How your credit card impacts your credit score

One of the most important reasons to use your credit cards responsibly is to build up your credit score and demonstrate your credit worthiness to lenders. Your credit score is a number between 300 and 900 that tells lenders how risky it is to lend money to you: the higher the score, the lower the risk. Let’s look at how your score is calculated, what is considered a good credit score, why your score is important and how you can improve it.

How your credit score is calculated

First of all, “credit” is a financial tool you can use to pay for something without physically having the cash in your wallet – on the promise, of course, that you will repay your creditor (the lender who gave you the credit) at some point in the future. Examples include credit cards, lines of credit, mortgages, student loans, etc. How you use your credit, over time, is ultimately what determines your credit score.

The following five pieces of information are used to calculate your credit score:

1. Your payment history on all accounts (this takes into account if you have been late paying any of your bills)
2. The balances of your open credit relative to their limits
3. How many years you’ve been building your credit history
4. The number of recent inquiries made (e.g. how many times you’ve recently applied for new credit)
5. The types of credit you have (credit cards, loans, etc.)

The two credit-reporting agencies in Canada – Equifax and TransUnion – don’t reveal exactly how credit scores are calculated, but a pie chart released by FICO¹, which is the largest credit-reporting agency in the United States, shows a quick breakdown of how they weigh the five factors.

As you can see, making the minimum payment (if not more) on time is the most important thing you can do to build up a good credit score. The balances on all accounts in relation to your total available credit, is the second most important factor to consider.

The length of time you've been building your credit for is another thing credit-reporting agencies look at when determining your credit score. For example, you'll have a better credit score if you use and pay off one card for five years than a card you've had only for a few months.

How much “new” credit – including how many times your credit report has recently been pulled – are indicators that you may be having trouble borrowing money and/or borrowing more than you can afford to repay.

Finally, it’s better to have multiple types of credit (e.g. a credit card, loan, mortgage, etc.) versus just one type, because it lets lenders know you are responsible when handling multiple forms of credit and carrying debt.

What is a good credit score?

All of the information outlined above is eventually turned into a three-digit number: your credit score. As we mentioned above, your credit score is a number between 300 and 900 – and the higher the score, the better. A perfect score is 900, but anything above 750 is considered excellent. You need a minimum score of around 680 to access the best interest rates on any new forms of credit you take out, including mortgages, loans, lines of credit, etc.

If your score is below 680, that doesn’t necessarily mean creditors won’t lend you money; it just means you’ll be subject to higher interest rates, as you’ll be seen as a risky borrower, and higher risks come with higher premiums. For example, if your credit score is below 600, you won’t be able to get a mortgage from one of the big banks. Instead, you’ll have to get a bad credit mortgage (which come with much higher interest rates) through a bank, private lender or trust company.

Why do you need a good credit score?

When the credit score was first introduced, it was meant to help financial institutions make “complex, high-volume decisions about creditworthiness.”³ Under that reason, it’s always been a piece of the puzzle in determining what interest rate borrowers can get, when applying for mortgages or other loans.

Today, however, it can be used in many other circumstances, including when you’re applying for an apartment rental, an insurance policy, and even a new cell phone contract. Some people even have to sign off on future employers running a credit check on them, before they can be hired.

Overall, credit scores are meant to prove one thing: how good or “trustworthy” you are with your finances. For this reason, you’ll want to build up and maintain a good credit score for as long as you’ll need access to credit, as the vast majority of people do.

If you’re new to Canada: Credit card and credit score basics

A credit card is a payment card you can use to make purchases online and in stores, and is often the first credit file you’ll open in Canada. Purchases you make are credited to your account, and a minimum payment – typically  $10 or 3% of your balance, whichever is higher – must be made on a monthly basis. Your credit card will come with a credit limit, which is the maximum balance you can carry on your account.

Many Canadian banks are eager to compete for your business, and will offer you a special deal for newcomers on a bank account and credit card package. This typically includes a chequing account with no monthly fee for the first year, and a credit card. For example, Scotiabank’s StartRight program offers no monthly account fees on a Preferred Package chequing account for the first year. The bank also recommends newcomers apply for the Scotiabank Passport Visa Infinite card, for which it promises a credit limit of up to $15,000 depending on your income. In most cases, newcomers must visit a bank in person with their residency documents and ID in order to get their first credit card.

If you don’t qualify for a newcomer program or don’t meet the income requirements for a regular credit card, you can establish credit by using a secured credit card instead. Secured credit cards require you to put down a deposit, usually equal to the credit limit. Once you’ve used your card for long enough to establish good credit, you may be able to apply for a regular credit card and get your deposit back. The Secured Neo Mastercard and Home Trust Secured Visa Card are two excellent options for newcomers with guaranteed approval.

It takes approximately six to twelve months to establish “good” credit using a credit card, after which time you may be able to qualify for a mortgage, other loans, and better credit cards like those that offer cash back and travel rewards.

How different types of credit cards affect your credit score

There are many different types of credit cards in Canada, including:

• Travel rewards credit cards, which let you collect points you can redeem for travel rewards like flights, hotels, car rentals and vacation packages.
• Cash back credit cards, which give you cash back on every purchase you make, usually with bonus cash back for certain spending categories.
• Balance transfer credit cards, which offer a reduced interest rate for a limited time when you transfer your balance from another card.
• Low interest credit cards, which offer lower interest rates than traditional credit cards.
• Secured credit cards, which offer guaranteed approval in exchange for a deposit.

In general, all credit cards will affect your credit score in the same way: your credit score will go up when you make the minimum payment on time each month and keep your balance low relative to your credit limit. Conversely, your credit score will go down if you frequently miss or make late payments or carry a high balance on a regular basis.

Secured credit cards can be helpful for building credit, as they usually offer guaranteed approval and give you a credit limit equal to the security deposit you put down. You can be approved for a secured credit card even if you have no credit history in Canada, and they’re a good alternative if you don’t qualify for newcomer credit card offers.

The only credit cards that won’t help you build your credit are prepaid credit cards, on which you load a balance and spend only what you’ve paid for in advance. These accounts don’t report to the credit bureaus and will neither help nor hurt your credit.

How to build your credit score using a credit card in Canada

Credit cards are useful tools for building your credit profile in Canada, and a good starting place when you don’t qualify for other loans and lines of credit. Follow these tips to optimize your credit card use for building credit.

Start with the right card

Get the highest credit limit you qualify for

This may seem counterintuitive, but part of your credit score is calculated based on your utilization: how much of your credit you’re actually using. By getting a higher credit limit, you can reduce your utilization ratio – but take care to not to use that additional credit, as it will simply worsen your ratio, and build up debt that can be difficult to pay down.

Use your credit card

Simply having a credit card will do little to build your balance; you need to use your card on a regular basis for your credit score to go up. That doesn’t mean you need to use your card every day, but aim to make a couple of purchases a month using your credit card, with a plan to pay them off immediately. It doesn’t matter where you use your credit card - all purchases will have the same effect on your credit score.

Make the minimum payment on time each month

Most credit cards require you to make a minimum payment of $10, or 3% of your outstanding balance each month. For example, if your balance is $1,000, your minimum payment will be $30.

It’s important to make at least the minimum payment by the deadline each and every month. Making payments on time is the best way to improve your credit score, and missing payments or being late can have a negative effect.

Don’t worry if don’t pay off your balance in full

It’s important to note that you don’t need to pay off the balance in full each month to build your credit score. In fact, having some credit utilization on your file may be better for your credit score than having none at all. Just watch out for interest charges, as most credit cards in Canada charge a hefty interest rate ranging from 19.99% to 24.99%.

While it’s okay for your credit score for you to carry a balance, you will want to avoid maxing out your card. Not only can it be risky for your finances, the credit bureaus may penalize you if you use too much of your available credit. Aim to use no more than 30% of your available credit in any given month.

Don’t apply for new credit too often

Having a second credit card will help your credit score, but be cautious not to apply for too much credit too quickly. When you take on a lot of debt at once, the credit bureaus see it as a sign that you’re not managing your finances well and adjust your credit score accordingly.

Aim to apply for a new credit card, loan or line of credit no more than once every six months. Note that it’s okay to apply for a few products at once if you only plan on using one – the bureaus see this as “shopping around” and won’t penalize you for it.

Keep your oldest credit card open, even if you don’t use it anymore

Part of your credit score is calculated based on your credit history: the length of time you’ve had credit in Canada. But when you close an account, it no longer counts toward that period of time. (Closing an account won’t undo any positive or negative impact it has had on your credit, however).

Whatever your first credit card in Canada is, keep it for as long as you can. It may do more good for your credit score than you realize.

Check your credit report often and report errors immediately

It’s possible for credit bureaus to make mistakes, and it’s important to catch them early to avoid harmful demerits on your credit report. There are a number of free tools available that you can use to check your credit score and report. Aim to check your credit at least once per year and be sure to report any errors as soon as you find them to protect your credit score.

References and Notes

1. FICO - What’s in Your Score?
2. FCAC – How to Improve Your Credit Score
3. MoneySense – A Score to Settle