Understanding how your credit score is calculated

The basics

One thing you may have heard about in the past is how important it is to have a good credit score, but what exactly does that mean? Your credit score is a number between 300 and 900. The higher your number, the better your credit score is, which is important if you ever need a loan in the future such as car financing or a mortgage. Companies such as Borrowell allow you to quickly check your credit score for free, so there’s no excuse not to find out how you’re doing.

Now that you know your credit score, you can see how you rank based on the chart below:

Poor


300 - 574

Fair


575 - 549

Good


650 - 719

Very Good


720 - 779

Excellent


780 - 900

As weird as it sounds, you may actually have two credit scores in Canada since there are two credit monitoring bureaus: Transunion and Equifax. Not every credit product you have reports to both agencies, which is why you may have two different scores, but both agencies use the same five factors to determine your score. By knowing how your credit score breaks down, you can take the steps to improve or maintain your credit score.

Your payment history - 35%

It should come as no surprise that your payment history is the biggest factor that determines your credit score, counting for 35% of the calculation. Lenders want to know that you’re creditworthy, so they’ll look at your payment history first.

What they want to know is if you’ve made your payments and if you’ve done it on time. Assuming you’ve done both, you’ll likely find yourself in a good position. Even if you’ve missed a payment in the past by accident, it may not ruin your credit score right away, as lenders understand that sometimes you may have just forgotten. That said, you don’t want to get into the habit of missing payments (especially two in a row) on a regular basis, as that’s pretty much a guarantee that your credit score will drop significantly.

How much credit you’re utilizing vs. how much you have available - 30%

How much credit you use on a regular basis compared to how much you have available to you is known as your credit utilization ratio. This is another major thing that determines your credit score.

Let’s say you have a credit card with a limit of $1,000 and you regularly maintain a balance of $800. Even though you pay your bill off in full and on time every month, there’s a chance your score could still be lower, since you’re utilizing 80% of your credit available.

Now let’s say you applied for another credit card that comes with a $1,000 limit, or you asked for a credit limit increase on your current credit card to $2,000. Your credit utilization ratio would now be 40%, which looks better in the eyes of the credit monitoring bureaus.

The length of your credit history - 15%

Lenders like to see a history of credit management, which is why it’s a good idea to start building your credit history early. The good thing is that things such as your cell phone bill, Internet contract, and even your student loans would count towards your credit history, so you likely already have a credit profile established.

With that being said, these accounts need to be in your name. If you’re simply a member of the plan or an authorized user on a credit card account, you may not be building a credit history. It’s in your best interest to establish your own credit history even if that means getting a no-fee credit card that you use infrequently.

Recent credit activity - 10%

Whenever you apply for new credit, a hard check is down on your history, which results in a loss of 10 points on your credit score. This normally isn’t a big deal since your credit score would go back up after a few months if you’re making your payments, but it could be a concern if you’re applying for a bunch of credit cards in a short period of time.

For example, let’s say you applied for five credit cards in a span of eight weeks (not that you would do that, right?) – your credit score would, in theory, drop 50 points. That could potentially drop your credit score from very good to good or from fair to poor. More importantly, lenders may be wondering why you’re trying to access so much credit and be hesitant to give you access to more. This could be a huge problem if you’re trying to get a major loan such as car financing or a mortgage, which is why you want to avoid applying for a lot of credit in a short period of time.

Types of credit used - 10%

Finally, there are the types of credit you use that affect your credit score. This was a bigger deal in the past when lenders would check to see if you were constantly dipping into your line of credit as it implied you are short on cash. These days it doesn’t seem to matter what type of credit products you have access to, as lenders seem not to care too much.

Final thoughts

If you find your credit score is lower than expected, don’t panic. No one ever has a perfect credit score, and things can fluctuate from time to time. But if you want to improve your credit score, take a look at the factors above and take the steps to increase your rating.

Barry Choi is a Toronto-based personal finance and travel expert who frequently makes media appearances. His blog Money We Have is one of Canada’s most trusted sources when it comes to money and travel. As a completely self-taught, do-it-yourself investor with no formal training, he makes money easy to understand for all Canadians. His specialties include personal finance, budget travel, millennial money, credit cards, and trending destinations.

Barry Choi is a paid Sonnet spokesperson.
Looking for a home and auto insurance quote?