What happens to your credit rating when things aren’t going well?

Many people are concerned about their credit rating. After all, this may determine whether you qualify for a mortgage or a car loan — and possibly even whether you get the apartment you’ve applied to lease. Your credit rating could also influence your interest rate: the lower your credit rating, the more perceived risk the lender takes on, and the higher the interest rate tends to be.

There are many factors involved in calculating both your credit rating and your credit score, including:

• Your payment history,
• How much credit you use versus how much you have available,
• The length of your credit history,
• Public records (such as bankruptcy), and
• The number of lender inquiries made on your credit file.

Making senses of the rating systems

The credit score most people are familiar with is a three-digit number ranging between 300 and 900 sometimes called the Beacon score (or FICO score in the U.S.). A rating above 660 is generally considered good, and anything above 760 is considered excellent. Anything between 560 and 660 is considered fair, and below 560 is considered poor.

However, the Beacon score is not the only benchmark used by Canada’s two main credit reporting agencies, Equifax and TransUnion. They also reference other systems to evaluate your credit performance with respect to certain classes of loans or specific loans themselves. 

Revolving credit score

A revolving credit score indicates how well you have done with a revolving lender (e.g. credit card) on a range of R1 to R9. In this rating system, the lower the number, the better. 

The one-to-nine rating system is also used for other types of credit such as installment loans (e.g. auto financing), open loans (e.g. lines of credit) and mortgage loans. However, for simplicity’s sake, let’s stick with the revolving credit score for now. 

Among the factors which impact your credit score noted above, payment history is by far the most important. Your R-rating with a particular lender will reflect how well you have done with your payments against the following criteria:

• R1: Payments made as agreed in the contract
• R2: 31 to 59 days late
• R3: 60 to 89 days late
• R4: 90 to 119 days late
• R5: More than 120 days late
• R6: Not generally used
• R7: Regular payments under a debt management option or a settlement (including Consumer Proposals)
• R8: Repossession of an asset
• R9: Bad debt, collections, uncollectable, Bankruptcy

The downward spiral of bad credit

Many of the people I interact with as a Licensed Insolvency Trustee already have challenged credit reports, with lenders rating them at an R2 or worse. If the debt situation has worsened to the point of being sent to collections, they may already be rated R9.

It is often very difficult to recover from a situation like this. Catching up would require large, consistent payments. Sometimes slashing expenses can accomplish this, but without an income boost or windfall, it may be impossible.

An R9 may remain on a person’s record indefinitely even if they are able to make occasional payments. I’ve seen people limp along like this for years. 

Short-term pain for long-term gain

Perhaps surprisingly, a formal insolvency proceeding like a Consumer Proposal (or if necessary, a Bankruptcy) can put an end to year-over-year credit doldrums by settling or eliminating the debts and providing a fresh start and an opportunity to rebuild. If a debtor is already ranked at an R9, completing a Consumer Proposal, for example, will improve the debtor’s rating to an R7.

If a debtor has the financial means to make a Consumer Proposal (a formal debt settlement agreement with their creditors), this can help accelerate the path to debt freedom and the timeline to rebuild credit as well. Consumer Proposal terms include affordable zero-interest monthly payments – often amounting to less than the full balance owed.

Once the proposal is paid in full, the R7 will remain on the debtor’s credit report for only three years. Compare this to an R9 which may remain on a debtor’s credit record for up to seven years from the date of last payment.   

More than splitting hairs

Lenders sometimes don’t distinguish between an R7 and R9 rating when assessing credit risk. Both ratings indicate the debtor has struggled to manage credit in the past and required some form of relief. However, an R7 rating offers a distinct advantage given the shorter timeframe it remains on a credit report after the proposal terms are satisfied. And the sooner those negative ratings are dropped from the credit report, the sooner one can rebuild their overall credit score.

Know your options

A good credit rating can help you access life-changing loans, secure favourable interest rates, and take advantage of many opportunities in life. Having bad credit doesn’t make you a bad person. Many people often fall behind due to circumstances which are largely beyond their control. The good news is it’s not permanent, and there is help available to get a financial fresh start.

MNP Licensed Insolvency Trustees offer Free Confidential Consultations to review your financial situation and discuss your options. We can help you find the right strategy to recover from your financial setbacks and plan a better future. There are rarely any quick fixes, but there are permanent solutions. Give us a call and find yours today.