Repairing your credit isn’t easy and it isn’t fun, I should know. But, it’s possible to do if you have the patience and will to get it done.

Why Bother?

I’ve had a number of clients over the years who’ve asked me that question. Why should they bother to clean up their credit, what good is it to them? Well, most of us understand that our credit is what determines whether or not we can get various loans, and then what interest rate we’re offered for it.

At some point in our lives, most of us have had the need for a home loan, car loan, or general purpose loan. With bad credit, you’ll be hard pressed to be approved for these types of loans and if you are approved, you’ll have higher interest rates, which equates to more money out of your pocket. A 9% rate on a $150,000 mortgage is a lot of money. It’s much different than paying 9% on a $15,000 car loan. If you want good rates that will save you money and allow you to spend it on other things, rebuilding your credit is a great way to start.

Every once in a while I’ll get someone who doesn’t think this explanation suffices. They say they don’t need a car loan or a house loan; they can just rent and keep their old car. Ok, fine. Let’s take a look at that scenario then. Almost every apartment complex, utility office, and insurance company checks your credit before signing you up.

Your credit report reflects your payment history and all of these vendors want to know that you’ll pay them. If you’ve ever applied for an apartment and were told that you need a deposit including first and last month’s rent, that’s because you have no credit or bad credit. If your electric company wants a $200 deposit before they connect you, that’s because you have no credit or bad credit. If you want to be able to get electricity turned on in your place – be it a house or an apartment – and not have to pay through the nose to do it, you need to repair your credit.

What if you live with friends and everything is in their name? Do you still need to worry about your credit? Well sure. What about your car insurance? If you have bad credit, your premiums could be higher or you could be flat out refused for coverage. You see, you’re a risk and no one likes a risk, especially in today’s market. There is very little in this life that doesn’t depend on our credit rating anymore.

I drag this out to illustrate a point. There aren’t many scenarios in which it would be appropriate for someone not to be concerned about their credit score. I know there are plenty of people who aren’t the least bit concerned about it; however, they should be.

Bottom line: Having bad credit costs you more money.

What is bad credit?

As strange as this may sound, many people don’t know the difference between bad credit and good credit. If that’s the case for you, not to worry, you aren’t alone in that respect. Before we talk about fixing your credit, though, let’s talk about what bad credit is and where it comes from.

First of all, it’s important to know who determines your credit score and how they determine it. Your individual score is based on the formula from the Fair Isaac’s Company. This company works independently from the three credit bureaus and uses their unique formula to assign your credit report a number based on your history.

The credit score was invented as a short-hand method for banks and lenders to assess a borrower’s creditworthiness. Going through a credit report is time consuming for lenders and so Fair Isaac’s created what is commonly called the FICO score. This score is comprised of various factors from your credit report and then computed to produce a number between 300 and 850.

The lowest possible credit score is technically 0, this means you don’t have any credit at all. However, once you start amassing credit, your score will jump up and fall between 300 and 850. This is simply a range that Fair Isaac’s developed for the purposes of providing lenders with a “snapshot” of your financial picture. The higher your number, the more creditworthy you are considered.

Given this information, what then is considered bad credit? Numerically speaking, the magic number that most lenders are looking for is 620. Anything below that and you’re extremely lucky to get credit at all. If you do, then you’re looking at pretty high rates. From 620-680 is considered good credit, and the average American credit score runs at about 680. Anything over 680 and you’re moving into very good and excellent credit.

One thing you have to realize when looking to repair your credit is that it is very difficult to achieve a perfect credit score, in fact, only 1% of the population has done so. However, someone with a 720 credit score is going to get as good a deal as someone with an 820 credit score, despite the 100 point difference. This is because lenders typically tier their rates based on score groups. So someone with a 720+ credit score is one group. The next group may be 680-719, the one below that may be 620-679, and so on. The tiers will vary per banking institution and lender; however, the point is that a perfect score is not necessary to get the very best rates on the market. The rate will be determined based on the score group you fall into.

So now that we’ve talked about the range and what constitutes bad credit, let’s talk a little about how that score is determined. Unfortunately, the exact formula that FICO uses is not known to anyone besides themselves. There is also going to be some changes made this year to the formula, so what’s listed here could change, depending on what FICO determines with the new scoring model.

However, we do have a fair idea of what goes into the scoring model as it currently stands. As such, the breakdown is as follows:

35% – Payment history
30% – Amounts owed
15% – Length of credit history
10% – New credit
10% – Types of credit used

So, you can tell from just a glance that the biggest factor in determining your credit score is payment history. That is why you will hear people say that paying your bills on time will have such a big impact on your score. It may seem like such a simple thing, but the fact is, people lend you money with the expectation that you will repay it on time, as per the terms agreed upon. It makes perfect sense, then, that this should also be the largest factor in your credit score. Remember, the credit score is merely a “snapshot” of your credit report.

The next largest item is amounts owed. No one wants to lend to someone who is maxed out on all of their credit cards because the message that sends the lender is that you can’t handle anymore credit. This is also why you’ll hear people say to keep low balances on your credit cards. Anything too close to the credit limit will affect your score, and by extension, your ability to get new credit.

Obviously, the length of time you’ve been in the credit bureau will affect your score, and this is also why only 1% of the population has reached 850. To get up to 850, you have to be in the credit bureau for at least 30 years. But, the point of a credit report is to show your history and lenders like to see a solid block of positive repayment history.

New credit and types of credit are each at 10%, meaning they play a role in your score, but are not nearly as important as the others. While they aren’t as important as the other factors, you still want to watch the number of new accounts you open and keep a fair balance between revolving lines and installment loans. Just to clarify, revolving lines are usually credit cards. They refer to lines of credit that can be used again and again as the balances are paid down. Installment loans refer to standard loans with a fixed rate and a fixed term. Repayment over that term will result in the loan being paid in full and closed.

How to Repair Your Credit

Now that we know why it’s important to repair our credit reports and what is considered a bad score, let’s look at how we would go about repairing it.

Step 1: Get a copy of your credit report

In order to know where you stand, you’ll need to get a copy of your credit report. Normally I advocate getting one copy from one of the three credit bureaus every four months, that way you have a steady idea of where you stand throughout the year. However, in this situation, I believe it is important to have the full picture sitting in front of you. As each of the three credit bureaus is a little different in the information they list, you may have things showing up on one that’s not on another. You’ll want to know.

You are entitled to one free copy from each of the credit bureaus every year. If you have not already pulled a copy for the year, then your request should be free. However, the credit reports themselves do not include the score. If you want the score, you’ll need to pay for that separately.

Keep an eye out here because we’ll be posting a guide on how to read your credit report, step by step. You’ll get to see just what a lender looks at when they make decisions, and hopefully, you’ll have a better understanding of the things you need to be looking for. In the meantime, if you need help with looking over your credit report, visit your personal banker at your local bank or credit union, or your personal financial advisor with your brokerage firm. Either should be able to help you, or at the very least, direct you to an expert.

Step 2: Check for errors

Once you’ve got your report(s) sitting in front of you, the first thing you want to do is make sure that the information listed is correct.

- Double check the name and social security number.

It is not uncommon for Jrs., II, and III to get mixed up so make sure you’ve got your report and not your father’s or brother’s.

- Be sure the address and employer are current.

Lenders like to see consistency and they like accurate information. Making sure you have the most up-to-date information listed on the report reflects well on you.

- Go through your accounts and check for mistakes.

If there are any accounts that do not belong to you, show open when they should be closed, were closed by you but do not say “closed by customer,” show late payments when there were not any, or list bankruptcies not identified by their chapter, be sure to inform the credit bureau immediately.

Each credit bureau has a dispute form online that you can fill out, or you can hand write (or type) a letter to them. This secondary method is actually preferred because you are able to include supporting documentation for your claims. If you have supporting documents, send them in.

The credit bureau has 30 days to investigate the claim and get back with you on a decision. If you disagree with the credit bureaus decision, you have the right to send an explanation to be attached to your credit report so that lenders and others pulling your credit can view it. The credit bureau must attach it to your file.

Here’s an example of a good dispute letter:

Date
Your Name
Your Address
Your City, State, Zip Code

Complaint Department
Name of Credit Bureau
Address
City, State, Zip Code

Dear Sir or Madam/To Whom It May Concern:

I am writing to dispute the following information in my file. The items I dispute also are encircled on the attached copy of the report I received.

This item (identify item(s) disputed by name of source, such as creditors or tax court, and identify type of item, such as credit account, judgment, etc.) is (inaccurate or incomplete) because (describe what is inaccurate or incomplete and why). I am requesting that the item be deleted (or request another specific change) to correct the information.
Enclosed are copies of (use this sentence if applicable and describe any enclosed documentation, such as payment records, court documents) supporting my position. Please reinvestigate this (these) matter(s) and (delete or correct) the disputed item(s) as soon as possible.

Sincerely,

Your name

Enclosures: (List what you are enclosing)

You can find this same letter at myFico.com under their samples. I use this letter as an example because it works. It’s the same letter I sent to the credit bureaus when I had charges to dispute and it covers everything that the credit bureau needs in order to get the dispute processed. You merely have to fill in the blanks.

Step 3: Work on cleaning up the credit report

If you had some errors on your report and you’ve gotten them fixed, you may have noticed an increase in your credit score. Congratulations. That’s the easy part. Now comes the tough part. First off, understand that while it is easy for your credit score to drop, it’s much more difficult to raise it. This is mostly because it takes time to build a good credit history.

First of all, it is important to understand that any derogatory accounts or collections listed will remain on your credit report for seven years – unless they are removed beforehand for whatever reason. After the seven years, if the item isn’t paid, the collection agency can put it back on and the seven years starts all over again. This does happen, so just be aware. If you’re a few years away from seven years and thinking you can dodge paying someone, think again. It can come back to haunt you.

Now, there is a little silver lining in this news. A collection or derogatory account only affects your credit score for five years. So, even though it’s still on your report, your score won’t be impacted by it anymore. However, lenders still look at the whole report. And just because that collection isn’t factored into your score doesn’t mean we don’t consider the possibility that you won’t repay us.

While a good score is important, it’s not the end all of the lending process. I’ve had customers apply for loans with a 700 credit score that we’ve had to deny because of past history, public judgments, and various other derogatory accounts on a report. Typically, the score you carry – assuming all other factors are in accordance with an approval – will determine the interest rate you would qualify for. It’s not a determining factor on its own. The point of this guide is to help you clean up your credit report, not just improve your score, though by extension, improving the one does help improve the other.

Ok, moving into how you can clean up your credit report.

Payment History Tips

As your payment history accounts for 35% of your overall credit score, this is the largest area to focus on. Here are some tips to help you get there.

- Make a budget.

Bet you didn’t see that coming! Seriously, you need to get to a point where payments can be made without struggle and be on time. In order to do that, you need to know precisely what’s coming in and what’s going out. If you’ve been avoiding the ‘b’ word for some time now, you’ll want to get acquainted.

- Make your payments on time – every month.

Now that you’ve got a budget all worked out, you’ll want to make your payments on time from here on out. This will help you build a positive repayment history that looks solid to lenders.

- If you’re behind on anything, catch up and stay there.

If you have bills that are past due, call your lenders and make arrangements. The worse thing you can do is ignore them, so be proactive and call them first. Once you’ve gotten yourself caught up, stay there. Remember, you need positive repayment history over a period of time in order to improve your credit report.

Amounts Owed Tips

The next largest item that’s factored into your score is the amount of money that you owe other people. It accounts for 30% of your overall score and is the area that most closely affects your debt-to-income ratio – a number that if too high, even an 800 credit score can be turned down for.

- If you still have credit cards, keep the balances low.

The ideal balance-to-limit ratio is 40% if you’re carrying a balance. This shows that you are capable of using the card responsibly and makes lenders more comfortable giving you money. When you have high outstanding debt, it negatively impacts your score and lenders are not likely to add to that debt.

- Pay off your debt when you can rather than moving it around.

Sometimes it is tempting to take advantage of low rate offers and move large balances to lower rate cards; however, you still have the same amount of debt – which was the problem in the first place. If you want to improve your score, pay down the debt.

- If you have no credit cards and can’t get approved for one, try a secured credit card.

This is actually preferable to getting a card with a high interest rate, annual fee, and monthly maintenance fees. Those “credit repair” credit cards often come with a lot of risk of their own. Stick with a secured card, make your payments on time, and establish a history of solid repayment.

Length of Credit History and New Credit Tips

- Don’t close out unused credit cards and limit the number of new ones opened within a short period of time.

Cancelling a credit card closes out the history on that card. So, if you had a credit card for seven years and decided to close it, those seven years of history are now gone. Because longevity is the name of the game when it comes to credit scores, yours just plummeted. Likewise, opening too much new credit has a similar affect. You have not established history, so your score is lower. Having a whole bunch of new credit and then requesting more is also a red flag to lenders.

- Manage any new accounts that you open responsibly.

You’re really going to have to stick to your budget with this. Adding new credit to the mix can sometimes feel like there’s extra money and that’s the mentality that got you in debt in the first place – for most people, anyway. If you can’t be responsible with a new account, or you feel it would be too much temptation, then you may want to forego it for awhile.

Types of Credit Used Tip

- You want a balance between revolving lines of a credit and fixed loans.

This gives your credit report a nice mix and shows lenders how you manage different types of debt.

Cleaning up your credit report isn’t going to happen overnight, so don’t expect it to. Typically, it takes about two years to rebuild a decent credit history where you’ll be approved for credit cards and loans at decent rates. Some experts recommend that when looking to get a mortgage, you should wait four years from when you started cleaning up your credit report in order to get the best rate.

There are some great tools out there to help while you’re trying to rebuild your credit, but my personal favorite is MyFico. There is a lot of helpful information and credit education that can be found on the site, but what I like best is that it provides a tool to help you gauge how your actions will help or hinder your score. You can find more information about it at www.myfico.com.

If after reading this guide, you feel like you need more help, you may want to consider a credit counseling service. There’s nothing wrong with seeking help to turn your financial life around; however, you will want to be careful. There are many companies out there who would seek to take advantage of your situation and claim they can get derogatory accounts removed from your report. Very often, the means they use to do so are illegal and unethical and can often come back to haunt you later on. It’s best to stick with reputable companies. For more information on credit counseling, be sure to visit the National Foundation for Credit Counseling or Association of Independent Consumer Credit Counseling Agencies. These companies specialize in helping consumers repair their credit reports the legal way, and can teach those in need better money management skills.

I hope you’ve found this guide helpful and best of luck as you set out to repair your credit! Let us know if you have any questions.

Photo by telstar

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