Everything You Wanted to Know About Credit (But Were Petrified to Ask)

Another Guest Post from Sean Cooper. Yeh, I am getting kind of slack on my rules.

Unless you’re filthy rich and you can afford to buy your home in cash, maintaining a good credit score is important. Not only does your credit score help you qualify for a mortgage, it can help you obtain the best mortgage rate, saving you thousands of dollars in interest over the life of your mortgage. If your credit score isn’t the greatest, you could pay a higher mortgage rate, or your application could be denied altogether. Not only does a poor credit score make it harder to borrow money, you could have a tough time finding a rental unit, since landlords often look at credit.

Credit has three parts: credit history, credit report and credit score. Your credit history is a lot like your resumé. It’s a summary of any time you’ve borrowed money. From your car loan to that $1,000 cell-phone bill you’d like to forget, your credit history is a tell-all of any time you’ve been extended credit. Your credit report is like an annual performance review of your credit history. This is where the student loan you failed to pay back in college can come back to haunt you.

Last but not least is your credit score. Your credit score is the magic number that lenders care so much about. You credit score is based on your credit history. This number helps lenders decide whether to approve your mortgage. The higher your credit score, the more favourable the mortgage terms will be. Credit scores typically fall somewhere between 300 and 900.

Credit scores don’t just come out of thin air. Credit reporting agencies keep track of your credit history and credit score. You can obtain a copy of your credit report for free, so take advantage of it. The easiest and fastest way is to use Equifax and TransUnion’s interactive phone services. You can also download and complete forms from the Equifax and TransUnion websites. Best of all, it won’t lower your credit score to check. Request a copy of your credit report and find out what your credit score is at least a year ahead of when you’re thinking of buying a home, to avoid any nasty surprises. (If your credit score is poor, you need time to work on improving it. This can take a year or more because of reporting lags.) If you find any inaccuracies or mistakes, get them fixed as soon as possible.

Understanding Your Credit Score

Five main factors affect your credit score. It’s important to understand each of them to help maximize it.

1. Payment History

Your payment history has the biggest impact on your credit score. As the saying goes, “The best predictor of future behaviour is past behaviour.” Things that can hurt your payment history include missing or making late payments, any debts that have been written off or sent to collections, and filing for bankruptcy. To protect your credit score, pay your bills on time. If you can’t pay the full amount, pay at least the minimum payment to keep your credit in good standing.

2. Available Credit

After payment history, available credit (also called credit utilization) carries the second most weight with lenders. Your total available credit (not your total credit limit) counts toward your credit score. Your available credit is how much credit you have at your disposal. It’s your credit limit (how much credit you have available to borrow) minus your current balance.

To determine your total available credit, tally up the credit limits on all your credit products (credit cards, lines of credit and so on). Ideally, you’ll want a credit utilization of less than 35%, but never, ever go over 70%, even if you pay off your balance every month. When you’re using a higher percentage of your available credit, lenders tend to get nervous and see you as a greater risk, even if you still pay your balance in full and on time. Have more credit than you need and use it responsibly.

For example, if you have a Visa credit card with a limit of $6,000 and a line of credit for $10,000, your total available credit is $16,000. Try not to borrow more than $5,600 at any time (35% of $16,000).

3. Number of Credit Inquiries

When it comes to credit inquiries, there are two types: soft hits and hard hits. Soft hits, such as asking for a copy of your credit report, won’t impact your credit score. Hard hits are inquiries that count toward your credit score.

Whenever you apply for credit, whether it’s a credit card or mortgage, lenders ask for a copy of your credit report. When this happens, a credit inquiry is recorded—a hard hit. Inquiries are expected every now and then, but too many over a short period can negatively impact your credit score.

Lenders can see how many credit inquiries have been made. To protect your credit score, limit the number of hard hits. When shopping for a mortgage, apply only at lenders you’re serious about. And try to apply for mortgages within a two-week period (these inquiries usually will be lumped together and treated as one).

4. Credit History Length

You may have heard that no credit can be as bad as poor credit. Lenders want to see that you have a track record of making your payments in full and on time. The longer your credit account is open, the more it helps your credit score.

Some people lack a credit history (maybe they’ve been afraid to sign up for a credit card after the financial crisis, or they’re a recent grad or new immigrant). If that’s you, take steps to start building your credit history today. Apply for a no-fee credit card and pay it off in full each month. Ideally, have at least two unsecured forms of credit with clean payment histories (paying off your balance in full on time each month) of a minimum of 24 months, with a limit of at least $2,000 each.

5. Types of Credit

Having only a single credit type, like a credit card, can hurt your credit score. Spice up your credit report with different types of credit. Instead of carrying a wallet full of credit cards, replace some of that plastic with a line of credit or personal loan. A word of caution: although it’s good to have different credit types, don’t go overboard—apply only for credit you truly need.

This post was written by Sean Cooper, bestselling author of the book, Burn Your Mortgage. Sean is also the managing editor of mortgagepal.ca.