You likely already know that your credit score is a number that impacts your ability to get a new loan. But if you have poor credit, working to improve your score can be a frustrating exercise. Understanding how your credit score is calculated by Canadian credit bureaus will help you positively manage your credit behaviour, so you can qualify for traditional credit like a mortgage or car loan at a reasonable interest rate.
This guide will explain the five factors that make a good or bad credit score and address the most common questions we receive about what does and does not affect your credit rating.
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The 5 main factors of a credit score
A credit rating is a score that provides lenders with a risk assessment about your creditworthiness. This score is determined by a credit report that includes your payment history on loans, credit cards, and certain bill payments. It tracks when you opened or closed accounts and whether your payments were on time, missed, or sent to collections.
Your credit history is updated monthly and processed by two credit bureaus in Canada: Equifax and TransUnion.
Credit scoring companies have a complicated mathematical algorithm to calculate your score, but their factors can be broken down into five main categories.
1. Payment History
Your payment history accounts for 35% of your credit score and is the most important factor you can control. Even a single late payment will lower your credit score. The higher your credit rating, the harsher the penalty for late payments. If you don’t miss any further late payments, your score may recover quickly; however, multiple late or missing payments will cause severe credit damage.
Late payments stay on your credit report for up to six years, although the impact of old late payments is less than new late payments.
2. Amount of credit in use
The balance due on your accounts calculated as a percentage of the amount of credit available to you (your credit limit) determines your debt to credit ratio, also referred to as credit utilization. A low credit utilization ratio leads to a higher credit score. Credit utilization also accounts for about a third of your credit score.
If you have maxed-out credit cards or lines of credit, this is a sign to lenders that you are a high-risk borrower. Accounts kept near their limit show lenders that the borrower is likely living beyond their means. However, if you don’t use anywhere near your limit, you will have a better credit score.
3. Length of credit
How long you have held a credit card account or line of credit shows potential lenders that you have experience managing credit. The longer you have a credit account, the better. Lenders like to see a long history of borrowing and paying off on time. Keeping long-term credit accounts in good standing will provide a strong credit score.
4. New credit
While it is important to hold credit to establish a positive credit rating, you should avoid opening new accounts frequently. Just as long-held credit accounts are good for your score, fresh debt can impact your rating in the negative.
Shopping around for new credit with multiple credit inquiries and loan applications will indicate to potential lenders that you may be a high-risk borrower. Taking on new cards and closing accounts frequently will also lower your report’s average length of credit history.
5. A good credit mix
Even if you always make your credit card payment on time and try to avoid maxing out your credit card, if you only hold one credit account, you will not reap the same benefits as a borrower with a good credit mix. You need to show a history of handling more than one credit account if you want a solid credit rating. Having multiple types of accounts, including installment loans like a car loan along with credit cards or a line of credit, can help your credit score.
Still, our experience tells us that having even two credit cards with a reasonable credit limit will help you build a good credit score. If you have declared bankruptcy or filed a consumer proposal and want to improve your credit score again, you will need to establish new credit accounts over a several months. Most traditional lenders want you to establish two new active accounts with a minimum credit limit of $3,000 each and keep a good payment history for three years to qualify for a low interest mortgage or term loan.
What helps your credit score?
There are multiple things you can do to help your credit score improve. However, you’re already taking the first step by learning how credit scores are calculated.
We also recommend reviewing your credit report at least once a year for accuracy. You do not want your score calculated based on incorrect information.
You can check out the credit bureaus’ websites or call them to obtain your free credit report:
- Equifax Toll-Free 1-800-465-7166
- Trans Union Toll-Free 1-866-525-0262
Pay bills on time
Paying your bills on time is the number one way to improve your credit score.
Unexpected life events happen to everyone, so there are two things I recommend that can help you stay on top of bill payments:
- Automate your bill payments, so you do not accidentally forget a payment.
- Have a small emergency fund, say up to $1,000, to cover you when the unexpected happens rather than using credit you can’t repay.
- Stay in communication with your credit cardholder or accountholder when severe financial hardships occur. If you know you will miss several payments due to an illness or work loss, see if they will provide you with a grace period. You will need to be in good standing with them, so don’t wait until you are already behind to reach out.
Keep utilization low
It’s generally advised that you not use more than 35% of your available credit if you want a good credit score. Using more than 35% of available credit shows lenders you are a high-risk borrower, even if you pay off the total amount every month. The impact of high balances on your credit is nearly the same as missing a bill payment.
If you are working to repair poor credit, we recommend keeping your utilization rate as close to zero as you can. You can do this by paying off your credit card as soon as you charge a purchase. We often advise clients to set up a single recurring payment, like a cell phone bill, then pay it off as soon as the charge is posted. This helps you ‘use’ your credit account while keeping your balance at zero.
Limit credit inquiries
While checking your credit history at least once a year shows financial responsibility, applying for multiple forms of credit in a close time frame will negatively impact your credit score. This shows potential lenders you may be living outside of your means and may use credit you can’t repay.
If you are shopping around for a good rate, be sure to ask the lender if they will be doing a hard or soft hit to your credit report. Soft inquiries are for background checks or pre-approvals and don’t affect your credit score. Hard inquiries appear as formal credit applications and are recorded on your credit history for three years.
Checking your own credit score or pulling your own credit report does not affect your credit score.
Don’t close too many accounts
Is it good for your credit score to close old accounts?
Living debt-free is a great goal that many Canadians are aiming for. If you’ve paid off debt on your own, don’t close your account. It helps your credit score if you show you can manage open credit accounts for a long time. Even if the balance is zero, closing an account will reduce your credit score.
If you have filed a bankruptcy or consumer proposal, these debts will be marked as ‘included in bankruptcy’ or ‘included in proposal’ and will be closed. Your goal will now be to open two new accounts as you rebuild.
Having a secured credit card
Will a secured card help you improve your credit score?
If you are rebuilding credit after an insolvency proceeding and do not yet qualify for a regular credit card, you can apply for a secured credit card. A secured credit card will impact your credit score because transaction activity is reported on your credit report like any other type of credit card. Your credit limit, outstanding balance and payments will appear monthly and help you build a good history of using credit cards wisely.
Do prepaid credit cards affect credit? Unfortunately, no. Prepaid credit cards do not affect your credit score because they are not reported to the credit bureau. Because you preload money on the card and use them more like a debit card, prepaid cards are not really a loan or borrowing mechanism.
What hurts your credit score?
Now that you know the ways to improve your rating, I’d like to talk about credit score factors you should avoid.
Missing or late payments and high credit card balances will impact your rating negatively, but there are smaller factors that many Canadians don’t think about. These are the top “invisible” actions to avoid that hurt your credit score.
Late payments on utility or service accounts
Credit scores are affected by any company reporting payments to the credit bureaus. In Canada, service accounts like your cell phone, home phone, cable and internet accounts are included on your credit report.
Paying your cell phone or internet bills on time generally will not improve your score because these payments are small. However, a late payment on a service account will have the same negative impact on your credit rating as a late payment on a credit card. So, keep all your accounts up-to-date to avoid hurting your score.
If you don’t pay a fine or traffic ticket, the province or municipality can send these kinds of fines to collections. If the collection company wants to, they can report the amount owing, and it will appear, not as a fine, but as an account in collection.
Similarly, outstanding fees like 407 ETR debts can appear on your credit report if sent to a collection agency.
When you receive a fine or fee, acknowledge it with the ticketing organization. You may be able to argue for a reduced amount, a payment plan, or for the fee to be waived. Either way, deal with it to avoid the fine going to collections and becoming a negative factor on your credit score.
Credit report errors
Credit reporting agencies get their information from lenders, and unfortunately, mistakes are common. The simplest – like your name, address, phone number, or employment history won’t affect your score but can affect your ability to qualify for a loan if they make it hard to confirm who you are. Other credit report errors, like incorrect balances, negative information reported incorrectly or not removed when they should be, or incorrect payment history, can harm your credit and lower your score. We recommend reviewing your credit report at least once a year to ensure accounts are being reported correctly.
The Canada Revenue Agency is responsible for collecting outstanding tax debts and Canada Student Loans in arrears.
In general, tax debts do not affect your credit score because they are not reported to the credit bureau. The exception is if CRA obtains a court judgment that can appear in your report’s public record section.
Canada Student Loan payments are usually reported to the credit bureaus, including your payment history. Falling behind on your student loans can hurt your credit score.
Taking the time to get your annual free credit history is vital to combat identity fraud. In Canada, identity theft is rising, and this can impact your credit score by having loans outstanding in your name that you are unaware of and didn’t authorize. Take control of your financial history by monitoring what is on your report, and dispute any nefarious transactions or credit applications before they do long-term damage.
What else do lenders look at when approving new credit?
While your credit score is an important factor in getting new credit, this is not the only requirement financial institutions will look at when reviewing your loan application. Lenders will look at:
- the amount and stability of your income,
- your current debt load and debt-to-income ratio,
- any assets you can use for collateral,
- your credit score.
Six credit score myths you should know
There are myths many Canadians share surrounding credit scores and credit history. Here are some of the top myths regarding credit scores:
Myth: Bankruptcy means you can’t access credit again
Filing a bankruptcy or consumer proposal is a step an individual can take to overcome overwhelming debt. While these processes do limit the credit available to you for a period of time, they will not stop you from accessing credit in the future.
The fact that you filed will appear on your credit report. Like with late payments, credit reporting agencies have retention policies for how long your bankruptcy or proposal remains on your credit report:
- a bankruptcy will remain on your credit report for 6 to 7 years from filing,
- TransUnion and Equifax websites say they will remove a proposal the earlier of 6 years from the date of filing or 3 years after completion.
Monthly bankruptcy or proposal payments are not reported on your credit report and have no impact on your credit score. Licensed Insolvency Trustees do not report any information to the credit bureau. Information about your bankruptcy or proposal is reported by the Office of the Superintendent of Bankruptcy. They will report whether you filed a bankruptcy or consumer proposal, the date you filed and the date of completion or discharge.
When your debts and credit history are too much for you to handle, taking steps to make a fresh start through a bankruptcy or proposal will help deal with your debts and allow you to restore your financial health and get you started on rebuilding your credit.
Myth: It is always good to increase your credit limit
Increasing your credit limit or accepting a pre-approved credit limit increase has both positives and negatives in terms of your credit score and overall financial health.
While higher limits can lower your credit utilization rate and help you keep your debt at 35% or lower of the available credit, raising the limit can also impact your score poorly by giving you access to more debt if you can’t control your balances.
The lender may also require a hard inquiry to increase the limit, so if you’ve recently applied for other loans, increasing the limit may lower your score initially. Even if you have been offered a credit limit increase, ask if the lender will do a hard hit after you accept.
Lastly, even if you have a high credit score, if you have a lot of available credit, a new lender may deny your application because they feel you already have too much credit available already.
The key is, only apply for credit when you absolutely need it.
Myth: Spouses share credit scores
Everyone who borrows has their own credit score in Canada. If one person in a partnership has poor credit or requires financial assistance, such as declaring bankruptcy, this will not affect the other partner’s credit score. It may only affect the other person’s credit if a debt is joint or is co-signed.
Myth: Paying off your car loan hurts your credit score
Once you pay off a term loan, like a car loan, the account will be closed since you’ve finished making payments under the term of the loan agreement. Closed accounts paid as agreed will be purged from your report ten years from the last reporting date.
Paying off your car loan won’t necessarily hurt your credit score, but if you are working to rebuild credit, having a monthly on-time car loan payment appear on your credit score will help improve your credit score if you are rebuilding.
Myth: Credit repair loans can improve your credit score
There are plenty of credit repair agencies proposing to set you up with small monthly payment plans they say are designed to help you rebuild your credit. The idea is they report these monthly payments to the credit bureau.
In truth, most credit repair programs do not work as advertised and can, in fact, have a significant negative impact on your credit report if you miss a payment, not to mention the costs associated with these loans.
Myth: Assets and income can improve your credit score
Most people are surprised to learn that your income and assets do not affect your credit score. Someone with a higher income may have a higher score, but that is likely because they can qualify for a higher credit limit and can afford to keep their balances low. How much they earn is not a factor. Similarly, having equity in your home does not improve your credit score.
Your income and assets you use as collateral can improve your chances of qualifying for a new loan. These are additional factors outside your credit score a lender will review in a loan application.
Repair your credit score with our free course
At Hoyes Michalos, we know that repairing your credit score can be done. Understanding the factors of a credit score is helpful if you’re looking for the steps to help you rebuild your credit on your own. Consider enrolling in our free credit repair course to learn more about how to improve your credit score.
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