Your credit score is incredibly important to maintain, whether you acknowledge it or not. Having a good score is vital when applying for a personal loan, leasing a car, or applying for a mortgage. Maintaining a good credit score can be difficult and requires work, but it’s manageable if you understand how it works.
High? Low? Positive? Good? Bad? This article will help explain what a credit score is, and how lenders use it to evaluate the financial health of a prospective mortgage borrower. Let’s look at the numbers.
What is a credit score?
Every borrower who has taken a loan would have a credit history, based on which a credit score is assigned. The score ranges from 300 to 900, and it is readily available to an individual or a financial institution. Other information like name, social insurance number, and marital status are also saved in the credit file used to derive the credit score. Users can get their credit scores from one of two major credit bureaus, namely Equifax or TransUnion, for a fee.
The credit model used to derive a credit score is based on several factors:
- Payment history: A person paying their installments or credit card bills in due time is expected to have a good credit score. Any defaults or payments lapses are recorded in the credit file and would negatively affect the score.
- Balance withdrawn from the total limit: This is calculated as Balance to Limit Ratio and determines the percentage of the loan available from the total limit allocated. A higher percentage implies that the borrower has utilized more of the limit and is a negative factor for their credit score.
- Length of the credit accounts: This may sound strange, but users need to have an established history of an account for a considerable period to have a good credit score. Repaying loans immediately may not translate into a better score for the borrower.
- Variations in loans taken: A person with a history of different types of loans like a mortgage, personal loan, or credit card transactions would gain an advantage when their credit score is calculated. Note that the emphasis is on a variety of loans and not the number of accounts.
- Having no debt: This is counterintuitive, but a person without any debt does not have a history based on which the credit score can be calculated. This could lead to a deduction in points from their credit score. It is, therefore, advised to have a credit history before applying for any loan.
A credit score may have numerous applications. Having a good score would ensure that the borrower can secure a loan without much hassle. Your score can be checked before renting a vehicle or a house. Prospective employers could also look at the credit score, which may reflect poorly on the candidate.
What is a good credit score?
We have already mentioned the range of credit scores that an individual can get. As a rule, any score above 720 is considered “good.” The chart below highlights the different range of scores and how it reflects on the person seeking a loan.
|Classification of credit scores|
|300 to 624 Credit Score -> Poor|
|625 to 679 Credit Score -> Below Average|
|680 to 719 Credit Score -> Fair|
|720 to 779 Credit Score -> Good|
|780 to 900 Credit Score -> Excellent|
According to the table, anything below 680 would make it difficult for the individual to take a loan. A score of above 720 should be maintained so that there is a higher chance of getting a loan. Different lenders may use similar terms, but the results should be the same. A bank may not provide a mortgage loan to someone who has a score of 650, but there may be smaller institutions that would be willing to lend at an additional cost in the form of higher rates or fees.
In the table below, a majority of Canadians have a credit score above 650. Over 55% of the population has a score in the Good to Excellent range. About a quarter of the population has a credit score that is below average or poor.
|Credit score distribution in Canada|
|Up to 549 Score -> 4% of Population|
|549 to 599 Score -> 5% of Population|
|600 to 649 Score -> 6% of Population|
|650 to 699 Score -> 11% of Population|
|700 to 749 Score -> 19% of Population|
|750 to 799 Score -> 27% of Population|
|800 to 849 Score -> 23% of Population|
|850+ Score -> 5% of Population|
Another analysis by Equifax found that the credit score of elderly citizens was better than that of younger Canadians. This could be attributed to longer credit histories, better earnings potential, and extended mortgage payment histories, among other factors.
It could also be inferred that the bulk of the population having a poor credit score comes from the younger segment. This will not be a concern if the level of debt in this segment is low, as the credit score would only improve with time as the credit history of such individuals is built.
How does your credit score affect your mortgage?
The lower your credit score, the less likely a bank or financial institution will give you a mortgage loan. While a score above 700 is generally considered good, it may not be the only factor that lenders consider. Moreover, the score generated by a lender can be different from the one given to an individual by a credit bureau.
A mortgage borrower could do a pre-approval instead of directly applying for a mortgage loan as well. In this process, the potential borrower provides information like proof of employment, assets owned, and current debts and other obligations. The lender then assesses the borrower and estimates the amount of money that the person can borrow. A rate of interest, along with the potential mortgage payments, is also provided so that the borrower knows how much they can afford to spend on a home purchase.
The credit score is an essential input in the pre-approval process, and lenders help to identify harmful elements if the credit score misses the mark. However, once a pre-approval letter is obtained, it does not guarantee that the loan would be disbursed. Borrowers still need to apply for the mortgage loan, and only after assessing the actual value of assets and other elements, will the loan be approved.
While credit score is one of the parameters that banks assess during the appraisal process, other factors are considered. Like the pre-approval process, a financial institution may investigate the following:
- Current income: This would include income from salary, rental income, and income from other sources like financial instruments.
- The current level of debt: While this may already be factored in the credit score, lenders assess how much debt a person owes.
- Employment history: Used to determine if an individual has some level of stability. Contractual jobs or ones with high variable pay may draw additional attention.
- Assets owned: The lenders would also appraise the value of the assets that the person declares.
- The property for which mortgage is taken: In the case of a default, the lender would have to recover the money by selling the mortgaged property. It is necessary to understand how the price could appreciate or depreciate in the future. It also ensures that the loan amount taken is appropriate for the selected property.
Minimum credit score requirements for a mortgage
Minimum credit score requirements can vary depending on the institution and mortgage insurer. The Canada Mortgage and Housing Corporation (CMHC) stipulate a minimum credit score of 680, if you’re making a down payment of less than 20%.
Private mortgage insurers, such as Genworth Financial or Canada Guaranty, have less stringent credit score requirements. Their requrements largely depend on the loan-to-value ratio of your mortgage.
As a general guideline, If you require mortgage default insuance (you’re making less than a 20% down payment), at least one of the applicants on the mortgage, should have a minimum credit score of 680. If you’re making a down payment of more than 20%, at least one of the applicants, on the mortgage, should have a minimum credit score of atleast 600.
Ideally you would have a credit score above 720 when applying for a mortgage. The minimum requrements outlined above serve as absolute minimums. Scores below these thresholds would mean your chances of getting approved for a mortgage are very low.
Getting a mortgage if your credit score is low
If your credit score is low, getting a mortgage loan can be difficult when approaching a bank. Banks generally have guidelines that they do not compromise since they are tightly regulated. Criteria such as good credit score, gross debt service ratio, adequate income, and loan to value are scrutinized before a loan is disbursed.
So, a borrower with a low score needs to find alternatives to obtain a mortgage loan. Some of the options that are available include:
- Credit unions: These are companies owned by the customers and have a non-profit model of operation. Credit unions sometimes provide loans at a lower rate of interest than banks, but the interest could be higher for people with compromised credit history.
- Trust companies: These act as a financial intermediary by accepting savings and disbursing these funds as mortgages and other loans. The level of regulation has increased over the years, but they’re aren’t as tightly regulated as the banks.
- Sub-prime lenders: These lenders offer mortgage loans at a higher rate of interest, with the down payment generally being higher. The mortgage typically does not have a variable rate of interest. Those with a poor credit score or lack of credit history can avail loans from these lenders, but the premium on the rate of interest can vary between 1% and 3% or more.
If the mortgage applicant’s score is not high, one idea is for an individual to apply for a loan jointly with someone who has a better credit score. As noted, the requirement set by CMHC states that any “one” of the borrowers should have a score higher than 680. Alternatively, the down payment can be increased to reduce the loan exposure.
How to improve your credit score?
There are simple ways in which a potential buyer can increase their credit score. If the borrower does not have a credit history, they can apply for a credit card and conduct few transactions. The outstanding dues should be paid on time. It is advisable not to use more than 30% of the credit limit allocated. Users should check these promptly. Other loans like a car loan or a personal loan could also be used to provide a diversified set of credit profiles.
Keeping a good credit score is important and should be reviewed regularly to make sure you are on the right track – there are numerous advantages to maintain a healthy credit score. Before applying, mortgage loan applicants should ensure that their score meets the minimum requirements for loan approval. This would also enable the applicant to secure a reasonable interest rate and reduce expected mortgage payments. Those interest costs add up over a lifetime, and if owning a home is one of your primary goals, starting with a good credit score is extremely important.