How is Credit Score Calculated?
A credit report contains a summary of credit payments and how you pay your financial obligations. Information in the credit report is used to determine credit score. In Canada, credit score can range from 300 to 850 or 900 (depending on the company calculating the score).
Credit score ranges in Canada:
- Poor = 559 and under (4% of Canada’s population)
- Fair = 560 – 659 (10% of Canada’s population)
- Good = 660 – 724 (15% of Canada’s population)
- Very Good = 725 – 759 (14% of Canada’s population)
- Excellent = 760 and over (57% of Canada’s population)
The higher the score, the lower the risk of the person reaching 90 days past due or worse (defaulting on their loan).
Credit score determines the interest rate you get for borrowing (whether it be mortgage or other loan types). It is often referred to as “FICO score”. FICO score is a proprietary tool created by the data and analytics company FICO (formerly called Fair Isaac Corp.). This is the most common calculation tool used by credit score agencies such as Equifax and TransUnion.
FICO score calculation is done using 5 major categories that when combined, make up one’s overall credit score:
- Payment History (35%)
- Amount Owed (30%)
- Length of Credit History (15%)
- New Credit (10%)
- Types of Credit Used (10%)
Payment History (35%)
This category is made up of the history of all your credit account payments, and whether you have paid them in a consistent and timely manner. It factors in all the payments you make for all your consumer debts (payments to credit cards, line of credit, car loan, personal loan, student loan, cell phone bills on contract, and other regular debts). It shows whether payments have been made on time, if there is any deferred payment plan, and how many payments have been late.
Payment history also factors in previous bankruptcies, judgements, liens, collections, and delinquencies. The time it took to resolve them, and how much time has elapsed since the problems appeared, are all taken into consideration. The more payment issues you have in credit history, the lower the credit score.
Amount Owed (30%)
The second largest component that makes up a credit score is the amount you currently owe, relative to the credit you have available. The formula assumes that borrowers with a high ratio of amount owed to amount available are at high risk. Borrowers who regularly spend up to or above their credit limit are at higher risk for defaulting on their loans. Lenders usually prefer to see borrowers with credit utilization ratios (the percentage of available credit that is actually being used) to be 30% or lower. Example: If you are approved for a line of credit with a maximum amount of $100,000, continually using up more than $30,000 all the time may lower your credit score.
Length of Credit History (15%)
This category is included in credit score calculation because time is needed to get a true understanding of how responsible someone is with credit. Someone who has been using credit responsibly over time would have higher credit scores.
People who have opened new credit cards or loan accounts only recently would not have a lengthy credit history just yet. Over time, if you pay your amounts owing consistently and on time, your credit score can increase. The longer your credit accounts have been open and in good standing, the better. This is why it is better to hold on to a credit card account for a long time instead of continually closing and opening new ones.
New Credit (10%)
Applying for and opening new credits and loans frequently are indicative of financial pressures, so credit score lowers a little. Lenders might see someone who keeps trying new credit accounts as someone who might be in trouble financially, and thus needs more money to borrow. Having a large number of new credits can also make it harder for the borrower to keep up with all of their payments.
This component of the credit score also takes into account the number of credit accounts that have been recently opened, how much time has passed since you last opened any new accounts, the number of times your credit has been checked in the past 5 years, and the amount of time that has passed since the most recent credit inquiries. Credit inquiries are often required before a loan can be granted. There is a difference between “soft credit inquiry” (such as those conducted by a phone plan provider company to determine your credit-worthiness), and “hard credit inquiry” (which can lower your credit score).
Types of Credit Used (10%)
FICO score does not only look at the current amount of debt and credit history. It also looks at the different types and variety of credit accounts that you have open. Everything else being equal (credit history, amount owed, credit utilization ratio), someone with a credit card account, car loan, and mortgage would have a higher credit score than someone with just a credit card account opened. Having a variety of credit types used indicates that the borrower is able to pay off different types of credit without any issue.
Different types of credit can also shed light on how you handle your money overall. Revolving forms of credit (such as credit card and line of credit) may increase borrower risk, compared to installment loans where payment amounts are set over a fixed period of time and then paid in full. Deferred payment plans can indicate the inability to save up for purchases ahead of time, or current financial troubles. Consolidation loans can indicate that you have had difficulty paying your debts in the past.
The biggest component that makes up a credit score is the history of payments, followed by credit utilization ratio (amount owed in relation to credit available). To improve your credit score (i.e. to get a lower mortgage rate or loan interest rate), have a realistic spending plan and always pay your credits on time. Keep track of your credit score (for any potential frauds and credit theft) through credit score monitoring and credit report providers such as Equifax and TransUnion.