The illusion of good credit

People are often hesitant to file a Bankruptcy or Consumer Proposal for fear of ruining their credit. They reason they must have excellent credit because they‘ve always made their monthly minimum payments on time. But this is often an illusion based on a fundamental misunderstanding of how credit scoring works.

Your credit score is not just a reflection of your payment history. It’s also a tool for lenders to gauge your ability to take on additional debt and pay down all debts within a reasonable amount of time. In other words, it measures your long-term potential of being a moneymaker (or a money loser) for creditors.

Building your credit score

A credit score is the product of a so-called black box algorithm. Numerous factors go into the box, which then runs a series of calculations and spits out the score. But it’s not exactly clear what happens inside that black box.

FICO, whose proprietary algorithm (i.e. black box) many credit bureaus use to determine credit scores, says these are the factors they consider:

Payment history (approx. 35 percent)

Making your payments on time does indeed contribute to a large portion of your credit score, but only slightly more than a third of your entire score. Unfortunately, that means while missing payments or making payments late can be detrimental, merely making payments on time will not be enough to guarantee good credit.

Factors which fall under this banner include:

• Payment information on all credit accounts
• Public records and collection items
• Details on late or missed payments, and their timeframe (30, 60, 90+ days, etc.)

To maintain or improve your credit score, always make your payment on time. Make at least the minimum payment if you cannot pay the full balance.

Outstanding debt (approx. 30 percent)

Another large chunk of your credit score is based on how much debt you currently have. With nearly a third of your credit score determined by this factor, this is an area where you may unknowingly be taking heavy damage.

Factors which fall under this banner include:

• Amount owing on all accounts
• Amount owing on different types of accounts
• Number of accounts which carry a balance
• Portion of outstanding debt on revolving credit accounts (e.g. credit cards, lines of credit)
• Amount owing on installment loans, compared with the original loan amounts
• Credit utilization

That last point about credit utilization is one of the most important factors in this category. It is a measure of the amount you owe compared to how much credit you have available. FICO’s research indicates people who use a high percentage of their available credit limits are more likely to have trouble making some payments now or in the near future.

To help improve your credit score, try to use less than 35 percent of your available credit on your revolving credit accounts.

Length of credit history (approx. 15 percent)

All other factors being equal, a longer credit history will generally increase a FICO® Score. We typically caution against cancelling old credit cards or lines of credit for this reason.

Factors which fall under this banner include:

• How long credit has been established generally (i.e. average age of all accounts)
• How long each specific credit accounts has been established
• How long it has been since you used certain accounts

If you’re currently struggling to manage credit, it may be necessary to close problematic accounts to prevent further damage in the payment history / outstanding debt categories. 

New credit (approx. 10 percent)

FICO’s research indicates that people who open several credit accounts in a short period of time represent a greater risk of defaulting on their debts. This is especially true for people who do not have a longstanding credit history.

Factors which fall under this banner include:

• How many new accounts have been opened
• How long it has been since a new account was opened
• How many recent requests for credit have been made
• Length of time since inquiries from credit applications were made by lenders.

To the last point, perfectly normal consumer behavior like comparison shopping for the favourable auto or mortgage financing may cause multiple lenders to request your credit report. FICO® Scores compensate for this by:

• Ignoring auto and mortgage loan inquiries made in the 30 days prior to scoring
• Counting inquiries of the same type (i.e., auto or mortgage loan) within a typical shopping period as just one inquiry

You can improve your credit score by limiting the number of times you apply for credit in a short timeframe. Be strategic in seeking credit, rather than using it to make up shortfalls in your budget.

Types of credit (approx. 10 percent)

FICO® Scores tend to favour responsible, purpose-driven credit use. For this reason, your score will consider the mix of credit products you have. It is not necessary to have one of each credit product — nor is it a good idea to open a credit account you don’t intend to use.

Factors which fall under this banner include:

• The types of credit accounts on the credit report (e.g. revolving vs. installment)
• The number of each type of accounts

Having a mix of credit products could help you increase your credit score; but be careful. If you cannot afford to repay any money you borrow, you could end up hurting, rather than helping your credit score.

Beware the predatory lender

Many lenders cater almost exclusively to borrowers with poor credit scores — typically those with fully utilized (i.e. maxed out) credit cards and lines of credit. Their willingness to extend financing may initially seem like affirmation of a positive credit score, but don’t get duped by their tactics. These creditors offset their risk by charging exorbitant interest rates, often in excess of 30 percent, which sink you even further into the cycle of debt.

MNP’s quarterly Consumer Debt Index consistently reveals fewer than two in five Canadians feel confident they can cover all expenses over the next year without going further into debt. Unfortunately, the more debt required to pay for household expenses, the more likely this is to take the form of predatory lending such as payday loans and high-interest credit cards. Once debtors reach this stage, it’s almost impossible to escape the self-feeding cycle of higher payments and higher debt without professional help.

If high interest financing seems like your only option, consider scheduling a Free Confidential Consultation with a Licensed Insolvency Trustee. We can help you choose the best solution for a permanent financial fresh start.