Understanding your credit score
In my last article, I discussed the five Cs of credit. Many people in the past couple of weeks have stopped and asked me just what that number means and how does a credit bureau calculate “my number”?
It turns out that your “number” is based not just on how you use credit but what types of credit you use, as well as how long you have used credit and how many requests you have made for credit recently.
Repayment history is the most important factor in calculating your credit score. In fact, credit reporting agencies use a system of payment timeliness ratings that indicate both the type of credit used and how timely you are in making minimum required payments.
For example, a credit card or line of credit is considered a revolving credit product, meaning that it has a credit limit which the lender expects you to revolve. In other words, over time the lender expects that the balance on the credit account will move between zero and its maximum limit.
So if you have a credit card with a balance, and your most recent minimum payment was made on time, this account would have an R1 rating. This is the highest rating you can receive.
In contrast, a term loan with a payment made on time would have a rating of I1. The “I” means it is instalment credit that has a regular monthly payment — for example, a car loan or lease.
These ratings can move from I1 or R1 to I9 or R9. A rating of R9 or I9 is a bankruptcy. The higher the prefix number, the number that comes after the letter, the more points you will potentially lose.
Another consideration is the proportion of a revolving account’s limit already taken by a balance. The more accounts with high balances relative to their limits, the lower potentially your score.
Rating agencies also take into account the relationship between the length of time that the account has been open or it was last used, and its balance.
Using a credit card as an example, your balance could be $800 on an account with a $1,000 limit. This would be considered high in proportion to the limit but if the account has been open for a reasonably long period your final overall credit score may not be negatively affected.
In contrast, a card with a high balance and that has been open for a short period of time could potentially reduce your score.
Finally, the number of recent credit requests can negatively affect your credit score.
Credit rating agencies differentiate between two types of credit request.
A “soft” request is, for example, a request you make for a copy of your credit report. This request will be excluded when calculating your score.
A “hard” request, such as your requesting a new loan, will potentially reduce your score. Too many “hard” requests can have a negative impact on your overall credit score.
In the final analysis, your credit score is yours. If there is one facet of your financial life you can control, it is how you use credit to maximize your score, given your other circumstances, so that you can minimize the future cost of borrowing. Remember, the lower your credit score the higher the cost of borrowing.
To find out more on how to get a free credit report, go to www.equifax.ca or www.transunion.ca; and remember, you are in control of your financial destiny.
Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’Meara@rdc.ab.ca.