Credit Scores and Rebuilding Credit in Canada

Introduction

In theory, a credit score should be quite simple – through an algorithm, you’re assigned a numerical score that determines your credit worthiness. The score is a weighted average of many factors, including but not limited to:

• Your payment history
• Your credit utilization rate, which is how much of your credit limit you have uses versus how much you have available to you
• Balance owing on your debts
• The length of your credit history
• Public records (such as bankruptcy)
• Number of inquiries into your credit file

Different Credit Scores

But the reality isn’t that simple. Here are the complicating factors:

1. Each of the two major credit rating agencies, Trans Union and Equifax, appear to have their own methods of calculating credit scores. Trans Union is somewhat opaque on how they calculate credit scores, but Equifax discloses the factors they consider and the weights they assign to each factor on their site.
2. The two free online services that provide your credit score are Borrowell and Credit Karma. Borrowell purchases the credit score it provides to consumers from Equifax, while Credit Karma purchases the credit score it provides to consumers from Trans Union. Yet the score calculated by Borrowell is different than that calculated by Equifax, even though it purchases its credit scores from Equifax. Similarly, the score calculated by Credit Karma is different than that calculated by Trans Union, even though it purchases its credit scores from Trans Union.
3. Finally, the credit score actually used by lenders to evaluate a consumer’s credit worthiness is not the same credit score that you can get from Equifax, Trans Union, Borrowell or Credit Karma. Most lenders use what is called a FICO Score which is not accessible to the general public on their own. FICO says that 90 per cent of Canadian lenders use its system, including major banks. To find out your FICO score, you would have to agree to what’s known as a “hard” credit check. That’s where a business runs a credit check as if you’re applying for a loan. A hard credit check could negatively impact your credit score. Multiple hard inquiries in a short period could lead lenders and credit card issuers to consider you a higher-risk customer, as it suggests you may be short on cash or getting ready to rack up a lot of debt.

How your FICO score is calculated

Since Canadian lenders will evaluate your credit worthiness based on your FICO score, you should understand how it’s calculated:

• Your payment history comprises 35% of your FICO score. It includes which of your accounts were paid on time, the amounts owed and the length of any delinquencies. Also included are any adverse public records such as bankruptcies, judgments or liens.
• Data about your debts comprises 30% of your FICO score. This data includes the number of accounts you owe money on, the type of debt and its total amount. Also included is your credit utilization rate.
• The length of your credit history comprises 15% of your FICO score. This factor includes the length of time your accounts have been open and how long it’s been since they’ve been active.
• The types of credit used comprise another 10% of your FICO score. Having a greater variety of differing types of accounts such as credit cards, mortgage payments and retail accounts is more beneficial than holding fewer.
• The last 10% of your FICO score is made up of data related to new credit applications such as the number of recent credit inquiries, and how many new accounts have been opened. Opening up too many accounts in too short of a time period is interpreted as a sign of risk and will lower your score.

Tips to Rebuild Credit

• If you’ve just been discharged from bankruptcy or if your consumer proposal has just been approved by your creditors, start rebuilding your credit right away. If your goal is to eventually apply for a mortgage to purchase a home, lenders generally use a 2/2/2 rule: 2 years discharged, 2 new credit accounts, $2,000 minimum credit limits with good repayment history. The easiest way to start is to obtain a secured credit card. Because your credit utilization rate is a major factor in your credit score, try to get card with a moderately higher credit limit (e.g. $2,000) – using a card with too low a credit limit will be of limited use in rebuilding your credit score.
• Use your credit card consistently – use it for everyday purchases and pay off the balance in full at the end of the billing cycle. By doing this, you’re reestablishing your payment history, which is 35% of your FICO score. Doing this over a long period of time will gradually increase your credit score since the length of your credit history contributes to 15% of your FICO score.
• Once you’ve established a track record with your secured credit card, you’ll be getting offers from credit card and loan companies. Don’t accept too many offers in too short a period of time, since data related to new credit applications contributes to 10% of your FICO score.