Canadians are taught the importance of managing their credit as part of financial well-being. Lenders use credit reports to gauge a borrower’s financial health and evaluate their overall creditworthiness, but many are unaware exactly how those numbers are calculated.
Credit bureaus are agencies responsible for collecting information on an individual’s credit history and provide a snapshot of their overall financial health based on the assets and liabilities they are responsible for. This could include:
In Canada, the two most commonly used credit bureaus are Equifax and TransUnion.
Reading a Credit Report
Credit bureaus like Equifax and TransUnion collect credit information from various sources, and devise a credit score for individuals, based on an overall assessment of their financial obligations and their income. The information is then packaged and sold to creditors to help them evaluate whether to approve loan applications from prospective borrowers. Although credit reports can vary slightly in their presentation, they all include:
How Credit Scores Are Calculated
Credit scores typically range from 300 to 900 in Canada, with higher scores demonstrating a more positive assessment of a borrower’s status. Each credit bureau has its own methodology for calculating credit scores, but the information collected is roughly the same, with scoring based on:
Generally a person’s payment history has the largest impact on a credit score, followed by the availability of credit relative to the amount owed to creditors. Certain public records and the number of credit inquiries can also have a negative impact on a credit score.
Borrowers are assigned a score of 0 to 9 based on the type of credit used – namely, revolving, open, installment, lease and mortgage. Learn more about credit ratings, and how they work.
In Equifax’s Risk 2.0 scoring model as an example, credit scores can be broken down into five categories:
It’s good practice to review your credit report at least once a year. You can request a free copy from Equifax.
Implications of Credit Status on Lending Decisions
Credit scores have a significant impact on a borrower’s life. Those with higher scores typically receive more favorable credit terms, and qualify for loans that borrowers with lower scores do not. A higher score translates into lower payments and less interest over the duration of the loan. Institutional lenders also consider factors such as capital, collateral, capacity to repay and the borrower’s unique set of circumstances.
Private lenders that have more flexibility in setting their own lending criteria may place greater emphasis on a borrower’s collateral, unique employment situation and other personal circumstances in determining whether to approve a loan. For mortgages, private lenders may also factor the location and physical condition of the property, assessing the borrower’s income, assets, debts and repayment history.
Banks and other legacy financial institutions employ more rigid lending criteria, which makes a credit score instrumental in determining loan eligibility. Traditional mortgage lenders usually extend the best mortgage rates to borrowers with a credit score of 680 or more. Borrowers with credit scores between 600 and 680 may still qualify for a mortgage but are likely to pay higher interest rates.
Credit reports play a significant role in how lenders evaluate risk when they lend out money, making credit bureaus powerful institutions in today’s economy. Of course, the extent to which lenders rely on individual credit scores in granting loans depends on several factors, including the type of loan, whether it is secured or unsecured and whether they are lending from a pool of private capital or from a traditional financial institution.
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