Financial Education: Understanding your Credit Score — the 5 Factors (Part 2/2)

June 21, 2022

Following Part 1, here are the 5 factors that determine our credit score.

Before I get started on this list, I also want to share that this is only ONE PART of credit — meaning: this is only one of the “5 C’s of Credit” you would see loan officers and brokers use to determine whether you would be extended credit when applying. Naturally, that’s coming up in the next article!

Everyday there are people with high credit scores that tend to get very shocked when they are turned down by a mortgage broker, a credit card application or a financial institution. I will continue to put the magnifying glass on credit score here and put the focus on the bigger picture (so to speak) next.

The 5 Factors

1. Payment History

First of all, I hope that everyone understands that when you borrow money, it’s your obligation to pay it back to whoever lent it to you unless they specified that it’s a gift that you do not need to pay back. Clearly, even if it’s a small loan between friends and family, chances are they are not going to go to the credit bureau and submit your payment history on you.

So, this largely applies to institutional lending — meaning that licensed lenders who you borrow money from. Even if you’re repaying your debt but are late — either a few times during the time you’re supposed to pay it back, or consistently, this is going to bring your credit score down.

The easiest way to look at this is to turn the table around. How would you rate a friend who borrows money from you and pays it back regularly and in full as agreed VS another friend who you keep on having to chase down to get your money back? Also, are you more likely to lend to someone with a history of bankruptcy or without? Unlike golf, we want high scores here — the higher the better.

2. Amounts Owed

This only matters if you carry an outstanding balance. If you are the type that pays off all your bills on time — especially credit cards, then you’re likely pretty safe here.

This particular factor is also known as ‘utilization rate’. To be honest, you can ask a credit counsellor, a representative from one of the credit bureaus, your banker, a mortgage broker, or even the person who’s sharing all this information with you right now, none of us can provide you with a clear answer on what percentage you should stay under.

Let me take that one step further and this requires some illustration here: some people say to stay below 50% of your credit limit and some say 75% for your credit score to not be impacted negatively. This really only applies to revolving credit accounts — I’ll get to what that means later (in Types of Credit). For now, let’s use a credit card as an example. Also, for demonstration sake, let’s just use 75% as our number here. I would suggest that grab a piece of paper and a pen and write along as you read on.

Say, if your visa account has a credit limit of $10,000 and you’re carrying a balance of $8,000. That is 80% in utilization rate on that account. This will then impact your score negatively and thus bring your score down. 😔 That’s a frown face. I know what some of you want to ask: what if I have a total of $50,000 in credit limit between my 5 credit cards — assuming each card has a credit limit of $10,000, and I only have an outstanding balance of $30,000, which works out to be 60% utilization rate — sounds great, right? Not necessarily! It depends on the breakdown of each card balance. You can very well have 3 cards that are maxed out and 2 cards you pay down regularly (so no outstanding balance), it can and likely will impact your score negatively. So…work with someone (a credit counsellor, a mortgage broker, or a financial wellness Coach — depending on how much help you need) to get this fixed or starting paying some of these down.

3. Length of Credit History

This is probably the most straightforward one of the 5 factors — the longer you’ve had your credit products for (provided that you’ve been a good girl or good boy at paying it back), it can only help your credit score to rise. The logic is that, if you’re delinquent to the point that your lenders refuse you the product, you would not have that account as an active/open account at the time of pulling your credit score and report. Also, if that’s the case, it’ll definitely stay on your credit report not just as an inactive account, but also one that’s involuntarily closed. It’s like a cautionary tale that one lender is sending to your other lenders and, worse yet, all your potential future lenders.

4. New Credit

Some people know this as a ‘pull’ or a ‘hit’ on your credit. The proper term is an ‘inquiry’ — in case you’re wondering. It’s good to know that there are hard inquiries and soft inquiries. One decreases your credit score and one does, well, nothing to it.

If you’ve just ‘inquired about your credit report or credit score’ via one of the websites I suggested, that was a soft inquiry and does NOT impact your credit score negatively. Actually, it doesn’t even matter which site you got it from. The focus is on ‘who’ originated the inquiry. If you’re just checking up on yourself — it’s no different than checking your bank balance or even blood sugar level to make sure you’re on track.

On the other hand, a hard inquiry is like an ex (or soon-to-be ex) looking into your finances, there’s usually an ulterior motive and that’s usually bad.

When do hard inquiries happen, you ask? They happen every time you apply for a credit product —

• a new credit card,
• a line of credit,
• a personal loan,
• a mortgage,
• a car loan,
• a phone plan,
• get your place hooked up with electricity and gas, or
• a retail card to get some furniture or home theatre.

Doing too many of these in a single year can definitely impact your credit score for the worse. How many? Like ‘utilization rate’, I wish I got a solid answer from all industry professionals and even the credit bureaus directly, but no one is making a giant poster with a number on it to show us! However, collectively, our best and deductive conclusion — that’s right, this is more Sherlock Holmes than relying our Spidey sense — is between 4–6 per year. If your score is on the low side to begin with, max it out at 4. If you feel like you have room to stretch, add 2 more times in a year.

Why do hard inquiries decrease your score? The concept is actually quite simple, by definition, hard pulls (just changing it up to get some street cred here…) indicate that you’re actively shopping for a loan of some sort, and you’re making it known. Think of it this way, you ask your Dad for some money, he says yes, then you ask your Mom, she says yes, then you ask your friend, he/she says yes, then you ask your coworker, he/she also says yes. Now you have all this money in your pocket, what’s stopping you from fleeing to sunny Mexico and live like a king or queen, and never return to pay them their money back?

On the other hand, if you’re in need of money and ask your Dad for it, he says no, then you try your Mom, and she says no, you do this for a few more times, by the time you get to person number 7, they are going to wonder why the previous people didn’t lend you any.

Lastly, as a light bulb moment, when it comes to credit, it’s always better to have it and not need it, than to need it and not have it. (This is VERY important.) Repeat this line to yourself LOUDLY (or loudly in your head): WHEN IT COMES TO CREDIT, IT’S ALWAYS BETTER TO HAVE IT AND NOT NEED, THAN TO NEED IT AND NOT HAVE IT.

So, plan your 4–6 hard pulls a year wisely! Just a side note, most credit limit increase requests now require hard pulls as well and now you know what that means!

5. Types of Credit

Finally, we’re talking about the different types of credit. They were briefly mentioned earlier when we were discussing the ‘new credit’ factor.

What exactly are they?

This is probably not the part you need to remember as much as the 5 factors as there are 5 main types that most of us at some point in our lives will inevitably all have — open, revolving, instalments, lines of credit and mortgages.

An open credit type is where the account holder (or the card holder) can draw credit as needed up to a certain amount with the total balance due and payable IN FULL within a specific time frame. Examples would be an American Express charge card, your utilities and cable bills. Basically, an account that you’re not allowed to hold an active balance in it unlike a typical credit card.

Speaking of credit cards, that brings us to the next type that is a “revolving credit”. Think of a revolving door (or maybe even a hamster wheel), a revolving credit is open ended where the cardholder can ‘draw’ credit from the card up to a certain limit, then make regular/required minimum payments. A line of credit often falls under this category as well. A line of credit is usually different from a personal loan in that a line of credit typically requires interest-only payments as long as you continue to pay down your balance. A personal loan often times requires you to make principle-and-interest payments.

That brings us to instalment credit — a personal loan or a car loan usually falls into this category as these loans come with a fixed number of equal payments. If you are still carrying a student loan, chances are, this is where that belongs as well. An instalment loan typically starts with the maximum amount you’re approved to borrow, and, unlike a revolving credit account, that amount can only go down from there.

Lastly, a mortgage. It’s structured similarly to an instalment credit and typically applies only to real estate. Note that a HELOC (home equity line of credit) usually functions more like a regular LOC, thus, more of a revolving credit account.

Conclusion

There you have it! Understanding your credit from an investor’s perspective.

Like everything else, once you understand how it works, it appears simple and you can leverage it to your advantage. When you start learning about the different creative financing strategies and instruments later, you will see how a high credit score is not even a necessity (most of the times).

My Real Conclusion

The credit you carry will be built a lot based on your integrity in the business world. That’s the REAL currency of CREDIT you will also need to pay attention to maintaining.

Tomy dedicated readers, I thank you for your support and feedback. If this is the first time you’re reading one of my publications, I hope you’ve enjoyed it and learned a thing or two.

If you’re wanting to be a part of a community of real estate investors from around the globe, here is the T.A.L.E.N.T.ed Investors Facebook Group. It’s a place where people come together to share experiences, knowledge, successes and challenges, and money making opportunities!

For those of you who prefer watching videos, here is the YouTube channel where some of my work (very raw) has been shared.

Lastly and definitely not least, Bootcamp! If you prefer the live interaction and delivery to help you build some foundation, our next Bootcamp is on July 23 and July 24. Go ahead and register for a session for either day to help you further your financial education.

(Written at home in Edmonton, AB)