Canadians have an obsession with credit scores, especially when it is about their finances. Those three digit score preoccupy several households across the country, particularly younger individuals and families. They binged on consumer debt and driven household borrowing levels to all new highs. The mindset that prevails is that having a strong and rising credit score means you’re on safe ground.
However, more and more people are sadly realizing that it doesn’t work like that. Having a credit score even as high as 792 is no guarantee that you won’t end up with a trustee discussing resolving your insolvency. That’s because the system isn’t formed to do what you’d like it to.
It’s never been easier to receive your credit score. Google “credit score” or “credit report” and you have ample of services allowing you to receive free monthly updates, complete with charts to show whether your score is up or down from the month before. They promise speed.
The trouble is, it’s possible to have too much information sometimes. And people’s understanding of how the credit system works—based on internet forum advice, social media, friends and family—has led individuals to take all kinds of actions with their borrowing that can lead to trouble. Let’s explore some of these below.
Dispelling some credit score confusion
First of all, you should understand the credit reporting system in Canada is designed for the banks, by the banks, to help the banks. They are the intended customers, not you. Your credit information is a product that the credit bureaus, like Equifax and TransUnion, sell to the banks and other lenders. You are not a client of the credit bureaus. You are the product. Once you accept this, it all becomes vivid.
Moreover, metrics like credit scores and mortgage delinquency rates present limited information about the likelihood that somebody will get into trouble with their finances and file an insolvency. It is likely that a homeowner who has not missed a single payment on his mortgage file for a consumer proposal or a bankruptcy.
It’s also vital to remember that the credit score you see might not be the one the bank views. Lenders can (and do) order credit reports that are designed to meet their specific needs. They may over-highlight certain aspects of credit score factors, such as credit utilization or newer credit borrowed, and de-emphasize others. They are evaluating your creditworthiness (their profitability), and because they pay the credit bureaus, they form the rules. But they’re not doing so to ensure you’ll pay them back so much as to ensure you’ll carry balances and keep making interest payments. That’s how banks make money, folks. So if you pore over your credit score trying to determine how to game it, it may not even help you much.
Problems with credit score obsession
Most people understand that a credit score (the 3-digit “FICO” score) consist various factors. These combine to form your score, which is calculated differently between credit reporting agencies. Certain factors count more than others. Credit repayment history and credit utilization form the bulk of the score. While the length of your credit history, new credit, and your mix of types of credit you have, form the others. But did you know your own personal and professional stability can be a factor? For instance, whether you’ve moved recently, or move frequently. Likewise, your employment history matters—have you worked at many different places, or held more steady employment? The latter tends to have a higher correlation with credit repayment, so lenders like to factor that in.
Now let’s elucidate some of the ways that being obsessed with a better credit score can cause problems.
1. Payment history
The largest chunk of your credit score pie is your payment history, accounting for 35 per cent. In simplest words, if you make all required payments on time, your credit score will improve. However there are several caveats:
- Not all payments are tracked
- There is no extra benefit to paying a balance in full
- There is also no benefit to making extra payments
- The terms of the credit vehicle in question are not taken into account.
The consequence is that someone who pays the bare minimum on their credit cards, yet is behind on their rent, has a seven-year car loan and is inching close to insolvency, could actually have a better credit score than someone with just one credit card who faithfully and prudently pays their balance in full each month. You’d almost think lenders would much rather lend to the former than the latter, and you wouldn’t be wrong.
2. Credit utilization
You must utilize credit to improve your credit score. In fact, it’s better to have several sources of credit. The system’s formula can only assess your delinquency risk if you use credit. It’s often suggested that to improve your FICO score, borrowers should maintain a balance on revolving accounts of 30% of their borrowing limit.
What that means is if you have a credit card as your only form of debt, it is actually better to carry a balance to improve your credit score. In fact, you can even lower the utilization factor of the score (thus improving the score) by increasing a given credit limit.
It is perhaps that income does not factor into it. So factually, someone making $100,000 a year who has three credit cards with a $20,000 limit on each and a $6,000 outstanding balance may have a better credit score than someone with only a $1,200 balance on a single $2,000 limit credit card who earns the same income.
3. New credit and multiple sources of credit
The system tends to reward you for having multiple debts. For instance, if you have only a single credit card since you spent a couple of years paying off other debts, your credit score is likely worse than if you have a credit card (with a balance, naturally), a leased vehicle, and a mortgage. The credit score rewards indebtedness, because it is a product for the banks.
The downside of chasing a better credit score
Attempting to master the system by tailoring your borrowing habits to what you think is the right credit score ‘formula’ can actually improve your credit score while making you financially worse off:
- Holding to the magical 30% utilization rate may increase your score, but it means you pay a lot more interest over time.
- Having a broader mix of credit may help your score, but it means you end up indebted for longer, and pay more interest over time.
- Widening your credit limit may help your score, but it means you’ll inevitably end up with more debt and again paying more over time.
Lastly, instead of having an obsession with a good credit score, you should work on your repayment reputation. A positive reporting of your repayment history will attract lenders. Canada Auto Experts can help you establish good credit in less time with an online car loan application and form an installment trade line on your credit report. With a timely repayment history on your car loan, credit score is subject to shoot up. Call 1-855-550-5565 to talk to a credit specialist today!
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