Is being debt-free good for your credit report?

There’s a common belief among many consumers that habitually carrying a small amount of debt is beneficial to one’s credit report. And, conversely, that being completely debt free has a negative impact on your credit score.

It would be easy enough to say this is not true and end the discussion there. However, there are some nuances which merit further discussion.

What you learn about how credit reporting and scoring works, what you can do to improve your credit, and common debt habits which may be helping or hindering your progress may just save your credit — and save you a few dollars every month.

What is a credit score?

Your credit score is a specific number assigned to you by TransUnion and Equifax Canada, the nation’s two major credit reporting agencies. This numeric representation of your borrowing risk can range anywhere from 300 (poor) to 850 or 900 (excellent). It is intended to reflect the likelihood you will repay money you owe.

For example, an Equifax score of 700 means approximately 82 percent of people with that score (700/850) are likely to repay their debt.

In contrast to your credit report — which includes additional qualitative details such as your payment history, types of accounts, credit utilization rate, and how much you currently owe — a credit score computes all these factors into a single, qualitative judgement which lenders can reference quickly and easily.

Your credit score will likely fluctuate from month to month based on the specific criteria on your credit report reported to each agency by your creditors. How much and how often it changes ultimately depends on how you utilize the credit available to you.

How is your credit score determined?

Below are the broad factors that determine your credit score and the approximate weighting assigned to each factor:

• Payment history (35%): Do you pay your bills on time and in full? Have you missed any payments? Have you needed to make payment arrangements?
• Credit utilization (30%): How much credit, as a percentage of your total credit available, are you using at any given time?
• Length of credit history (15%): How long have you maintained your oldest credit account?
• Frequency of credit applications (10%): How many hard inquiries (e.g., applications for new credit or credit limit increases) appear on your credit report and how often?
• Types of credit (10%): Do you use a range of borrowing vehicles (e.g., revolving, installment, open) such as a credit card, mortgage / car loan, and utilities account?

We can see your credit score is not only based on your credit behavior and payment history, but it is also important to limit how much of your available credit you draw upon. To improve your score, you want to use less than 50 percent of your available credit limit on your revolving credit lines (e.g., credit card, line of credit). Below 30 percent is even better.

For example, if you have a $1,000 limit on your credit card, try not to use more than $300 at any time before paying it in full. Higher utilization signals to enquiring creditors there’s a higher risk of missing or defaulting on payments if something were to happen to your income.

What is a good credit score in Canada?

Equifax Canada classifies credit scores within the following five ranges:

TransUnion Canada follows a similar, though slightly different structure:

According to Equifax data, just over half of all Canadians have a credit score above 760 and approximately a third of Canadians having a score under 559.

Debunking some common credit score myths

There are, unfortunately, some common misconceptions around credit scores that often cause people to take unproductive, and sometimes counterproductive, steps to improve their situation. Let’s take a moment to clear these waters:

1. Your income or job does not affect your credit score: This will likely be part of a lender’s credit adjudication process but is not part of the credit score calculation.
2. Spouses will rarely have the same credit score: There will almost always be slight differences (usually owing to the score factors above), even if all your debts are jointly held.
3. Your score is not necessarily affected by your ex if you divorce: Provided one of you continues to pay your joint debts, the other person’s financial pitfalls will not impact the other.
   
   Note: You are responsible for having your name removed from joint matrimonial debts with approval from the lender. A divorce agreement or court order does not prevent a creditor from seeking liability from both of you for the full amount of the joint debt if they haven’t agreed to release you.
4. Your credit score isn’t necessarily free: The credit bureaus must provide you with a free copy of your credit report every year. However, they are not required to include a credit score.
   
   Note: Be aware that other third-party credit score provides (e.g., Credit Karma or your bank) may share your information with outside parties.
5. You will have more than one credit score: As above, Equifax and TransUnion use slightly different calculations. Also, not all creditors report to both credit reporting agencies, so some debts may show up on your Equifax report and nor your TransUnion report, and vice versa.
6. Filing a Bankruptcy or a Consumer Proposal does not permanently ruin your credit: A record of a first-time filing for each will remain on your credit report(s) for 6 to 7 years, depending on the Province you reside in.
   
   Note: Any debt management solution that does not result in you paying your lenders according to their contractual terms will impact your credit report. Remember the impact is temporary and the program(s) include education on how to develop a realistic budget and establish goals suitable to your circumstances.
7. Becoming debt-free will not automatically result in a perfect credit score: Remember, your credit utilization is only one measure of your credit score which counts for less than a third of your total score.

Why is being debt-free not ideal for my credit score?

First, it’s important to distinguish between being debt free and being a responsible user of credit. If your idea of being debt free means never taking out loans and never using credit cards and lines of credit, this is unlikely to generate a high credit score. Lenders will simply lack the data they need to score you accurately. It’s possible to worsen this challenge if you close your credit accounts or let them go inactive.

On the other hand, it’s possible — and indeed preferable — to use your credit accounts responsibly and still not have any outstanding debt carry over from month to month. Remember, your score is based on your credit behavior and payment history, so you need to maintain at least one active account (i.e., credit card or line of credit) to tell the scoring system how you’re managing your debts.

Utilizing one credit card for regularly budgeted purchase (e.g., groceries), charging less than 30 percent of your credit limit, and paying the balance in full by the due date will ideally show the scoring system evaluate that you are responsible with credit.

For maximum benefit, familiarize yourself with your statement date (usually 2-3 weeks before your payment due date) and avoid paying your credit card off until that statement is issued. Else your credit activity may not even be reported to the credit bureaus.

Cut yourself some slack

It’s easy to become obsessed with your credit score, but perfection isn’t a necessary or perhaps even an advisable goal. A good credit score can certainly help you qualify for more borrowing opportunities and interest rates. But note the emphasis is on good, as defined above by the credit reporting agencies. In other words, higher than 660 for Equifax and 743 for TransUnion.

Some of the criteria such as low credit utilization and a responsible payment history are certainly beneficial for overall financial health. If you focus on those, along with managing your money, budget, and debt carefully, your credit score should take care of itself.

Perhaps even more important than fussing about your credit score is to check your credit reports at least once every year to ensure your information appears accurately — and report any errors to the credit bureaus and your lenders as soon as possible.