Big Purchase? What It Means For Your Credit

You’re at a dealership shopping for a used car. You’d hoped to pay cash, however nothing in your price range suits your needs. So, you step back to consider your options. There is enough room on your line of credit to purchase a more expensive model you like. You could easily buy the vehicle and take it home today. But you hesitate. You wonder how such a big purchase will affect your credit.

Before making your decision, you’ll need to consider how several factors affect your standing with current and potential future lenders. These are broadly reflected through two measurements: your credit rating and your credit score. Understanding both will be helpful in deciding when and how to use credit.

Credit Rating:

Your credit rating is a specific measurement of how conscientious you are with your debt. Each credit card or loan on your credit report is assessed based on your payment history. It considers:

• how diligently you make your monthly payments
• whether you make your monthly payments on time
• whether you have had any debts included in a consumer proposal (or other debt payment plan)
• whether you have ever filed for bankruptcy
• whether any of your debts are in collections.

A rating of “1” is the highest and best rating while “9” is the lowest. A rating of “0” means the debt is either too new to rate or has never been used. There is also a letter in front of the rating. This represents the type of debt. For example, “R” is used for revolving debt (e.g. credit card or line of credit) and “I” stands for instalment account (e.g. a loan or mortgage). 

Credit Score:  

Your credit score is a more global picture of your credit health. It considers your credit ratings, along with other information, such as:

• the amount of credit you have available to you
• the number of credit instruments you own
• the balances on your credit accounts relative to their limits
• how often you carry an outstanding balance
• the number of “hard” credit inquiries made on your file (e.g. applications for loans, credit cards or financing) [Note: “Soft” credit inquiries, such as updates from existing lenders or requesting your credit report do not affect your score.]

In Canada, credit ratings range from “300” – which indicates your credit file is either very new or that you have had some trouble repaying your debts – to “900”, which is the best possible score. Generally, a score of “650” is the target you want to aim for, as this will qualify you for most loans, credit cards and lines of credit. Anything below a score of 650 will make securing new credit more difficult.

Finding the Balance

When using credit, you want to avoid extremes. Keeping too high of a balance on your credit for too long can negatively impact both your credit rating and your credit score. This is especially true if you can’t keep up with your regular payments. Interest charges and penalties will accumulate and cause your debts to grow faster than you can pay them down. It may also result in you relying on multiple forms of debt and causing even more damage to your credit report and your finances.

Alternatively, using your credit infrequently or not at all can have a similarly negative effect. Lenders want to know about your spending habits and how reliably you will make payments. Without a credit history to work from, your credit score will be low and may make it difficult to obtain credit – especially for big purchases.

The best way to build a strong credit report is to focus on making small, frequent purchases and ensuring you pay the balance off regularly. If you must keep a balance on your accounts, you should always try to use less than 35% of the total credit available to you. Not only does that position you favourably in the eyes of lenders, it also helps to prevent your debt from spiraling out of control. To know what your current utilization rate is, simply divide the sum of your outstanding balances by the sum of your credit limits and multiply by 100.

So, About That Big Purchase…

If you decide to make the purchase, you will see an immediate reduction of your credit score. This is due to an increase in your utilization rate. How significant that reduction is depends on where your new balance sits in relation to that 35% threshold – the further it goes above, the greater the impact will be.

With that said, provided you make regular payments on the balance of your debts and those payments are made on time, you will notice a net improvement on your credit rating over the long term. Moreover, as the balance of your debts decreases, your credit score will also go back up. So, unless you plan on applying for any other forms of credit before the purchase is paid off, you will likely never notice the negative effects.
Where this purchase could cause trouble is if you are unable to make regular payments on time. Being delinquent on your debt will lower your credit rating. Having a sustained utilization rate over 35% will reduce your credit score. And a combination of late payment penalties, interest charges and the likelihood that you’ll rely on other forms of credit to cover your monthly expenses will make it painfully difficult to break free from the cycle of debt you become trapped in. Making matters worse, the longer you are stuck in this pattern, the more harmful it will be to your credit report. Not to mention, the final cost of your purchase will be significantly higher than it would have been if you’d paid cash.

Beware the Hidden Costs!

Often, it’s not the cost of the purchase itself that gets you into trouble. It’s the hidden costs associated with it. Take your new car for example:
Before making your purchase, you carefully considered whether you could afford the monthly payment and the insurance premium. But did you factor in the other costs associated with owning a vehicle ownership – such as fuel, maintenance and annual registration fees? These affect your budget and ability to make your other credit cards or loan payments. The same applies to the purchase of a home where property taxes, repairs, utilities, etc. may not have been factored into your budget. 

Checking Your Credit Report

TransUnion and Equifax are Canada’s two primary credit reporting agencies. Both offer services to regularly check and report your credit for a fee. They will also provide you with an abbreviated report free of charge, however you must request this by mail and they will not include your credit score in the free report.   

If you find yourself in a situation where you are falling behind on your payments, contact MNP for a free consultation to find out how we can help.