The Definitive Credit Rebuilding Guide
Bad credit is no longer a financial death sentence. Between reading credit reports, credit-building micro-loans, secured credit cards, concierge credit-monitoring services, and more you’ve got all the tools you need to beat the credit companies at their own game.
What is a credit score, anyway?
Sometimes your credit score can feel bit abstract. You know you want your credit score to be good, and certain things can ruin it, but it’s easy to you feel like it’s something beyond your control. While there indeed are external factors that can make it harder for some people to have good credit, virtually everyone is capable of improving their credit by taking a few concrete actions over a long period.
Credit scores are used to measure your trustworthiness as a borrower. By far the most common type of credit score used in the US is the FICO credit score. Created in 1989 by Fair, Isaac, and Company (FICO), the FICO credit score uses a formula based on statistical correlations to determine the risk that a borrower will default on a loan. It expresses that risk as a number between 300 and 850 (the higher the number, the lower the risk). The FICO credit score is designed to be more objective; since it is calculated with a formula the same information will get the same credit score regardless of the lender’s biases.
Lenders each decide on what ranges fit into what classification, but they are generally within 20 points of one another, for each category. A typical classification would consider any score below 630 (FICO scores start at 300) to be “bad credit,” “fair credit” if it’s between 630 and 689, “good credit” if it’s between 690 and 719, and “excellent credit” if it’s 720 or better. The average credit score in 2011 was 711.
The exact formula FICO uses to determine your credit score is not available to the public, but they have made public the major factors. These factors are your payment history (worth 35% of your score), your debt burden (30%), the age of your credit accounts (15%), your mix of credit types (10%) and your recent credit application history.
Personal Credit vs. Business Credit
There are two kinds of credit scores, a personal credit score, and a business credit score. A personal credit score looks at your history with personal loans, lines of credit and credit cards. This is the what’s most commonly meant when someone references your credit score. A business credit score looks at your business’ history with financing. Personal credit scores are measured from 300 to 850. Business credit scores are measured from 0 to 100.
While building up good credit is essential for your business, your first business loan is based largely off of your personal credit score.
Why is Your Credit Score Important?
First and foremost, your credit score is important because it plays a role in various degrees to almost every sort of loan. Many loans which do not consider credit scores are predatory in nature. Even the fairest loans which do not ask for credit checks require collateral or charge high rates because lenders need something to counterbalance the added risk of untrustworthy borrowers.
For many people, the most important loan they will ever need is their first home loan, so we’ll use it as an example. If you’re looking to get a conventional home loan, you typically need a credit rating of 720 or better. VA loans, which are only given to veterans, are more lenient because of their government backing, but they still ask for a credit score of at least 620. FHA loans are the easiest to qualify for, but even in the most borrower-friendly economy, FHA loans are rarely given to borrowers with credit scores below 500. The size of the down payment for home loans is also related to the credit score of the borrower (with the exception of VA loans). For conventional loans, the down payment is decided on a case by case basis. For FHA loans there is a hard line between borrowers with credit scores of 580 or better, who pay 3.5% down, and those with credit scores below 500, who pay 10% down. Additionally, if you do qualify, your credit score will affect the rates that lenders will offer you and the size of the loan you qualify for.
While businesses have their own credit score, lenders will usually take the personal credit score of the business’ owners into account as well when looking over a loan application. Personal credit is an especially large factor for a business’ first loan because the business will not have established much credit. So, having a good personal credit score is important if you ever plan on starting a business.
Credit scores have an essential role if you’re trying to receive financing, but they also affect your life in some other surprising ways. Insurance companies often charge more to clients with bad credit scores. Employers often check the credit score of prospective employees before hiring them (even though studies have shown that there is no correlation between scores and job performance). Poor credit can even make it more difficult to find a home to rent.
It’s important to start improving your credit now, even if none of these reasons seem to apply in your near future. Improving your credit is never impossible, but one thing it almost always takes is a lot of time, and you never know when your plans might change.
While building credit is something a person can do by themselves, credit counseling can make it easier for you to get your credit back on track quicker. A credit counselor can review your finances, help you with budgeting skills, and help you consolidate your debt. Credit counselors tend to be more focused on helping you to reduce your debt than directly helping you to improve your credit rating. However, if you have a significant amount of debt, reducing that debt will be an essential step towards improving your credit.
Selecting a credit counselor is an important process. Make sure your counselor has your best interests in mind, as many are more invested in profiting off of a vulnerable population than helping people manage their debt. Be wary of any for-profit credit counseling service, but also be careful with non-profit services, as the non-profit label does not necessarily prevent counselors to direct you towards high-cost services. With any credit counseling agency, you should do a little research before committing to them. We recommend starting by getting the Better Business Bureau’s rating of the agencies you’re considering.
Most non-profit credit counseling agencies are legitimate, but it’s worthwhile to be cautious and keep an eye out for red flags. Before agreeing to work with an agency, ask for some detailed information about what they do. If they try to charge for that information, it is probably best to avoid working with that agency. A credit counselor should look over all of your finances and lead you through your options before recommending a debt consolidation and repayment plan. While debt consolidation is often the best choice to get out of debt, if a credit counselor doesn’t seem interested in exploring other options, then its a sign that they might be more interested in collecting fees than helping you find the best option for your situation.
When you do find an agency, they will assign a counselor to you, but after you meet your counselor you can request another. Having professional and insightful advice is the most important quality in a counselor, but you have to remember that fixing your finances is a lengthy and often personal matter, so finding someone who you feel comfortable with is key.
If you and your counselor decide to consolidate your debt, remember to be realistic about what you can pay. Debt consolidation has a very high failure rate, due primarily to people underestimating the budget that they need to get by or the number of unexpected expenses that will arise. Failing to repay a consolidated debt repayment plan is costly and can lower your credit score even further. It is better to repay your debts over a slightly longer period than to risk failure.
Credit Consultation for Veterans
One service that offers many of the benefits of credit counseling without the fees is the Lighthouse Program. This program is only available to veterans, service members, and their families, who don’t prequalify for a VA loan (credit score under 620). Your consultant will review your finances (debt, income, assets, credit history, etc.), and help you correct any errors in your credit report, and come up with a plan to improve your credit score and your financial position more generally. For veterans that are looking for a home but are struggling with bad credit, this program might be a perfect choice.
Credit Counseling vs. Rebuilding Your Own Credit
While credit counseling helps a lot of people get their finances in check, there are some drawbacks, so it is not necessarily the right choice for you. While many credit counseling agencies are non-profit, it is important to remember that even a non-profit with the purest of intentions has expenses. While a lot of services are provided for free, and many non-profits will waive fees to those who really can’t afford them, most credit counseling agencies will charge fees at some point in the process. If you have a complicated financial situation, then the savings of having a good debt repayment plan can easily outweigh the fees. However, if your finances are simple enough to plan a way out of debt on your own, then the fees could make the process longer. A rule of thumb is that using a credit counselor is only worthwhile if you have more than $5,000 of outstanding debt.
Since credit counselors tend to be more focused on reducing your debts than improving your credit scores some of their recommendations can (at least in the short term) bring down your credit score. Consolidating your debt is one such case. By transferring all of your debt into a single loan, it makes it quicker to pay off, but it can also lower your credit ceiling. With a lower credit ceiling you will have a higher credit utilization (the % of your available credit being used), which reduces your score. Sometimes consolidating this debt and taking a temporary hit on your credit rating is necessary to get back to square one and rebuild your credit effectively, but if your debt burden isn’t too high keeping your sources of debt separate may be the best route to building good credit.
Rebuilding Your Own Credit
If you decide to rebuild your credit score without the help of a counselor, you must make sure your plan is realistic and you must stick to it. While making your plan it’s important to remember the five major factors to you FICO credit score (payment history, debt burden, the age of accounts, mix of credit types, and recent credit application history). These factors should be prioritized by the importance FICO gives them, and by the ease of which you can improve them. For example, you should never miss a minimum payment because you budgeted too much into paying down a debt that is near its ceiling. When planning patience is key, rebuilding credit can take years, and it is better to have a safe plan which takes a little longer, than one which stretches your budget and may lead you to miss a payment or another major setback.
Getting your credit checked
In order to improve your credit, first you need to know where your credit stands. Fortunately, by US law, you are entitled to one free copy of your credit report a year from each of the three major credit bureaus(Equifax, Experian, TransUnion). You can request a report directly from the individual bureaus or use AnnualCreditReport to apply to all three. Your report will include your current credit score, as well as a history of all the events which contribute to your credit score (positively or negatively). If you’ve used your annual free credit report, but want a new report to check on your progress, you can pay for a report, and it is not prohibitively expensive.
Your FICO credit score is decided by a standardized algorithm, so the different bureaus should give you the same score if they have the same information. However, the bureaus do not share information with each other, so sometimes there are discrepancies. We recommend getting all three reports initially, to check if there are any discrepancies (and correct them). Once you’re fairly certain the three bureaus have the same information; then you can order them separately to get more frequent updates on the state of your credit.
Once you have your reports, you should read through them carefully. It’s best to color code
the information with a different color for:
- Incorrect information (payments that are incorrectly labeled late, accounts which don’t belong to you, etc.)
- Past due loans
- Accounts that are over their credit limit
Also take note of any discrepancies between the three reports, any positive credit information that’s missing from the reports (successfully repaid loans, etc.) and the dates of the incidents which negatively affect your credit score. All of this information will be essential when you’re making your plan to restore your credit.
Disputing Credit Report Errors
Improving your credit almost always takes a lot of time. Past mistakes stay on record for a long time (more on that below), and debts take time to pay down. However, occasionally a good portion of someone’s poor credit will be a result of a clerical error. If this applies to you, your credit can be improved within a matter of weeks if you have a successful dispute. Disputes can be made online, over the phone, or by mail. If you make you dispute online, make sure you take screenshots throughout the process to have proof of your dispute. For the same reason, disputes sent in by mail should be done by registered mail, and making your dispute over the phone should be avoided. Send a copy of your credit report with the error clearly indicated, as well as a copy of whatever proof you have that it is an error, and never send the original.
If your claim is successful, then your information will be updated, and you will receive a new credit report. While it’s easy and important to correct any errors in your report, and an improvement in your credit score is likely, it’s extremely rare for a credit score to go from poor to good just by the correction of errors.
Changing Your Habits
To succeed in rebuilding your personal credit, you need to examine the financial habits that brought you here in the first place. Poor credit is usually caused by perpetually spending more than you make. Reducing your debt can only be done by increasing your income or decreasing your debt, but for many people, an increase in your income means an increase in your spending. The best way to improve your spending habits is to create a detailed and realistic budget for your monthly expenses, and then (the hard part) stick to your budget. Make sure your budget includes contingency funds for unexpected expenses.
While something as simple as a spreadsheet can work, there are several apps which can help you develop and track your a more detailed budget. These apps include Mint, PocketGaurd, and Wally. Pick the app that feels most natural to use, as the key to budgeting is consistency.
Settling Past-Due Debt
Now that you have your spending under control, you should factor making debt payments into your budget. In order to improve your credit score most efficiently, you need to prioritize your debts. The most important factor to your FICO credit score is your payment history, worth 35% of your total score. While you cannot change history, you can prevent it from repeating itself, so your priority should always be making your monthly payments on all of your debt. If you continuously make your payments on time, your credit score will eventually improve, albeit fairly slowly.
Your next priority should be catching up on any outstanding late payments. While it is most important not to be late on new payments, the negative impact of a late payment will not be forgiven until some time after the payment is caught up. The quicker you’re able to catch up on your payments, the better. If you have enough savings to catch up on your payments right away it may be worthwhile using them. If you don’t have the funds immediately available, you can contact the lenders you’re behind on and make a payment plan for them. When making this plan, the goal should be paying down the past due debt as quickly as you can without risking ever missing a minimum payment.
Once all of your accounts are current (meaning that there are no late payments on any of your sources of debt), then all you can do to improve the payment history aspect of your credit score is continue to make your minimum debt payments and wait for your previous transgressions to be forgiven.
Timeline for Forgiveness
Something that is always stressed when people talk about rebuilding credit is that it takes a long time. Exactly how long depends on how quickly you can repay your debts, but one thing that’s constant is the amount of time for events which negatively affect your credit to be forgiven. Most of these events, like repossessions and foreclosures, are forgiven after seven years. These years are measured from the point that the debt had been repaid, for example, late payments are forgiven seven after the late payment was made, not seven years after the original payment was due. Bankruptcies are forgiven after ten years from the filing date unless the bankruptcy is a chapter 13, then it only takes seven.
Bring Down Total Debt
The next most important aspect of your FICO score is your debt burden, sometimes referred to as your credit utilization, and it is worth 30% of your total score. Your debt burden is the percentage of your total credit that is currently debt. Whenever you make a payment on a credit card or a line of credit, you increase your available credit; whenever you withdraw from your line of credit or use your credit card you decrease your available credit.
There is a logic to paying the highest interest debt first down first, as it reduces future payments most and therefore frees up cash to pay down your other debts quick. However, your debt burden gives more weight to accounts which are closer to their maximum limit. The best strategy for improving your credit score is often a balance of paying down the highest interest debt and the debt that is closest to its limit. It is important to remember that having open accounts helps keep your credit limit up and helps give add age to your credit. So while completely paying off a loan, or consolidating your debt to speed up the repayment process may have its benefits, they may also lower your credit score.
Establishing New Credit
While the biggest part of improving your personal credit score is setting right some of the mishandling of credit done in the past, adding new credit can also play a significant role. Most forms of conventional financing can play a role in improving your credit score. Ideally, you would use as many different types as you can, as a full 10% of your FICO credit score is based on the mix of your sources of credit. However, since you are trying to rebuild your credit score, your credit rating is likely too low for a lot of forms of credit. If that the case the best place to start is by getting a credit card.
While there are many different choices of credit cards which offer different rewards, the most important choice with regards to building your credit rating is whether you get a secured or unsecured credit card. A credit card is secured when the borrower makes a cash deposit before getting the card; this deposit is usually equal to the limit on the card. This provides a lot of security for the lender since the most the borrower can owe on the card can be paid for by the deposit, if the borrower defaults. The need for a deposit removes some of the normal benefits of an unsecured credit card, like increased financial flexibility, but by having a secured credit and making your payments on it, you are creating good credit history and improving your score. The main function of a secured credit card is to show that you can be a responsible credit card user.
Unsecured credit cards do no require a down payment. Since there is no down payment, they are a higher risk for lenders and so most lenders ask for a minimum credit score of at least 600. While providing you with added financial flexibility, unsecured credit cards actually help build your credit score faster than secured credit cards. Generally, if you can qualify for an unsecured credit card, it makes more sense to get it instead of a secured credit card. If your credit is too low for an unsecured credit card, then get a secured credit card and think of it as a stepping stone towards an unsecured card.
While applying for credit cards (or any other type of financing for that matter) remember to limit your applications to one or two carefully selected options that you are at least fairly likely to be approved for. This is because FICO tracks your credit inquiries and if you send out a lot of applications in a short time, it hurts your credit score.
As you establish a track record of good credit with your credit card, your credit score will start to improve. With an improved credit score, you can accelerate the process by getting more financing. To maximize the benefits, you should vary the sorts of financing you use. Be sure to include some revolving credit (accounts that can be drawn from and paid down as needed like a line of credit) and some traditional loans (like a student loan or mortgage). As you get more loans, you can gradually increase the limits of the loans until you have reached the point where your credit is strong enough that you can meet all of your financial needs.
If you are at the stage of rebuilding your credit that you are looking to get new loans, or if you simply have questions about the rebuilding process, please use the chat box in the bottom right corner to get in touch with an expert.