How to Build your Credit Score in Canada?
What is a credit score?
Credit score is a number that represents how trustworthy you are when you want to borrow money. This number is calculated by a company called a "credit bureau." What they do is collect information given by various companies (ex. - financial institutions, credit card companies, phone companies) and use that information to give an assessment of an individual's credit.
There are two credit bureaus in Canada, one being Equifax and the other being TransUnion. They both have different formulas to calculating your credit score, however they look at the same factors. There are 5 main factors that will be discussed below to help build your credit score. But before doing so, it's important to understand why having good credit is important.
What is the benefit of having good credit?
Having a high credit score is important because it is one of the main factors that lenders look into when assessing whether they should let you borrow money. It can affect whether or not you can get approved, how much you can get approved for, and the interest rates on the debt instrument you are applying for.
This is especially important when you're looking to apply for a large loan in the near future. If you want to finance a car, take out a mortgage, or take out a personal loan, your credit score is an important factor to consider. This is why it's crucial to think ahead and start building your credit early, so that you can be prepared for when you need to apply for a loan.
Below are the 5 main factors considered in your credit score (please note that the percentages are approximate and they can change over time):
1. Payment History (35%)
Payment history is your track record and ability to pay your bills on time. Missing the minimum payment on your credit card of $10 could negatively impact your credit score as much as missing a $1000 payment. Make sure you don't miss the minimum payments. It is an easy way to gain (or lose) credit score. Some creditors will report that you haven't paid them to your credit bureau (such as city parking ticket collectors). Sometimes third-party collection agencies can also contact your credit bureau and will ding you for it.
Make sure you're aware of who you owe money to and ensure you pay them on time!
Some people prefer to use their debit card or cash for all of their transactions. There is nothing wrong with that, however using your credit card for transactions help build a history for you in regard to your payment history. If you're looking to build your credit, you might want to use your credit card for your transactions. Just make sure you pay the full balance every month so you don't accumulate debt. If you find it too tempting to spend beyond your means, look to other types of credit to build your credit (more in factor #4).
2. Credit Utilization Ratio (30%)
The credit utilization ratio is your level of indebtedness. This is how much credit you are using compared to how much credit you have available. If you have a credit card with a $10,000 credit limit and you have a balance of $2500, then your credit utilization ratio is 25%.
You want to keep your balance on your credit below 35% of the credit limit. This would be the safe zone for credit utilization. Once you get over 70%, then your credit score will start getting negatively impacted. You want to avoid getting above 70%, even if you're paying it off every month.
Sometimes you'll be offered a "pre-approved credit limit increase." When you accept these, your credit score will be positively affected as it lowers your credit utilization ratio. You just want to make sure that you're responsible with your credit. If you're maxed out and get these promotions (and yes, they will offer it even if they know you're maxed out), then the temptation of using more credit might not outweigh the lower credit utilization.
3. Length of Credit (15%)
The longer you have an account open, the better. It shows your track record as someone who manages their credit. The longer you have it open, the more the credit bureaus have to look at to help assess you.
Sometimes when we have too many credit cards, we want to cancel our old ones that we don't use anymore. You want to make an informed decision because if your old credit card was the one you were using for two decades and the new one has just been used a few months ago, cancelling the old credit card can negatively impact your credit score.
Of course you also don't want to have 10 credit cards lying around, so be selective with which ones you will use the most and keep to help build your credit.
4. Type of Credit (10%)
You want to have a mix of different types of credit so that the credit bureaus can have a more comprehensive understanding of how you manage credit. Here is a short list of different forms of credit: Credit card, line of credit, car loan, mortgage, personal loan, consolidation loan, student loan, and unpaid loans taken on by collection agencies.
Different types of credit have different levels of risk in the eyes of the credit bureau. You want to have at least two different types of credit being used or paid off to help accelerate growth of your credit score. Although your phone bill isn't a form of credit, it helps the credit bureaus assess your ability to pay your obligations in a timely manner.
5. Inquiries (10%)
Every time you try to apply for a new form of credit, it has a negative impact on your credit score. There are "hard credit checks" and "soft credit checks." Soft credit checks are meant to view a brief overview of your credit. A hard credit check takes a comprehensive look at your credit, and lowers your credit score. Why is that?
You need a "hard credit check" when applying for many forms of credit or certain financial accounts. If it seems like you're constantly looking to get a loan every two weeks, there becomes a question of your capacity to maintain the credit.
As long as you don't make too many "hard credit checks" in a short amount of time, there is no problem applying for credit or opening an account. Personally, I say 1 or 2 hard credit checks every 6 months is fine. It will lower your credit score momentarily, and will come back up after a few months, assuming everything else is in good order.
One thing to note with all these is that it's easy to make a mistake here and then. You might forget to pay your credit card one month or close an old credit card that you used for a long time. Just remember that if your credit score is high, negative factors can have a small impact. On the flip side, if you have a low credit score, negative factors make a large impact. So It's important if you have a low credit score to be more diligent with managing your credit. If you have a high credit score, don't stress over missing one credit card payment or cancelling an old form of credit.
It's only one piece of the pie
When you're looking to get approved for a loan, your credit score is a very important factor. However, it's not the only factor. There are many other factors, such as your ability to make repayments if you take on the loan and how much of your own capital you put in.
There are many things to consider and, again, it's important to learn early to be prepared ahead of time, so you can get approved for whatever loan you're applying for. With mortgages becoming harder and harder to get approved for nowadays, it can easily take a couple years ahead of time to plan for it.