Credit scores play a vital role in the financial world, especially when it comes to purchasing a home. Whether you’re a first-time homebuyer or a seasoned homeowner looking to refinance, a good credit score is essential in obtaining favourable interest rates and loan terms. In this blog post, we’ll discuss how credit scores are calculated and the importance of building credit.
How are Credit Scores calculated?
Credit scores range from 300 to 900. The higher your score, the better. The two major credit bureaus in Canada, TransUnion and Equifax, use different algorithms to calculate credit scores. This can lead to having a different score for each bureau. However, they all consider the following factors:
Payment History: Your payment history accounts for a large portion of your credit score. It reflects whether you’ve paid your bills on time, how many late payments you have, and how long it’s been since you missed a payment.
Credit Utilization: Your credit utilization ratio has the second biggest influence on your credit score. It reflects the amount of credit you use compared to your credit limit. A higher credit utilization ratio can lower your credit score. Aim for keeping your credit utilization below 30%
Length of Credit History: The length of your credit history is how long you’ve had credit accounts open. The longer your history, the better. A short credit history, or no credit history, can be a red flag or lower your credit score as there is not enough data to qualify how responsible you are with your allowed credit.
Credit Mix: Your credit mix is the types of credit accounts you have, such as credit cards, loans, and mortgages. It is good to have diversity in your
credit history to show that you are able to maintain good standing with allowed credit in many situations for different products. However, keep your utilization in mind when opening new accounts.
New Credit: New credit accounts impact your credit score. New credit accounts you’ve opened recently and how many credit inquiries you’ve had impact your score as they indicate possible high-risk behaviour or taking on a lot of debt in a short period of time.
Why is it important to build credit?
Building credit is essential, especially if you’re looking to buy a home. A good credit score can help you obtain favourable interest rates and loan terms, which can save you thousands of dollars over the life of your mortgage. If you have bad or no credit, you will be considered high risk and if you are able to get a mortgage, the interest rates may be several thousands of dollars more expensive than if you maintain a good or excellent score.
Here are some tips for building credit:
Pay Your Bills on Time: Payment history is the most critical factor in determining your credit score. Make sure to pay your bills on time to avoid late fees and negative marks on your credit report. If you miss a bill payment or credit payment, even if it is only one, it will appear as a blemish on your credit history for up to seven years.
Keep Your Credit Utilization Low: Your credit utilization ratio accounts for a large portion of your credit score. Try to keep your credit utilization below 30% of your credit limit to avoid lowering your credit score. For example, if your credit card spending limit is $10,000, do not carry a balance higher than $3,000 if you can avoid it. Ideally, you want to be allowed to borrow a high amount while showing that you are responsible enough not to need it.
Maintain a Mix of Credit: Having a mix of credit accounts, such as credit cards, car loans, and mortgages, can positively impact your credit score. However, make sure not to take on too much debt, as high debt levels can negatively impact your credit score. There is a fine line between a healthy mix of credit and biting off more than you can chew in the eyes of the credit bureaus.
Avoid Opening Too Many New Credit Accounts: Opening too many new credit accounts can negatively impact your credit score. Only apply for credit when you need it, and make sure to shop around for the best interest rates and terms. If you need more credit down the road, increasing your limit with an old account is better than consistently jumping from credit product to product, as it shows a stable and growing history.
Monitor Your Credit Report: Monitoring your credit report can help you catch errors and fraud early on. You’re entitled to a free credit report from each of the two major credit bureaus once a year. You can also sign up for services like Borrowell and Credit Karma, which allow you to monitor your credit in an ongoing manner. However, remember that these systems are not perfectly accurate, and the score you see may not be your actual credit score. There is a good chance they will be close, though. Make sure to review your credit report regularly and dispute any errors or inaccuracies.
Credit scores are essential in the financial world, especially when it comes to purchasing a home. Understanding how credit scores are calculated and building good credit habits can help you obtain favourable interest rates and loan terms. If you’re looking to buy a home, start building your credit today by paying your bills on time, keeping your credit utilization low, maintaining a mix of credit, avoiding opening too many new credit accounts, and monitoring your credit report regularly.