What is a credit score?
A credit score is a number that reflects your credit risk level ranging from 300-850. The higher the number the lower the risk you are to a potential lender. The higher a persons credit score is, the more likely they are to secure some form of a loan with favorable terms.
The factors that directly contribute to a credit score is not definitive, however, most assume that the following are the key factors; payment history, amounts owed, new credit, length of credit history, credit mix.
Of the 5 factors mentioned above, payment history and amounts owed are generally seen as the most important. Below is a chart showing a rough composition of what makes up credit scores:
What is a credit score used for / who uses them?
Whenever we apply for credit (i.e., debt) the lending institution uses our credit score to see if we are suitable borrowers. Banks, credit card companies, auto dealers, retail stores, and most other lenders use scores to quickly summarize a consumer’s credit history, saving the need to manually review an applicant’s credit report and provide a better, faster risk decision.
When buying a house, a car, getting a line of credit, or applying for a credit card it is very likely that our credit score will come into play. The better our credit score, the most favorable terms and interest rates we are likely to receive.
Let us take the example of buying a house. In Canada, the prime lending rate is now 3.70% (think of prime rate as the starting point). So when we get approved for a mortgage, the lending institution takes several factors into consideration (down-payment, income, mortgage terms, loan duration, etc.), credit score being one of them.
With a good credit score, there is a higher chance that the interest rate on the loan will be lower. Having a lower interest rate can save borrowers tens of thousands of dollars over the life of a loan.
Example (hypothetical situation):
Let us assume that someone with a credit score above 750 gets a loan with an interest rate just below prime at 3.65% on a $200,000, 30-year mortgage. Payments will be about $915 per month. Over the 30 years, the borrower will pay $129,411 in interest. Now assume that their credit score is 640. Their interest rate could now be 5.24%, increasing payments to $1,103 per month. Over the 30 years, they are now paying $197,141 in interest. That a difference of $67,730 in interest payments.
How to build a better credit score:
Go out and get a credit card and stay disciplined. Pay off your balance in full every month and ensure you never miss a payment. Credit cards are the easiest way to build up your credit score. Even a small $500 limit helps drastically.
If you cannot get approved for a credit card, become an authorized user on someone else’s credit card (a great option for young adults living with parents, or college/university students). Not only are you building a credit score, the person who is authorizing you is being rewarded with more benefits from the card (i.e., cash back, travel miles, etc.).
Other forms of debt such as student loans, auto loans, personal loans, secured loans can also help give your score a boost. In addition, paying for things like rent, hydro, cell phone and other types of bills may positively affect your credit score.
No matter how you go about building your credit it is important to remember some crucial tips:
- Avoid paying interest. By this, we mean that you should be aiming to pay off the loan quickly. This is even more crucial if the loan has high interest rates.
- Do not miss payments. Payment history makes up a large part of your credit score composition. It is important that you make your payments on time, and preferably in full. Not doing this is easy with credit cards, but can have significant negative side effects.
- Do not overspend. Do not acquire more debt than you need or can afford. Just because you get approved for a larger loan doesn’t mean you should use it. Overspending can lead to heavy payment burdens increasing the change of missing payments, more accumulated interest payments, and can wreak havoc on your credit score.
- It takes time. Your credit score won’t go up significantly as soon as you get your first credit card or buy your first car. It takes time to build a consistent record in your payment history. Think years not months.
How to check your credit score
There is the common misconception that checking your credit score can hurt it. This isn’t always the case. There are two types of credit checks: soft-credit check and hard-credit check.
An inquiry that occurs when a lender that has an existing relationship with you, checks your credit report as a background check. Credit cards companies do this most often when they want to offer you increased credit limits. Soft inquiries can occur with or without your permission, but don’t worry – they won’t affect your credit score.
An inquiry that occurs when a new prospective lender checks your credit report to make a lending decision. Hard inquiries can lower your credit score, especially frequent ones, and will typically stay on your report for two years. Multiple hard-checks in a single year can communicate to a potential lender that you are desperate for credit and higher risk, especially if you have been turned down multiple times.
If you would like to check your credit score, the two most reputable sources are Equifax and Transunion. Both of these sources do have a cost. There are also free services out there, most notably, CreditKarma. Like stated above, checking your own credit score won’t hurt it because it is a soft inquiry.
If you would like more information on credit card and consumer debt, read our past blog post on Credit Card/Consumer Debt. Or if you would like more information on interest rates, read How High Can Interest Rates Go?.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy.