Mortgage Basics

From Payment History to Credit Utilization: Demystifying the Components of Your Credit Score

From Payment History to Credit Utilization: Demystifying the Components of Your Credit Score
Written by
  • Ashley Howard
| 9 August 2023
Reviewed, 9 August 2023
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    A good credit score is more important than ever, largely thanks to its impact on your ability to borrow money. Your credit score is not just a number; it’s a powerful tool that can greatly impact your financial future. Yet, understanding the various components that make up your credit score can often feel like navigating a labyrinth. 

    As a Canadian consumer, understanding the components of your credit score will ensure that you’re on the right path to be viewed favourably by lenders when applying for loans or other types of financing. Whether you’re a borrower for the first time or looking to improve your creditworthiness, read on as we delve into the credit scoring system’s intricacies, demystifying what determines your credit score.

    Key Takeaways

    • A credit score is a 3-digit number ranging from 300-900 used to determine your creditworthiness.
    • Regularly reviewing your credit report can help you quickly spot errors in reporting,  fraud and identity theft. 
    • Payment history, credit utilization, credit inquiries, length of credit history, and having a mix of credit products are common components that determine your credit score.

    What is a Credit Score, and why is it Important?

    A credit score is a 3-digit number ranging from 300 to 900, providing lenders with a snapshot of your creditworthiness. It is a numerical representation of how likely you are to repay your debts based on your past financial behaviours. Credit scores help lenders assess your ability to take on debt and are used to determine your credit capacity predicting the likeliness of timely payments in the future. 

    Your credit score is important because it influences your ability to obtain credit, such as loans, credit cards, and mortgages. Your credit score can even affect the interest rates offered when applying for a mortgage. 

    A higher credit score indicates lower risk, making you a more attractive borrower to lenders and will help you get the most competitive rates. On the other hand, a lower credit score may limit your access to credit and result in higher interest rates. Understanding the components of your credit score is one step you can take early to improve and maintain a healthy credit profile.

    Common Components of a Credit Score

    A credit score is typically calculated using a scoring model that weighs each factor that is then used to calculate your credit score. Your credit score can vary based on the company providing the score, the data the score is based on, and the method used to calculate it. 

    Common components include payment history, credit utilization, credit inquiries, length of credit history, and credit mix. Let’s explore these components to better understand how they impact your credit score.

    Payment History and its Impact on Your Credit Score

    Your payment history reflects how consistently and responsibly you have managed your debts and whether you’ve made timely payments. Your payment history is a complete picture of all credit cards, credit lines, retail & store credit cards, installment & term loans, auto loans, student loans, and secured credit facilities such as home equity credit lines and mortgages. 

    Your payment history will also consider any of your credit facilities that have ever been delinquent. In addition to this, your payment history will show if you’ve ever gone bankrupt, had a property foreclosed on, garnishments placed on your wages by the courts, and any accounts reported to collection agencies. 

    Late payments, missed payments, or defaults can have a negative impact on your credit score. On the other hand, a history of timely payments can help establish a positive credit history and boost your credit score. Paying all your bills, including credit cards, loans, and utilities, on time to maintain a strong payment history is important to maintaining a good credit score.

    Understanding Credit Utilization and its Influence on Your Credit Score

    Credit utilization compares the percentage of your available credit that you use out of your available limit. Utilization is calculated by dividing your total credit card balances by your total credit limits and multiplying the result by 100. 

    It is recommended that you keep your credit utilization at 30% or lower to help improve and maintain your credit score. High credit utilization can indicate financial strain to lenders. If you consistently use more than 30% of your available credit, it may be time to review your spending habits or increase your credit limits. 

    The Role of Credit Inquiries in Your Credit Score

    When you apply for credit, whether it’s a credit card, loan, or mortgage, the lender may perform a credit inquiry to assess your creditworthiness. There are two types of credit inquiries: hard inquiries and soft inquiries. 

    Hard inquiries appear on your credit report and negatively impact your credit score. Hard inquiries occur when you apply for new credit cards, car loans, personal loans, mortgages, and sometimes rental applications. 

    Applying for multiple credit products in quick succession is generally not recommended, as each inquiry will impact your credit score and could leave lenders wondering why you need access to credit so quickly. It’s important to note that multiple inquiries in a short timeframe may raise red flags for lenders.

    Shopping around for a mortgage with multiple lenders and brokers within a 45-day period will only count as 1 hard credit hit on your credit report. This is due to the nature of the professional business activity that credit rating agencies assign to certain professionals, such as mortgage brokers and agents.

    Soft inquiries do not appear on your credit report and do not impact your credit score. Soft inquiries occur when you check your credit report, are pre-approved for credit products or limit increases, when potential employers perform credit checks, and when insurance providers check credit to determine your risk or offer discounts on your premiums.

    Scoring models also vary on the length of time used to study your payment habit patterns. For instance, the FICO score used by professionals looks at your credit score from the time you were registered on the credit bureau. Whereas soft credit score only looks at your last 3 years of credit repayment history.

    How the Length of Credit History Affects Your Credit Score

    The length of your credit history plays a role in determining your credit score. Generally, a longer credit history provides more information for lenders to assess your creditworthiness. It allows them to see how you have managed credit over time. If you are new to credit or have a short credit history, your credit score may be lower, as there is less data available to evaluate your creditworthiness. Building a long and positive credit history by responsibly managing your credit can help improve your credit score.

    The Importance of Credit Mix and Types of Credit Accounts

    Having a diverse mix of credit products can positively impact your credit score. Lenders like to see a diverse mix of credit facilities that show you can manage different types of credit responsibly. This includes revolving credit, such as credit cards or credit lines, and installment or term loans, such as mortgages, home equity, car, and student loans. 

    How to Improve Your Credit Score

    Improving your credit score takes time, but it is achievable with the right strategies. You can gradually improve your credit score by following these steps and practicing responsible credit management.

    Review your credit reports from the major credit bureaus to ensure they are accurate and up-to-date. Most financial institutions provide free access to your credit report using Equifax or TransUnion through their online banking portals. Reviewing your credit report regularly can help you quickly dispute any errors or discrepancies. 

    Focus on making all your payments on time to help establish positive repayment history and improve your credit utilization ratio. Work to reduce your debt, primarily high-interest debts, as those can take longer to pay off and could negatively impact your credit score. Consider consolidating debts into an existing lower-interest loan or transferring balances from higher-interest to lower-interest credit cards, but not as a long-term bandaid solution. 

    Avoid closing old credit accounts, as they positively affect your score by contributing to the length of your credit history. Be cautious of applying for new credit unless necessary, as each hard inquiry can lower your credit score. Plan to keep new accounts for 3 years or longer, as opening and closing accounts can remove 50 or more points from your credit score.

    Tools and Resources to Monitor and Manage Your Credit Score

    Several tools and resources are available to help you monitor and manage your credit score. Consider signing up for a credit monitoring service, such as Credit Karma or Borrowell, that regularly updates your credit report. These services can help you detect any suspicious activity or identity theft. Additionally, many credit card companies and financial institutions offer free access to your credit report. Take advantage of these resources to track your progress and improve your credit score.

    Frequently Asked Questions

    What is the difference between hard and soft credit checks?

    A hard credit check is based on your whole credit history, while a soft credit check is limited to 3 years of credit history. A soft check doesn’t appear on your credit report, whereas a hard check does on your credit report.

    How does new credit affect your credit score?

    Setting up a new credit card or loan can take away as much as 50 points from your credit bureau, whereas a mortgage typically takes away up to 100 points from your credit score. However, once you start using and making payments to these facilities, they will increase your overall score and positively impact you.

    Will shopping around for a mortgage affect my credit score negatively?

    Credit rating agencies will count multiple applications for a mortgage within a set period of time, usually limited to 45 days from the first credit check, as only one hard credit inquiry on your credit score.

    Final Thoughts

    Your credit score is one if not the most crucial aspect of your financial life. Regularly monitor your credit score so you can quickly notice if there are errors in reporting or any suspicious activities like fraud or identity theft that could negatively impact your score. Keeping a close eye on your credit report and promptly addressing any issues can help you improve your score.  

    Knowing the components that make up your credit score and understanding how to use credit responsibly is vital to building and maintaining a good credit status. Remain vigilant in maintaining an active mix of credit products and low utilization rates, as these are essential to building or rebuilding your credit score.