One financial toll of hard times is damaged credit. When many people are struggling to stay safe and put food on the table, things like bills can come in second place. For those who are looking toward what appears to be the light of the end, it may be time to consider rebuilding credit from whatever damage has been done.
Good credit takes a bit of time to build. Great credit takes longer. Any credit, however, can be damaged quickly. Rebuilding is always possible. There is no credit situation that can never be recovered. Most credit situations can show improvement relatively quickly. It is the most current information in your credit file that has the greatest impact.
When we look at credit scores, we need to understand what they are. A credit score is a numeric representation of your creditworthiness, based on the information contained in your credit history. Lenders use this score to help them make decisions of whether to extend you additional credit or at what interest rate they might extend you additional credit.
For the most part, your credit score has no affect on your day-to-day life. A poor score can do some things behind the scenes. It may, in many states, cause your auto insurance rates to increase. But most of what you see is only when you go to obtain new credit. That’s when it makes the big difference.
Small improvements matter. We tend to think in terms of moving up by the hundreds. But that’s not always where the difference is. Sometimes the difference is crossing a lower threshold.
Many auto lenders consider scores below 625 subprime. Below that cutoff they won’t consider you or they’ll put you in an extremely high rate bucket. Moving from a score of 610 to 630 — a pretty small increase — can make a dramatic difference both in your ability to obtain an auto loan and the rate that you’ll pay. Small differences can make a big difference.
Start with a fresh copy of your credit report from annualcreditreport.com. That’s the site the government requires the three major bureaus maintain to provide you with your free reports. You can rebuild your credit in line with how your score is determined.
Step One: Rebuilding Positive Credit History
Your payment history is the largest single component of your credit score. And it tends to be one of the first to go when things get tough.
You need to pay all your open credit on time every time to rebuild your payment history.
One hundred percent on time every time. It’s okay if you have to make only minimum payments, that’s better than being late.
If you are unable to make at least minimum payments on all your accounts, you should contact lenders to see if you can work out terms. But you need to be making consistent at-least-minimum payments to build positive history.
Step Two: Reduce Utilization
Credit utilization is the second biggest factor in determining your credit score. Utilization is the ratio between the credit you are using and what you have available. For installment credit, it is the ratio of your current balance to your original balance. There’s a common misconception that this applies only to credit cards. That’s just not true.
Revolving credit, such as credit cards, are the accounts where it is easier to make a utilization difference. Utilization, much like payment history, is one of the first things that gets damaged when people go through tough financial times. They charge things and run up balances. Sometimes they don’t have a better alternative.
When it comes to utilization, you want to bring down your total balances in relation to your available credit or original loan amount, as applicable.
It makes sense to focus on revolving credit, as that’s the easier way to make a big impact. This also needs to be done account by account, not just in aggregate.
To clarify, your total credit used compared to credit lines matters, both in aggregate and for individual accounts. You need to not only bring down the total, but also to focus on bringing down those with the highest percent utilization.
Also bring small accounts to zero. The number of accounts with balances compared to the total number of accounts also matters. If you can pay off a few small-balance accounts, that should help your score.
These first two steps are the biggest factors in determining credit and the easiest ways to make an impact through improvement. The next three steps are longer term, but also need to be considered to make sure you don’t ding your credit at the wrong time.
Step Three: Consider History
Your length of history is the third determinant of your credit score. Length of history considers the age of your oldest account, your newest account, and the average age of your accounts.
Opening or closing accounts can hurt you when you will be applying for credit soon. You don’t want to close an old account or open a couple new ones a month or two before you’re going to apply for a mortgage or auto loan.
This issue is often misunderstood. Yes, you want to have long-term accounts and not a lot of new ones. But, most important, you want quality accounts.
Let’s say you have a credit card that has both a high interest rate and an annual fee. You hate this card, but keep it because it’s your oldest. And you pay a fee to do so. No, no, no.
How History Should Factor Into Rebuilding Credit
You can and should get rid of accounts that aren’t good accounts or aren’t good for you. But don’t do it this month if you’re getting a car next month. Wait until you don’t think you’ll be getting a car or house for a little while, then cancel the undesirable card.
In the long run, your score will be fine. Focus on only taking on accounts you plan on keeping. Don’t apply for accounts that you don’t want. Then this won’t be a problem. But you will find that you periodically find an account you want to ditch and that’s ok to do. Just consider your timing carefully.
Step Four: Consider Credit Mix
Credit mix is the number of types of accounts you have. It is one of the last two of the factors in determining your score. It is a lesser factor, but if you want great credit it bears consideration.
You can build good credit with only revolving credit, but to get great credit, you need to broaden the mix.
Installment loans, both auto and personal loans, will broaden the mix for most people starting out. Ultimately, you will want real estate debt as well. Sometimes the opportunity to add installment debt is right in front of you.
You might have run up a card during some tough times, but not damaged your credit. Or maybe you ran up a card with a big vacation or something. You might take an installment loan to pay off that card, paying the installment loan over the next 12 or 18 months.
Bingo, credit card debt gone, credit mix expanded. Don’t do that again! Next time, build your savings first. But once you have trouble, don’t be afraid to use it to your advantage.
Step Five: New Credit
New credit has the same weighting as credit mix. It is a determinant of your credit score because people who add a bit of new credit at once are more likely to have credit problems. It is an indicator of possible future trouble — unless you use credit wisely.
If you use credit, you will have periodic new accounts. But you won’t have many new accounts, and never a few at the same time.
This is also a misunderstood topic. It isn’t just new accounts, it’s inquiries for credit. And not every inquiry counts. If you check your credit or score, it doesn’t impact your score. The inquiries you want to be careful of are the inquires you initiate for the purpose of obtaining credit.
Inquiries stay on your credit report for two years. They are a factor in your score for only 12 months. And some groups of inquiries are treated as a single inquiry.
The scoring companies expect that you will shop for the best rates or the best deal in some situations. They don’t ding you for this. Not intentionally. They expect you will shop for mortgages, auto loans, and school loans. They give you a window where all inquiries for one of those specific purposes is treated as a single inquiry. It would be nice to know exactly what that window is, but there are variables.
Most of the older or well-established models use a window of two weeks. For example, if you were shopping for a car, all inquires made within a two-week period would be considered as a single inquiry in determining your score. Newer models may give you up to 45 days.
The problem is that both newer models don’t replace the older models; both remain in use. If you group any inquires for one of these three purposes within a two-week timeframe, you can be confident they’ll be treated as a single inquiry.
The Bottom Line on Rebuilding Credit
It's possible to rebuild credit out of any situation. Most adverse credit history remains on your credit report for seven years. But it has diminishing impact; adverse history five or six years ago is far less damaging to your score than adverse history last month.
Even bankruptcy, which stays on your report for 10 years, has minimal negative impact a few years out if you build positive history after the negative event.
You can do other things to help the situation along. If your credit is very bad, you might need to start with a secured credit card or become a cosigner on someone else’s account. Either of these can help you rebuild your credit.
The climb up may be a little slower than the fall, but the key is to just make steady progress. If you make thoughtful credit decisions and make all of your payments on time, your score will reflect your good credit behavior across time. That’s what scores do.