Have you ever wondered how your credit score is calculated? You are not alone! If you have at one point in your life applied for a credit card, personal loan, car loan or mortgage, then you must know that the lender pulled up your credit bureau file and computed your credit score in order to assess your creditworthiness.
So how is your credit score calculated?
The answer is not plain black and white. The score that you get when you purchase your credit score directly from the two major bureaus – TransUnion and Equifax – may be different from the score that individual lenders compute when they assess your credit file.
Note that free credit scores are now available from online lenders in Canada including Borrowell, Mogo and Ratehub. Generally, the credit scores you will receive from these sources are ranked as follows:
760 – 900 → Excellent
725 – 759 → Very Good
660 – 724 → Good
560 – 659 → Fair
300 – 559 → Poor
Factors that are usually considered by lenders and credit bureaus when calculating credit scores are similar. In general, numerical weights are applied to various aspects of your credit file and a formula is used to compute the final credit score. The lender may calculate the score in-house or use the services of a vendor, such as FICO.
Five criteria utilized by FICO (a major credit score vendor used by most financial institutions) include:
1. Loan Repayment History (35%)
This makes up 35% of your credit score, making it the most important factor when credit scores are concerned. This criteria takes a look at how you have been paying off debt owed on your credit cards, car loans, line of credit, cellphone bills, etc. Do your payments come in late? any delinquencies? bankruptcy? missed payments? debts in collections? liens? and so on. Paying your bills on time, all of the time, is a good maxim to live by.
2. Total Amount Owed (30%)
This comes in second place in order of importance and determines 30% of your credit score. This criteria looks at how much you owe across board, and how easy it is for you to pay what you currently owe. Additionally, it assesses your current debt-to-credit ratio. If your credit utilization ratio is very high, it may have a negative impact on your score. Keeping your credit balance at 35% or less of your credit limit looks better to lenders. For example, if you have a credit card with a credit limit of $1,000, try to keep the outstanding balance below $350.
3. Length of Credit History (15%)
When you have used credit for a long time, lenders are better able to assess your creditworthiness, for good or bad. If you don’t have a credit history, lenders have nothing to work with and cannot assess your creditworthiness. This is why people new to credit always start with a lower credit score. The longer you use credit responsibly, the better your credit score. This is one reason why it may not be advisable to close old credit card accounts.
4. New Credit Accounts and Applications (10%)
When you apply for new credit, lenders make what is known as a “hard inquiry” on your credit file and this is reflected in your credit history. The number of recent credit accounts or enquiries and their frequency will impact your credit score. If you have many enquiries within a short period of time, lenders may assume that you are having financial difficulties and therefore pose an increased credit risk.
Inquiries made by you such as when you request your credit score or report, are referred to as a “soft inquiry” and do not impact your score in any way.
5. Credit Mix (10%)
This makes up 10% of your credit score. Having a diverse mix of credit such as a mix of credit cards, lines of credit, mortgage and personal loans, will impact your score positively if they are in good standing.
Credit scores are very important in Canada and can impact your financial realities in more ways than you can imagine. Understanding how they are calculated can be helpful if you are trying to improve your credit score.