The Illusion of Good Credit

Dispelling the Myth of High Credit Score

Contrary to popular belief, maintaining a high credit score is more than just making timely payments. Many individuals are under the illusion that they have good credit simply because they promptly cover their minimum monthly dues. However, credit scoring is a multifaceted process that takes into account various other factors. Let’s unravel the intricacies of credit scoring and debunk the illusion of good credit.

The Enigma of Credit Scoring

A credit score is not solely a reflection of your payment history. It’s a tool designed to help lenders assess your capability to handle additional debt and repay all your debts within an acceptable timeframe. It essentially quantifies your long-term financial reliability from the lender’s perspective.

The calculation of your credit score is akin to a black box process. Several elements are fed into this black box, which then performs a series of computations to deliver your score. However, the internal workings of this black box remain somewhat of a mystery.

FICO, a renowned credit scoring agency, uses a proprietary algorithm (the so-called black box) to compute credit scores. The factors that they consider encompass:

Payment History (Approximately 35%)

Punctual payments contribute significantly to your credit score, accounting for just over a third of your total score. However, mere timely payments won’t necessarily ensure a high credit score.

The elements considered under this category comprise:

 

  • Payment details on all credit accounts;
  • Public records and collection items;
  • Information on delayed or missed payments and their timings (30, 60, 90+ days, etc.)

 

To maintain or enhance your credit score, it is imperative to always make your payments on time, even if it’s just the minimum amount.

Outstanding Debt (Approximately 30%)

The amount of debt you currently possess forms another large part of your credit score. Nearly a third of your score depends on this factor, and it’s where many people unknowingly take a hit.

The aspects considered under this category comprise:

 

  • Total amount due on all accounts;
  • Amount due on different types of accounts;
  • Number of accounts carrying a balance;
  • Share of outstanding debt on revolving credit accounts (e.g., credit cards, lines of credit);
  • Amount due on installment loans, compared with the original loan amounts.

 

Credit Utilization

Credit utilization, or the ratio of your current debt to your available credit, is a vital factor. FICO’s research indicates that individuals using a high percentage of their credit limits are more likely to struggle with payments.

To boost your credit score, aim to utilize less than 35% of your available credit on your revolving credit accounts.

Credit History Length (Approximately 15%)

All things being equal, a longer credit history will generally have a positive impact on your FICO® Score. Hence, it’s typically recommended not to cancel old credit cards or lines of credit.

The aspects considered under this category comprise:

 

  • General duration of established credit (i.e., average age of all accounts);
  • Duration each specific credit account has been established;
  • Duration since certain accounts were used.

 

If you’re currently finding it difficult to manage credit, closing problematic accounts to prevent further damages might be necessary.

New Credit (Approximately 10%)

FICO’s research suggests that people who open several credit accounts within a short timeframe pose a greater risk of defaulting on their debts. This is particularly true for those lacking a longstanding credit history.

The aspects considered under this category comprise:

 

  • Number of new accounts opened
  • Duration since a new account was opened
  • Number of recent credit requests
  • Duration since credit application inquiries were made by lenders

 

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 elevate your credit score by limiting the frequency of your credit applications within a short timeframe and strategically seeking credit rather than using it to cover budget shortfalls.

 

Types of Credit (Approximately 10%)

FICO® Scores tend to favor responsible and purpose-driven credit use. Therefore, your score will consider the mix of credit products you have. However, it’s unnecessary (and unwise) to open credit accounts you don’t intend to use.

The aspects considered under this category comprise:

 

  • Types of credit accounts on the credit report (e.g., revolving vs. installment);
  • Number of each type of accounts;
  • Possessing a mix of credit products could enhance your credit score. However, if you’re unable to repay the borrowed money, you could end up damaging your credit score instead of improving it.

 

Guard Against Predatory Lenders

Certain lenders prey almost exclusively on borrowers with poor credit scores—typically those with fully utilized (i.e., maxed out) credit cards and lines of credit. Although their readiness to extend financing might seem like validation of a positive credit score, don’t be fooled by their tactics. They compensate for their risk by levying exorbitant interest rates, often exceeding 30%, pushing you further into the debt cycle.

MNP’s quarterly Consumer Debt Index consistently reveals that fewer than two in five Canadians feel confident about covering all expenses over the next year without incurring additional debt. Unfortunately, the more debt required to meet household expenses, the more likely it is to take the form of predatory lending such as payday loans and high-interest credit cards. Once debtors reach this stage, escaping the vicious cycle of rising payments and escalating debt without professional assistance becomes virtually impossible.

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

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