Your credit score is a black hole, all powerful & mighty, possessing complete control over your financial future and interest expenditure. Knowing this, we must determine how one should go about navigating such an abyss. Where do you start? What is good credit and what is bad? How do the numbers that Equifax or Mogo spit out at you actually come to exist?
If you’re asking these questions, don’t feel alone. A 2016 BMO survey reported that 56% of Canadians don’t actually know their credit score, and of the 44% that do, only 16% check it more than once a year. Better yet? only 35% of the Canadian Millennial population claim they know how to achieve a proper credit score – and the icing on the cake – only 20% of that same population have actually checked their credit score.
These numbers aren’t presented to scare you, or to make you feel as though you’re inferior to your credit score-checking peers. They’re to let you know that the concept is tough for most and the fact that you’re here means that you’re ready to enter the big leagues.
In the simplest way possible, I’m going to break down what your credit score is, how it gets to where it’s going, and how you can take full control of your financial future.
What it is
I’m sure that most of you are familiar with what a credit score is – you’ve been told all about how a good credit score will lead to more leverage potential in the future (this being your ability to borrow money at a reasonable interest rate) and how building a good financial reputation will save you thousands (if not hundreds of thousands) of dollars over your lifetime. If you’re confident in your understanding, feel free to scroll down to the next section. If you’re looking to learn more about the concept, continue on.
In it’s simplest form, a credit score is your ‘responsibility rating’ in the financial world. It tells banks, lenders, and the like what they can expect to get when they decide to loan you money. Are you a reliable customer who will pay them back? If so, they’ll be more inclined to give you more money & even do it at a cheaper interest rate (they want to keep you happy, right!) You can only become a reliable customer though by being a reliable customer, and this is where your credit score begins.
Everyone starts with a credit score of zero, and bills/expenses such as phone bills, car payments, insurance payments, credit card payments, mortgage payments – the list being virtually endless – help build you a reputation. Your ability to pay back these things (in full, and on time) show potential lenders that you’re true to your word and a reliable client.
Understanding the credit score concept is as simple as understanding which stores you choose to shop at. If a retailer consistently sells you poor-quality clothing that breaks or tears, you’ll be far less likely to continue shopping there (i.e. their credit is very low and you don’t want to give them your business).
But how exactly can we make sure that we’re doing everything possible to achieve a proper credit score?
How it Gets to Where it’s Going
Obtaining a good credit score isn’t quite as simple as understanding what a good credit score means, and it’s certainly not as simple as just paying off all of your bills (although that does have a big effect). Your credit score is comprised of 5 components, all 5 of which work in tandem to create your credit profile. Each of these components can be managed independently, and the breakdown below should help you understand what it is that makes up your holy number.
1. Payment History (35%)
Your credit score is a testament to your ability to pay back debt on time, and as such, your payment history has a large weight. At just over 1/3 the total score, you’ll want to put a lot of attention towards getting all outstanding payments covered on time. It’s important to note that missing a payment on a $6 credit card balance is just as bad as missing a payment on a $600 one – both showcase that you’re unable to be relied on.
If you’re looking to build a solid credit score, one of the first things you’ll want to do is set a calendar/mental time stamp that allows you to remember when bills are to be paid & how much is owed (to the dollar). It’s generally easier to set up automatic payments, but if this isn’t an option, make sure you stay on top of them yourself.
2. Utilization Ratio (30%)
Interestingly enough, the amount of credit that you use is almost as important as actually paying off the credit itself. Your utilization ratio (i.e. the percentage of your total credit available that is being used at any given time) tells a great deal about your reliance on debt and your ability to manage funds efficiently.
Generally, financial institutions/lenders like to see a credit utilization ratio of around 30%, and absolutely never more than 70% for a prolonged period of time. This means that if you’ve got a credit card limit of $5,000, you should aim to keep no more than $1,500-$2,000 on it at any given time and you should avoid going above $3,500 at all costs. Even though this may mean paying off your credit card on a weekly/bi-weekly basis, the penalties for carrying high balances will be far more detrimental than the 15-seconds it takes to log in to your online banking.
3. Length of Credit (15%)
As we continue our descent down the scale of importance, we find ourselves looking at the 15% credit weighting that credit length has on our score. One’s length of credit is essentially their financial track record – showing parties how long you’ve had credit open for and how you’ve been able to manage it over the years.
Your length of credit is something that can’t be sped up – earning this 15% will come from holding steady credit products and keeping them in-line over extended periods of time. Getting started on this today will ensure that 3-5 years from now you’ll have an easy 15% of your score covered.
4. Types of Credit (10%)
Although coming in at only 10% of your credit score composition, your types of credit definitely have an impact on how potential lenders look at you. Personal types of credit are best spread out – showing that you’re utilizing different forms of debt and not becoming reliant on a single type emphasizes stability. As an example: Having 10 credit cards at the age of 23 will not make you seem like a young millionaire.
A proper credit spread should incorporate many forms of debt – a mortgage, credit cards, lines of credit, etc. These different forms are known as revolving (they change over time) and fixed (they are locked in), and they show that you have a good breadth of credit and that you can handle different payment types.
Now, this isn’t to say that you should be taking out as much debt as possible as quickly as possible, it’s just to say that you should be conscious of the credit that you hold and be strategic with account openings.
5. Inquiries (10%)
Our final component is the inquiries portion of your credit score. As silly as it may seem, the frequency with which your credit score gets checked has an impact on your credit score – this 10% portion telling that story.
Every time a hard-credit check is performed (these being the credit checks performed when you open a bank account, new phone plan, credit card, car loan, etc), your credit score is impacted. Note that soft checks (things such as checking your credit score on the Mogo Money App) don’t have any impact, it’s only when you’re opening up new forms of credit/debt that your score sees an adjustment.
You can stay on top of this portion and keep it in check by being diligent when it comes to account opening. Be aware of how many times you’ve applied for new credit products & don’t overdo the application process.
So you’ve figured out why your credit score matters, and now you know all about what makes up the number on your banker’s screen. How can you take control though and be sure that you’re setting up your credit score to act as an ally as opposed to an enemy?
Start by checking it.
Having an idea of where your credit score currently sits will offer you a wealth of information. Not only will it tell you how your financial prospects are currently looking, but it will clue you in as to whether or not your present practices are working.
If you find that your credit score is less-than-optimal, don’t fret. A proper credit score is something that can take years, often several, to build correctly. Start by implementing proper principles and use the above breakdown as your reference sheet.
Minor changes to your debt usage habits, payment processes, and account management will save you MAJOR money over the long term – get started while it’s still early.