How Credit Scores Are Calculated and How To Interpret Them

How credit scores are calculated and how to interpret them.

A credit score is an indicator of how well you have managed credit in the past and a predictor of how risky you are as a borrower.

So, it is important to understand how your credit scores are calculated if you’re interested in improving it.

In this post, we’ll look at the factors that are considered in calculating your credit scores, what a good credit score is and how to monitor them.

How is a Credit Score calculated?

Credit scores are computed from the information in your credit report, created by the 2 credit bureaus in Canada: Equifax and TransUnion.

As you apply for credits and make payments, the credit bureaus collect the information from various lenders to build your credit history.

The exact formula or model used by the agencies is unknown – they are proprietary information. But the main factors and their weights are known and explained in detail below

How credit scores are calculated. The factors and their weights

1. Payment History – 35%

The most important factor that is considered in calculating your credit score is your payment history.

With payment history accounting for 35% of your credit score, maintaining a clean history is very vital.

When you have a history of on-time payments on all your debt obligations, it indicates you’re financially responsible and likely to repay any new debt in the future. On the other hand, late and missed payments, especially when frequent, are a big red flag.

To understand how important the payment history is, consider this example: your score may drop by up to 100 points the first time you miss a payment, even if you had a good credit score before.

If you’re struggling to meet your payment obligations, it’s better to arrange for a deferral with your creditors than miss a payment.

Tips to improve your payment history:

  • Use a bills tracker to ensure you don’t miss any payment
  • Don’t take on any more credit than you can handle
  • Ask for a deferral or arrange a payment plan with your creditors if you can’t handle your current payments.

2. Credit Utilization – 30%

Your credit utilization, that is the ratio of your used vs available credit, has the second highest impact on your credit score. The ratio looks at all the credit that is available to you, both credit cards and lines of credit, and how much of it you’re using.

Loans are not included in calculating your credit utilization.

For example, consider 2 individuals with credit balances of $3,000 each:

The first has a credit card limit of $5,000 and the second has a limit of $10,000. Though they have the same balance, their credit utilization ratios are 60% and 30% respectively.

A high credit balance is an indication that you may be unable to pay all your debts in the future. All things being equal, the lower your credit utilization, the better your credit score will be and the more creditworthy you’ll appear to lenders.

So what is a good credit utilization ratio?

The general advice is to have a ratio below 30-35% but keep it below 10% if you can. A lower credit utilization rate will be seen as a more responsible use of credit than a higher one.

How do you improve the ratio?

You can improve your credit utilization by improving the 2 components of the ratio, the amount you owe and the available credit.

Here are the ways to lower the ratio:

  • Reduce the amount you owe: By paying off some of your account balances and clearing any new credits each month, your total debt will decrease and positively impact the ratio
  • Increase your credit limit: Asking your credit card company to increase your credit limit or applying for a new one, will also provide an immediate boost to your credit utilization ratio.

But be careful with applying for new credits.

In addition to negatively impacting your credit score through the hard inquiry on your credit file (see below), you may end up in a worse position if you don’t use the new credit responsibly.

Even worse, your application may be denied if your score is already bad.

3. Length of Credit History – 15%

How long you’ve had credit accounts contributes 15% to your credit score. The longer your credit history, the more evidence the lenders have that you can properly handle your debts over time.

Unfortunately, this factor will affect you negatively if you’re just opening your first credit or new to Canada. But over time, you’ll gradually see an improvement in your scores.

If you’ve ever been advised not to close an old credit card account, this is why. But closing an old credit card will not necessary affect your scores negatively. Why?

This is because the credit bureaus still keep records of your closed accounts for up to 10 years.

But closing a closed account may affect your credit utilization ratio. So it may still be a good idea to keep an old account open and use it periodically to keep it active (if there are no fees).

4. Credit Mix – 10%

Lenders want to see that you’re able to manage different types of credits such as credit cards, installment loans, mortgages and so on.

So if you don’t have different mix of credit accounts– or have too many types – your credit scores may be negatively impacted.

However, this doesn’t mean you should go ahead to get a new loan you don’t need just so you can have different credit mix on your profile.

While every factor counts, the credit mix has a relatively small impact on your overall score, so focus on the other factors and only apply for new credit when you actually need it.

5. Credit Inquiries – 10%

All requests for information from your credit file are logged as an inquiry. However, only those inquiries relating to active credit seeking, otherwise known as “hard” inquiry”, will impact affect your scores. By active credit seeking we mean, applying for a new credit card or loan.

Several inquiries within a short period of time could be an early indicator of financial distress, and in addition to other warning signals like an increase in credit utilization, may lead to a big drop in the credit score.

It is okay to shop for good rates when you’re getting a mortgage or car loan. But limit all the applications to a 2-week period. This way, all the inquiries will be combined and treated as one.

Other soft inquiries, like when you request for your own credit report, will not affect your score.

How to interpret your credit score

Credit scores range between 300 and 900, and while there are different scoring models used for the calculation, they all have same objective – predicting the borrower’s ability or likelihood to repay the debt.

So what is a good credit score, and what do the ranges mean?

Here is a general guide:

  • Excellent: 760 – 900
  • Very Good: 725 – 759
  • Good: 660 – 724
  • Fair: 560-659
  • Poor: 300 – 559

The higher your score, the more confidence lenders will have in your ability to service your future obligation.

On the other hand, the lower the credit score, especially for those in the poor range, the harder it will be to get approved for credit or qualify for better loan terms.

Here’s a short, and funny, video from Equifax on the subject:

Benefits of a Good Credit Score

As you’re probably aware, a good credit score will give you access to the best financial products and services. On the other hand, getting approved for new credits will be difficult if you have a poor credit score.

Here are some of the benefits of having a high credit score:

  • Higher chance of getting approved for credit
  • Preferred interest rates: With a good credit score, you’ll be able get lower rates that can save you thousands of dollars on the long run.
  • Higher Credit Limits

How can you monitor your credit scores?

The easiest way to monitor your credit scores and credit reports is to check them periodically. Fortunately, there are a number of free options available to Canadians.

For example, you can check your Equifax credit score and report by signing up with Borrowell. It only takes a few minutes to sign up and it’s a soft inquiry, so it won’t affect your credit score.

Click here to learn how to obtain a free copy of your TransUnion credit score and other free ways to get your credit reports in Canada.

By monitoring your credit scores and credit reports regularly, you’ll be able to spot any errors or unauthorized credit applications on time. You can reach out to the credit bureaus to correct any errors.

Related Post: How to get credit report and credit score free in Canada

Conclusion

We hope you now have a better understanding of how your credit scores are computed now.

To obtain your free Equifax credit report and credit score and start monitoring your scores today, sign up with Borrowell or read about the other options.

Also, learn how to improve your credit score fast here.

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Simon is a CPA by day and a Personal Finance Blogger by night. With over a decade experience in financial services, he's passionate about personal finance, investing and helping people take control of their financial life.

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