huge interest just to have a loan show up on your credit report is almost always a very bad plan.
So okay, let’s get to the practical advice section of the show here even though you’ve given us a bunch of practical advice already. We know that if you apply for a lot of loans in a short period of time and you’re turned down that could reduce your credit score. That seems crazy, you’re applying for credit because you need it, the credit bureau says if you really need the money you’re at risk, but regardless that’s how it works.
But this may be one case where the credit bureau’s actually right. If you take on debt that you can’t afford you’ll eventually find yourself getting late on your payments or worse not making your payments. So, if you’re applying for a debt consolidation loan or a second mortgage to deal with credit card debt and the bank turns you down, what should you do?
Ted: If the bank turns you down they think you have too much debt. If a bank thinks you have too much debt you probably have too much debt.
Doug: Because they’re in the business of giving you more debt.
Ted: That’s right, that’s how they make their money. So you should be considering alternatives, this is going to sound self servicing but a consumer proposal is a logical alternative if you’ve gone to the bank for a consolidation loan and they’ve said no. It’s better than getting a second mortgage or a high interest loan from somebody else simply because there’s generally no interest on a consumer proposal and it will address the fact that your credit isn’t as good as you think it is. It’s going to force you to deal with the problem.
Doug: Yeah and the problem is you’ve got too much debt.
Doug: That’s the problem, it’s as simple as that. So, okay I agree with all of that. So what are your final words of advice here then for people who are listening?
Ted: So I wish people wouldn’t get so hung up on the whole credit scoring system. It’s for the benefit of lenders; it’s not for the benefit of individuals like you and me. It’s about getting you to borrow more money as opposed to less money. I mean my recommendation is you only borrow what you need; you pay it off as quickly as you can and you manage your debt based on your finances, the money that you’ve got in not by trying to manage your credit score.
Doug: Well, I totally agree. In fact I think that’s exactly the point I made on page 51 of my book, Straight Talk on Your Money in the section called Worrying About Your Credit Score is Missing the Point.
Ted: Had to plug the book.
Doug: Had to plug it. Well, look we’re getting close to the clock here. So I think that’s good advice Ted, thanks for being here today.
Ted: Happy to be here.
Doug: That’s our show for today. Ted and I both agree your credit score is for the benefit of the bank, not you. You should not live your life trying to pursue the highest possible credit score. In many cases, a lower credit score or even what is considered a bad credit score is better for you than a higher credit score. The more credit you have and the more you use it, within reason, the higher your credit score. But the more credit you have the more risk you are taking, that was the first point Ted made. The more you borrow the more you pay in interest. The big bank may like that but it’s not good for you. Keep your debts low even if that gives you a bad credit score. And if you have more debt than you can handle as Ted says a consumer proposal is a good option in many cases. Getting rid of your debt once and for all is in your long term best interest.
We’ve covered a lot of ground today so as always you can find the show notes over at hoyes.com and I’ll include a full transcript and links to what we talked about today including our articles on why credit repair companies aren’t worth it and seven facts you should know about your credit rating. Thanks for listening, for Ted Michalos, I’m Doug Hoyes, that was Debt Free in 30.