ABR, MBA, B.Sc.
"How is your credit?"
If someone asks you this question, you might wonder what it means,specially if you are a new-comer from Sri Lanka.
In Canada, "credit" means your "creditworthiness" not anything else. It is not credit/debit in accounts. In other words, credit means how reliable you are, for someone else to give you a loan.
Why is your credit so important? - Because most of you think of buying a house when you come to Canada.
In order to buy a house you should be able to get a mortgage.
In order to buy a house you should be able to get a mortgage.
What are the requirements to get a mortgage? – A GOOD CREDIT SCORE AND SUFFICIENT INCOME.
In Sri Lanka you should have a good rapport with your bank to establish your creditworthiness. Then you have to stick to that bank for your financial needs. In Canada & USA there are central systems to monitor your creditworthiness. These places are called credit bureaus. There are two credit bureaus in Canada. They are Equifax (www.equifax.ca; T: 1-800-465-7166) and TransUnion (www.transunion.ca; T: 1-800-663-9980). If you go to a bank, a financial institution or a merchant they can see how your creditworthiness is. This process is called "checking credit ". The credit bureaus assign a credit score to you on completion of the process of checking your credit. The credit score is an indication of your creditworthiness at that time.
Establishing good credit is an important factor, when it comes to purchasing a house. A good credit score will not only enable you to purchase a house, but will also enable you to get a good interest rate on your mortgage. On the other hand, a bad credit score will prevent you from getting your mortgage approved. Hence, it is extremely important to establish a good credit score.
How do we do we establish a good credit score? The credit score is computed based on five factors.
1. Payment History
This means how well you have paid off your loans in the past. This has a 35% impact on your credit score. Settling your minimum payment on time has a positive impact on your credit score. In Sri Lanka, most people do not settle their credit card dues on the due dates. If we do this in Canada, the result will be a bad credit score. Late payments, judgments and charge-offs will also have a negative impact on your credit score. Missing a high payment has a more adverse impact than missing a low payment. Hence, it is important to establish a good payment history by paying off all your dues on time. It is very important to make your minimum payment on time, however small that amount is. Some people delay paying small amounts thinking that they can pay everything the following month. Even if your minimum payment is $10, make sure you pay it, so that you will not lose points from your credit score.
2. Outstanding Credit Balances
This is the ratio of the outstanding credit balance to the available credit limit. In other words, this is the amount you have borrowed as a percentage of the credit limit of that particular credit card. The outstanding credit balances have a 30% impact on your credit score. Ideally, the outstanding credit balance should be at least 10% below the available credit limit. That means if you have a credit card with a limit of one thousand dollars ($1,000), the outstanding balance should not be more than nine hundred dollars ($900) at any given time. I usually advise my clients not to exceed 80% of the limit, so that you reduce the risk of exceeding the limit.
3. Credit History
The credit history is the length of time since a particular credit line was established. This has a 15% impact on the credit score. A seasoned borrower will have a stronger credit score. Few years ago it was mandatory that you establish credit for at least one year for you to get a mortgage. However it is not mandatory now. There are programs to assist new comers to overcome the one-year credit history hurdle.
4. Type of Credit
The type of credit that you have, has a 10% impact on the credit score. A mix of loans – mortgages, credit cards, auto loans is more positive than having only credit card debts.
5. Credit Inquiries
The loan providers have to obtain your credit score before approving your credit line. The number of credit inquiries that have been made on a person’s credit history within a six-month period has a 10% impact on a person’s credit score. Each hard inquiry can cost from 2 to 50 credit points, but the maximum number of inquiries that will reduce the score is 10. Eleven or more inquiries during a six-month period will not have a further impact on a person’s credit score.
We now know how the credit score is computed, and the factors impacting the score. But you would realize that you should first have credit facilities to build a good credit score. You would also realize that it will be difficult to get a credit facility approved, if you do not have a good credit score. So, how would a newcomer, who does not have credit facilities in Canada “build credit?”
One of the first things that you should do when you arrive in Canada is to get a credit card. As newcomers do not have a credit history in Canada, most banks now offer secured credit cards. A secured credit card is a credit card that you obtain by having a cash deposit as security. In addition, there are credit cards that are offered by retail stores – Bay, Sears, Canadian Tire etc. It may be easier to obtain a credit card from a retailer, than a financial institution. Once you obtain a credit card, you should make your purchases using this, but ensure you settle the minimum payment on the due date. You should also ensure that you don’t make purchases up to the credit limit, so that you maintain a favourable ratio between the outstanding credit balance and the credit limit.
The next factor in building credit is to pay your utility bills on time.
What should your credit score be?
720 and over - Wonderful. You will be offered the very best mortgage rates
700-719 - Excellent score. You are a very desirable borrower
700-719 - Excellent score. You are a very desirable borrower
680-699 - Good credit. You should be in good shape to buy
660-679 - OK credit. 640-659 Borderline. OK if everything else is OK
620-639 - Weak credit. Everything else should be perfect
600-619 - Difficult. Need some work or a special program
Below 600 - Trouble! Try to fix your credit
What should you do if you have a bad credit score?
Typically, a person with a bad credit score is in this position because they lack structure in their lives. There are, of course cases where health has been a factor, or there has been a lay-off or fluctuation in employment, but for the most part, these are individuals who lack the discipline tom pay their bills on time or to curb their spending.
One thing that is important to remember is that the credit score is computed by a computer system that does not take personal factors into account. When you run a credit report, it is today’s snapshot of your credit profile. This can fluctuate dramatically within the course of even a week based on your activities. It is in your best interest not to go on a shopping spree and increase your credit card debts when you are trying to apply for a loan.
How do you fix a bad credit score?
1. Start paying your bills on time. Remember the payment history has a 35% impact on your credit score
2. If you have a number of credit cards, but use only one of them, and you are close to the maximum limit on that card, the ratio between the outstanding credit balance and available credit limit will be impacted. You should then distribute your debt over the other credit cards to improve this ratio which has a 30% impact on your credit score.
3. If you only have one credit card that is pushing the limit, try get a few more and spread the debt over the other cards to have at least a 20% margin of available credit on all cards. Although the new cards will effect the credit history factor, this only has a 15% impact on the credit score whereas the ratio between the outstanding credit balance and available credit has a 30% impact.
4. Do not close any existing credit card accounts even if they are at a zero balance. Some people think that they are doing themselves a favour by having fewer cards but they lose out on the credit history factor. Even if you do not have a good credit rating on those old credit cards, you are rewarded for having a long-term credit history.
5. Lastly, review your credit report to ensure that all credit facilities stated therein are in fact yours. There could be situations where someone else’s credit facilities are erroneously added to your file. If the credit score of the other person’s facility is weak, it could impact your credit rating.
So, the first requirement in getting your mortgage approved is to have a good credit rating.
The second requirement is to have a sufficient income to pay your monthly mortgage.
Lenders follow two simple affordability rules to determine how much you can pay.
The first affordability rule is that your monthly housing costs shouldn't be more than 32% of your gross household monthly income. Housing costs include monthly mortgage principal and interest, taxes and heating expenses — known as P.I.T.H. for short. For a condominium, P.I.T.H. also includes half of the monthly condominium fees. For leasehold tenure, P.I.T.H. includes the entire annual site lease.
Lenders add up these housing costs to determine what percentage they are of your gross monthly income. This figure is known as your Gross Debt Service (GDS) ratio.
The second affordability rule is that your entire monthly debt load shouldn't be more than 40% of your gross monthly income. This includes housing costs and other debts, such as car loans and credit card payments. Lenders add up these debts to determine what percentage they are of your gross household monthly income. This figure is your Total Debt Service (TDS) ratio.
So, the major two requirements to obtain a loan are: your income and the credit history.
We will now look at the types of mortgages available in Canada.
What is a “Variable Mortgage”?
A Variable Mortgage, as the word suggests, is a mortgage where the interest rate varies from time to time. The interest rate is tied directly to the prime rate. The prime rate is a rate that is set by the bank based on the prime rate set by the Bank of Canada. The current prime rate is 2.75% and the banks are now offering prime minus 0.65% which comes to 2.1%. Bank of Canada decides the prime rate at their periodical meetings. Usually they increase or reduce the rate by 0.25% at a time. For those who are ready to take a risk, the variable rate is an option. However, those with variable rate mortgages need to keep an eye on the prime rate and should keep in touch with a mortgage professional who can explain interest rate trends.
What is a “Fixed-Rate Mortgage”?
A fixed rate mortgage is where the mortgage rate is fixed for the selected period. The period could be 1 year, 2 years, 3 years, 4 years, 5 years or even 7 years, depending on the attractiveness of the financial instruments available at the time of borrowing. This type of mortgage is ideal for a conservative borrower who does not like to worry about the increase or decrease of the mortgage amount over a period of time. Fixed interest rates are determined based on the bond market, as the bonds are the main competing investment to mortgages for investors. Mortgages are prices higher than the bonds usually between 1.2% and 1.9% to account for the higher risk.
The most popular type of mortgage in Canada is currently the 5-year fixed rate mortgage.
The most popular type of mortgage in Canada is currently the 5-year fixed rate mortgage.
Now the banks are offering “Mixed Mortgages” with a 50% variable portion and a 50% fixed portion. This would be a good choice to reduce the risk of interest rate fluctuations.
What is an “Open Mortgage”?
An open mortgage allows you to pay closed mortgage. Usually the banks allow a prepayment of up to 15% of the loan balance. So, if you are planning to make a lump sum payment of more than 15%, an “open mortgage” is a good choice as it gives you the flexibility of paying off the loan.
So, which mortgage is cheaper…?
A study on a 30 year period has shown that those who are on variable mortgages save money. However, there should be a good management of cash flow to harness the savings from variable mortgages, as you have to keep the savings to meet the extra payments that you may to make, if the interest rate increases during your mortgage period.
What is the “Amortization Period”?
The “Amortization Period” is the time you take to completely pay off your mortgage. This period can be 15, 20, 25, 30, or 35 years. Banks had been offering 40 year mortgages up till last year. But it’s not available now. The advantage of having a longer mortgage term, is that you need less income for mortgage approval. The longer the period, lesser the income you need to qualify for the mortgage. Further, your monthly payment will be lower if you go for a mortgage with a longer term. Monthly payment for $100,000 mortgage with an amortization period of 35 years and an interest rate of 2.1%, is $335.95. Therefore for a $300,000 mortgage you will have to pay only $1,007.85 ($335.95 x 3). If the interest rate is 4.1%, the monthly payment for $100,000 is $446.71.
Now you have a good understanding of prerequisites to get a mortgage what the credit score is, its importance, how it is computed, what you should do if you have a bad credit score, and the different mortgage types available to you in Canada.