Don't be an unscorable
It's often said there are four Cs of personal credit: capital, capacity, collateral and character. The first three are easily calculated as the amount of money a person has, the ability to pay off a loan and what is backstopping the loan. But that last one – character – is trickier and is often determined by a credit rating.
Unfortunately, half the population doesn't understand what goes into creating their credit ratings, according to a Financial Consumer Agency of Canada survey of 1,700 people in 2006, and a quarter of them did not know what their credit rating was at the time even though such information is readily available for about $15 from reporting agencies such as Equifax Canada Inc. and TransUnion Canada
Such ignorance is too bad. Your credit score weighs heavy on the minds of loan officers. Have a score of 800? A mortgage is all but guaranteed. Less than 500? You may be left looking at alternative means of financing or waiting until your credit score improves. And if you've filed for personal bankruptcy in the last seven years you're probably an "unscorable," says Nadim Abdo, vice-president of Consulting Solutions at Equifax Canada in Toronto. In other words, good luck getting a mortgage.
How those credit scores, which range from 400 to 900, are calculated is built around proprietary statistical analysis by reporting agencies who get information about each credit instrument – called a trade – that an individual has and how those bills or debts are paid off.
Simply put, a trade can be a credit card, line of credit, personal loan, car loan or retail card, pretty much everything except mortgages, which are also starting to be collected, says Mr. Abdo. Each trade is then given a monthly rating, ranging from R1 (bill paid on time) to R9 (a write-off). The companies also collect and factor other public information such as personal bankruptcies, foreclosures and liens to build a profile on how credit worthy someone is.
"The system is based on the premise that people typically behave in the future as they behaved in the past," says Mr. Abdo. The rating is particularly useful in an age where people can apply for mortgages online, he adds. "The bank has no way of judging your character because you're not there, so they use these credit scores as a proxy for character."
Typically, a minimum score of 680 is needed if someone is putting a down payment of 20% or less of the home's value, says Martin Beaudry, vice-president of lending at ING Canada Direct in Toronto. A higher score means you can probably make a smaller down payment.
While a better score won't get you a better rate, there is another reason to have a solid credit history, Mr. Beaudry says. A score of 680 or better means a bank is more likely to let you exceed a debt-to-gross income ratio of 42%, the typical high-water mark for handing out mortgages.
Financial institutions will also look at other factors when deciding your credit worthiness including income, employment status and the down payment, as well as their own appetite for risk. If you meet those requirements, it's possible a bank will make an exception if your credit score is low. However, financial institutions have to regularly report to the government how many of these exceptions they make and such loans cannot exceed 3% of their portfolio.
Mr. Abdo says while even one missed payment will temporarily drop your current rating, it will also show up on your past ratings as long as you have credit. Both current and past ratings are available to financial institutions. Of course, missing three or four payments in a row will impact your rating even further, but a bankruptcy is the worst.
Credit is typically cut off after a bankruptcy is settled because your rating is wiped out. "In effect, you become an unscorable," says Mr. Abdo. "You then need to re-establish your credit." A bankruptcy stays on a person's credit file for seven years; 14 if a second bankruptcy occurs during that period.
Mr. Abdo says the total amount that you owe – and most Canadians owe less than $50,000 outside their mortgage obligations – isn't a factor, but regularly maxing out your credit cards will negatively impact your rating as will shuffling debt from one facility to another. "We don't know your income, but that kind of activity is a warning sign that something might be happening like an over-extension and the consumer may not be able to pay off the debt," says Mr. Abdo.
The best way to fix your rating? Make your payments on time and pay down your debt. "Some people go through difficult times, but their character is to improve that by making payments on time and paying down their debt," says Mr. Abdo. "It shows that they are more likely to be financially responsible."
