Getting (and staying) out of debt is a major goal for many. Dealing with the constant collection calls, struggling to make ends meet, wondering if you’re going to be able to put food on the dinner table for your family—the stresses of excessive debt are never-ending. Thankfully, there is a light at the end of the proverbial tunnel.
There are many ways to get out of debt—from simply saving up money and paying off bills to declaring insolvency, getting a debt consolidation loan, or even signing up for a debt consolidation program. However, when trying to get out of debt, it’s important to consider how your efforts can affect your credit score since that may affect the kinds of financial services you can secure in the future.
Credit Canada CEO Bruce Sellery recently sat down with Richard Moxley, author of The Credit Game, and his wife Jess on the Moolala podcast to discuss some of the peculiarities of credit scores and how certain methods of eliminating debt can end up negatively affecting your credit score.
What does a credit score mean? It’s a number that showcases how much “trust” lenders can put into you as a borrower. The higher the number, the more trusted you are as a borrower—which can mean that banks are more likely to provide you with favourable loan terms, credit card providers will give you higher-limit cards with lower interest rates, and other potential benefits when it comes to applying for financial services.
Need some help understanding your credit score and how debt (and debt repayment) can affect it? Read on for more information and advice!
Understanding Your Credit Score: How Many Credit Scores Do You Have?
One thing to know about your credit score is that you actually have more than one. There are two major credit bureaus operating in Canada: Equifax and TransUnion. So, when you ask “What is my credit score?” the answer can vary depending on which of the two bureaus your credit score is being pulled from.
Generally speaking, Equifax considers any score above 660 a good credit score. Meanwhile, TransUnion defines a “good credit score” as whatever score lets you meet your goals. Why? Because different lenders might have different standards when it comes to your credit score. For example, a 770 score might be enough to secure a loan with the interest rate you want under one lender, but another one might require a score of 800+ to do the same.
It's important to note that the two credit bureaus may assign different credit scores to individuals. Why do these discrepancies happen?
Why Credit Scores Differ Between Credit Bureaus
There are a few reasons why your credit score might differ between the two major credit bureaus in Canada.
One reason scores may differ is that, because Equifax and TransUnion are two different organizations that may have different reporting sources, information may be missing from one of their credit reports that is present on the other. This could either negatively or positively impact your credit score depending on the nature of the missing information.
For example, say you miss a few credit card payments before promptly getting back on track. The lender reported the missed payments to one credit bureau, but didn’t report to the other before your account went back into “good” status. Now, one bureau has a credit report showing delinquency in payments while the other does not—resulting in a different score.
Another issue may be a difference in the “weight” the two credit bureaus assign to specific types of credit activity. The five factors that the bureaus consider are:
- Debt Payment History. A measure of how frequently you make payments on time versus missing payments on your debts.
- Credit Utilization Rate. A comparison of how much credit you have available to you vs how much you’re currently using. For example, if you had $100,000 of credit available, and used $76,000, then your utilization rate would be 76% (you typically want it to be under 30%).
- Length of Your Credit History. A measure of how long you’ve been borrowing money for. The longer your history, the better it is in the eyes of the credit bureaus.
- Credit Mix. A check of how many different types of credit you have, such as installment loans, revolving credit, open accounts (i.e., lines of credit), and mortgages. Greater variety is typically better.
- Number of Hard Inquiries. Credit bureaus use this to estimate how frequently you’ve applied for different kinds of credit. Too many inquiries too fast can drop your score.
Both Equifax and TransUnion tend to place the most weight on the first two items in the above list—debt payment history and credit utilization rate—but the specifics can vary between the two.
What Can You Do If There’s a Big Difference Between Your Credit Scores?
If you check your free credit report from both Equifax and TransUnion (and you should periodically check each one) and notice there’s a big difference in your score from one to the other, be sure to take a close look at both reports to see if there are any discrepancies between the two.
For example, are there any big missed payments being reported on one but not the other? A slew of recent credit inquiries that you didn’t make? Anomalies such as these could be an indication of either missing data or even potential identity theft that you need to take care of so you can remove the illicit activity from your credit report.
While you can always expect at least a small difference in your credit score between Equifax and TransUnion, a major discrepancy of a hundred points or more should be a major warning sign that something’s wrong in your credit report.
If you suspect that you’re the victim of identity theft, contact the Canadian Anti-Fraud Centre or by phone. It can also help to reach out to Equifax and TransUnion and place a fraud warning or fraud alert on your credit report.
How Could Closing a Credit Card Hurt Your Credit Score?
While talking with Jess and Richard Moxley about what affects credit scores, Bruce asked about how closing a credit card account that you’ve had for a long time can be worse than missing payments on your debt. As strange as it sounds, closing your long-running credit accounts can actually do some harm to your credit score.
You might be wondering “shouldn’t getting rid of debt improve my credit score?” Yes! But, while paying off your debt is a good thing, closing your credit card accounts can actually lower your credit score.
Richard noted that this is because the credit bureaus are mostly concerned with current credit activity, and closing accounts turns them into old good credit, which sticks around, but doesn’t affect the score nearly as much as current credit activity and accounts.
Additionally, when you close a credit account it can negatively impact your credit utilization rate—which is one of the two biggest factors that credit bureaus use to determine your credit score.
For example, say you have $20,000 of credit available and are currently using $14,000 of it. That’s about a 70% utilization rate. Let’s assume that part of that debt is $6,000 that you owe on a credit card with a $10,000 limit. If you close that card after successfully paying it off, you would now have $10,000 of credit available with $8,000 of debt used up—bringing your utilization rate up to 80%.
Why Is This Important?
So, the basic piece of advice seems to be “avoid closing your credit cards if you don’t have to—even if you pay them off in full.” Doing this can help you enjoy the benefits of having good credit while minimizing the impact of debt on your life. However, not everyone is in a situation where they can control whether they keep a credit card open when they pay it off.
When would you not be able to keep your credit card accounts open after paying them off? If you take certain debt consolidation loans or join a debt consolidation program (DCP), you may have to give up your credit cards.
How to Build Your Credit Score
Say that you’ve recently closed one of your credit accounts already. What can you do to improve your credit score? There are a few things you can do to build up your credit after a drop in your credit score. Here are some sample credit-building activities to consider:
1. Apply for a Secured Credit Card
A secured credit card is a lot like a regular credit card in that you can borrow against a set amount of credit and pay it back later. The key difference is that you have to provide some collateral to secure the credit card at the start. This collateral may help determine how much credit the secured card is worth.
Activity with a secured credit card can be useful for building your credit just like with a regular credit card. However, because the secured card is so much easier to qualify for (since it’s backed by collateral), you can often get one even with a low credit score.
2. Avoid Applying for Too Much Credit All at Once
If closing a credit account or finishing off a loan can hurt your score, then opening a new line of credit or getting a new loan should help build your score, right? Well, it depends. Opening a new loan or credit card can help you improve your credit mix, provide current good credit activity, and help you improve your utilization rate.
However, applying for too much new credit in a short span of time can actually hurt your credit score because it puts a lot of hard inquiries in your credit history all at once.
So, while you do want new credit activity to show up in your report, be sure to take it easy.
3. Try to Keep Up with Your Monthly Minimums
If you can’t pay off your credit card debt each month, consider focusing on paying your monthly minimums instead to avoid missed payments and other issues that can hurt your credit score. If you do pay off a credit card in full, consider keeping it open just in case you need it later (or simply to keep your credit utilization rate down).
Having a long history of consistent on-time payments is a huge part of building credit—more so than actually paying off debt. If your goal is to increase your credit score rather than to get out of debt, it can be helpful to focus on making your monthly minimum payments to each of your accounts instead of paying them off in full each month. However, paying off debt to maintain a strong utilization rate of less than 30% is also a good idea!
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