What makes up a credit score?

What Makes Up a Credit Score?If there ever was a good time for Canadians to keep track of their credit scores, it is now. It could save you $1,000 a year in interest payments. Back in 1956, an engineer and a mathematician invented a process for analyzing business data to help institutions make sound financial decisions. The system, FICO, quickly evolved into scoring criteria that are used by lenders and investors to calculate the risk associated with loaning money to companies and individuals.

How Your Credit Score is Calculated
Here's how it works:

  • Financial information is gathered about your past and present borrowing habits.
  • That is then calculated into a number or credit score.
  • As proper repayments are made according to the terms of your credit card, line of credit or loan, your score will increase. Scores range from 300 to 900; the higher the number, the easier it is to obtain credit. The average Canadian credit score is 720.
If you keep up with your payments, you can get larger lines of credit at lower interest rates because you have proven you are trustworthy. If you have never had a credit card or loan, you will have no credit score and will have a difficult time obtaining credit, and will pay higher interest rates on that credit.

The Five Pieces that Make Up Your Credit Score
There are five factors that determine your credit score, according to Fico.ca:

1. Payment history. This, the most important, makes up 35 percent of your score. It is based on how well you pay off debt. Every time you miss a payment or pay late, your score will be lowered. Any major financial events in your life such as declaring bankruptcy, collection actions, past due payments and foreclosures will be kept in your payment history and drive down your score for five to seven years.

2. Total debt. This accounts for 30 percent of your total credit score. This is the total of all credit card debt, loans, mortgages and other debts you may have and the length of time it takes you to pay it all off. If you pay all your credit card debts right away, this will decrease your total debt and improve your score. The ratio between the amount of credit available compared with the amount you have used will also affect your credit score.

3. Credit history. Credit history accounts for about 15 percent of your credit score, and is determined by the length of time you have used credit services -- how long you have had credit cards, loans and mortgages. If you close an old credit card you have kept up to date for years, then start a new card, this shortens your history and can be detrimental to your credit score.

4. Recent credit is the amount a lender agrees to let you borrow, and is worth 10 percent of your total score. After you are approved for a credit card or loan, the recent credit number will be adjusted.

5. Credit types make up the last 10 percent of your credit score. Large loans such as mortgages have a greater impact on this number than a line of credit or a credit card.

Who Keeps Track of Your Credit Score and Why You Should Care
In Canada, there are three main credit bureaus: Equifax Canada, TransUnion Canada, and Northern Credit Bureaus. Each credit bureau may have a different score depending on the files they have on you. In Canada, free credit reports are always available if you request them. Understand that frequent requests won't affect your score as it does in other countries.

Credit scores are generally grouped together into six levels or brackets. Each level pays a certain interest rate. That's why it can pay to know your credit score. Let's say your credit score is 659. This means you fall into the 620-659 bracket. If you can increase your score by just one point, it will become 660. That puts you in the 660-699 bracket, which could save you hundreds a year in interest!

"The downturn has affected credit scores of some but not others," explains Scott Hannah, president and chief executive officer of the Credit Counselling Society. "Those with a loss of income are relying more on credit. The trend we are seeing is that consumers are more in debt, which is having an adverse impact on credit scores."

Hannah recommends that people check their gross debt service ratio -- the percentage of your annual debt commitments to your annual income. "Consumers should not exceed 20 percent. If they have a monthly income of $3,000, they should only be paying $600 to service debts. This way there is no decline in your savings rate. Then you're not leaving yourself open to emergencies."

Nadim Abdo, vice president of Equifax Consulting Solutions, writes, "Unfortunately, our latest data illustrates that the weaker economy coupled with high personal debt levels has led to an increasing number of consumers declaring bankruptcy." This has a long-term effect on credit scores and will lower the Canadian average credit score.

Written by Christopher Ibotrain.

Updated July 10, 2009

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