It doesn’t take much to damage a good credit score. A missed payment here, a late payment there, and before you know it, your score has dropped below 650 and into dangerous territory. And the worse your credit gets, the harder your life becomes.
Your credit score impacts every aspect of your financial life. From renting an apartment to being approved for a mortgage, from auto loans to student loans, your credit matters. Credit can even impact your insurance premiums. Plus, many employers check credit scores as part of the vetting process when hiring new employees.
While rebuilding your credit score usually takes several years for a full recovery, you can see progress almost immediately once you begin to take action to repair it. The hardest part is getting started.
A Tale of Two Credit Scores
To illustrate the financial impact of your credit score, consider two friends, Lackadaisical Lucy and Steady Eddie. Lucy has a weak credit score of 575, while Eddie has an excellent credit score of 775.
Both apply for the same vacant apartment. The landlord immediately declines Lackadaisical Lucy (after she pays the application fee to run her credit report) and offers the apartment to Steady Eddie.
Another apartment opens up next door, and after some begging, Lucy convinces the landlord to conditionally accept her — if her parents co-sign her lease. Lucy then faces a choice: sheepishly ask her parents for help or move into a shoddier apartment with lower standards.
A year later, Lucy and Eddie each want to buy a home. They can each afford around $1,500 per month for their mortgage payment, and they start talking to lenders for prequalification.
With Eddie’s strong credit, lenders quickly approve him for Fannie Mae’s HomeReady program, which requires only a 3% down payment. They quote him at half a point (a lender fee of 0.5% of the loan amount) and an interest rate of 3.4%. He plans to borrow around $335,000 to $340,000, for a monthly principal and interest payment of roughly $1,500. That puts his down payment at around $10,000 and his lender fee at around $1,700.
Lucy has a harder time of it. Most lenders take one look at Lucy’s credit score and turn her away. She finds one willing to underwrite a Federal Housing Administration (FHA) loan with an interest rate of 5.5% and a lender fee of 2 points. The lender explains that they’ll try to submit the loan for a 10% down payment — the lowest allowed by FHA loans for borrowers with credit under 580 — but that the underwriter will likely require 15% to 25% down.
Lucy eventually gets a loan for $250,000, which costs her $5,000 in lender points and a monthly payment of around $1,420. The lender requires a 20% down payment, so she has to save up $50,000 before she can buy. In other words, she borrows nearly $100,000 less than Eddie, but pays nearly as much as him in monthly payments. She also pays five times the down payment and roughly three times the lender points.
In other words: Credit matters.
How the Credit Bureaus Calculate Your Credit Score
Most credit bureaus use the FICO credit-scoring model, developed by the Fair Isaac Corporation. The FICO model uses five overall factors to generate your score:
- Payment History (35%). A large portion of your score is determined by your payment history — specifically, whether you’ve made all monthly payments on time. Your score improves with a history of consistent on-time payments.
- Balances Owed (30%). Another major part of your credit score comes from the ratio of your current balances as a percentage of your total available credit line. For example, if your credit card imposes a $10,000 limit and you currently have a $2,000 balance, that comes to a 20% balance ratio.
- Length of Credit History (15%). The longer you’ve held your accounts and the older your available credit data, the better.
- New Credit Applications (10%). The bureaus don’t like to see multiple applications for new credit at once. This is why it “dings” your credit score when you apply for credit and the creditor pulls your credit report.
- Credit Mix (10%). Credit bureaus believe that more diverse credit accounts reveal a more rounded and complete glimpse into your creditworthiness. They like to see several types of accounts, such as credit cards, installment loans like auto loans, and a mortgage.
Negative public records also drag down your score. Two of life’s most stressful occurrences, divorce and bankruptcy, can wreak havoc on your credit score. Beyond the emotional trauma, divorce often leaves debts that linger long after the legal battle ends. During a divorce, be sure your divorce decree specifically assigns legal responsibility for each debt. Close any joint accounts that are paid off and order a free copy of your credit report so you can see what debts and accounts bear your name (more on that shortly).
Nearly as stressful, bankruptcy also affects your credit score. If your score was high — say, around 750 — a bankruptcy may plunge it by 100 points or more. Your credit score suffers for as long as the bankruptcy shows on your report, although you can rebuild your credit and finances after bankruptcy with effort.
There are three types of bankruptcy:
- Chapter 11 and Chapter 7 bankruptcies, which remain on your credit report for 10 years after filing
- Chapter 13 bankruptcy, which stains your credit report for seven years after filing
All of the individual accounts you owed when you filed for bankruptcy are supposed to be removed from your report after those periods. Check your credit report and make sure your bankruptcy is removed as soon as it’s eligible to be purged.
Finally, other black marks that hurt your credit include charge-offs, collection accounts, judgments, and tax liens. If you owe someone money and don’t pay it, expect it to come back to haunt your credit report.
12 Steps to Rebuilding Your Credit
Not every one of the steps below applies to every consumer, and you don’t necessarily need to finish one step before proceeding to the next.
Start simple and take these steps as slowly and incrementally as you like. Credit scores rarely leap up overnight; it takes time, patience, and ongoing effort to gradually improve your credit.
1. Stop Taking on New Debt
Before you do anything else, stop the bleeding. Debt — particularly credit card debt — creates a vicious cycle. So take your cards out of your wallet right now, hide them somewhere safe, and delete all saved credit card data from online shopping sites so your cards stop accruing any more debt.
It sounds simple, but for most consumers, debt lies at the root of their credit problems. Break the cycle so you can focus on paying down debts and improving your overall finances.
Consider using the old-school cash envelope budgeting system to give your financial life a full reset. Paying cash for everything makes spending money far more tangible, which means you end up doing less of it.
If you absolutely must pay for something digitally, use your debit card, not a credit card, so you’re limited to only what you currently have in your checking account.
2. Commit to Paying Every Bill on Time — For the Rest of Your Life
You will never improve your credit score if you keep making late payments. It’s that simple.
Start with a commitment to yourself: “I will never make another late payment again.” Say it out loud, write it down, declare it to friends and family members, post it on social media. You don’t get any excuses, “cheat months,” or exceptions ever again.
Next, set up automated payments for all debt payments that report to the credit bureaus. That includes your mortgage, car loans, credit cards, student loans, personal loans, and sometimes even utility bills. The payments should leave your checking account each month without you having to lift a finger. Nearly all creditors allow for automated payments through your online account.
3. Check Your Credit Report
Now that you’ve stanched the worst of the bleeding, you need to check your report to establish a starting point for your credit repair journey. The three primary credit bureaus — Equifax, Experian, and Transunion — allow you to pull your credit report for free once a year, with no ding to your score. In fact, federal law mandates it.
Review every account, both open and closed, that appears on your credit report. Make sure that each appears accurate, and if you see one that seems incorrect, follow the steps to fix errors on your credit report. It’s free, surprisingly simple to do, and is the fastest way to boost your credit score.
Unfortunately, you generally don’t get to see your actual credit score when you pull your annual free report. For that, consider a credit monitoring service. You have several options for free and paid credit monitoring services. I use Credit Karma as a free option. They provide you with your Transunion and Equifax scores, updated weekly, and alert you about major changes, such as new accounts reporting on your credit or data breaches. You can also select more robust options like ScoreSense. They’ll provide you with all three credit scores as well as credit monitoring.
Pro tip: If you notice errors on your credit report, companies like Dovly can help. Built around technology, Dovly will continuously monitor your credit report to see if there is anything affecting your credit scores. If they find anything, they will work on your behalf to fix the errors. Most customers see an improvement in their credit score within six months and the average increase is over 50 points. Sign up for Dovly.
4. Pay Down Your Credit Card Balances to Below 30%
As outlined above, the second-most important factor bureaus use to calculate your score is your balances. Specifically, they like to see all your rotating credit balances representing under 30% of your credit limit.
For maximum impact on your score, bring each credit card’s balance below 30% of its total limit. For example, if a card’s limit is $10,000, pay the balance down below $3,000.
It’s for the second-fastest way to improve your score after fixing errors on your report. The more money you can put toward paying down your balances, the faster you can improve your credit score.
5. Revisit Your Budget & Reduce Your Spending
Your credit is a reflection of your financial health. By increasing your savings rate, you can funnel more money into paying down debt balances, which simultaneously improves your credit score and reduces the interest you pay on rotating credit line balances.
To maximize your savings rate, put every single expense under the microscope and create a new budget from scratch using a program like You Need A Budget. Use four weeks’ income as your monthly revenue for budgeting purposes, because that’s all you can count on receiving in any given month.
It helps to start with your target savings rate as the first “expense” in your budget, then add other expenses from there, so that you build your budget around your savings rate as your highest priority. Your savings shouldn’t be an afterthought consisting of whatever’s left over at the end of each month. It should be the core of your budget.
6. Create an Emergency Fund
Without an emergency fund, your carefully crafted budget flies right out the window after the first speed bump.
Unexpected expenses hit all the time. From surprise medical expenses to home repairs, car maintenance costs to family emergencies, expect to get hit with surprise bills every year.
Start with $1,000 in a separate savings account held solely for emergencies. CIT Bank’s Savings Builder account is one of our favorite online savings accounts. Dave Ramsey’s Baby Steps put this step before all others, and for good reason. It may not directly impact your credit, but without an emergency fund, you can’t keep your other financial commitments.
Blowing your budget at the first unexpected expense dumps you right back at square one on the credit game board.
7. Open a Secured Credit Card (If You Don’t Have Any Cards)
Different consumers face different credit challenges. Some have open credit cards and simply need to pay off the balances and establish a history of on-time payments moving forward.
Others have no opportunity to reestablish payment history. They may have lost their credit cards due to abuse or may never have had cards in the first place.
If you have bad credit or no credit, you need a credit account to demonstrate a pattern of on-time payments. Secured credit cards offer a relatively cheap and easy way to do this.
The credit card company holds your cash as collateral for your credit card. The secured credit card works like a normal credit card and reports to the bureaus normally, but the card company is protected against default — which it requires because of your uncertain credit history.
The good news is you don’t have to use these training wheels forever. Once you establish a better credit history, you can move on to a normal credit card.
Note: Be careful not to confuse secured credit cards with reloadable prepaid cards. Prepaid cards do not report to the credit bureaus.
8. Get a Co-Signer on a Credit Card
If you don’t love the idea of a secured credit card, you could ask a family member or close friend to co-sign your application for a new credit card.
On the plus side, you get a “normal” unsecured credit card. On the minus side, if you fail to make each payment on time, the late payments hurt not only your credit, but your co-signer’s as well. And if you default, the co-signer remains equally liable for your unpaid balance.
This says nothing of the embarrassment of having to ask such a large favor or the risks to your relationship.
Alternatively, you can explore the similar option of becoming an authorized user on a family member’s existing credit card. You get a card in your own name, but it’s linked to their card account. When you make a purchase, it goes on their statement and runs up their balance.
The advantage for you is that the card company reports the card account to the credit bureaus in your name as well, helping to establish your credit history.
Your family member could potentially keep your card in their possession and not even give you the card number, preventing you from running up their balance. And even if they let you physically keep it, they can keep an eye on the balance and your activity within their own account.Either way, they get better protection while helping you establish a credit history.
9. Pay All Card Balances in Full Every Month
Responsible credit card holders pay their balance in full every single month. Thus, they incur no interest costs and only see the benefits of rewards, fraud protection, and other credit card perks.
It sounds simple, and it is. But 37% of U.S. households maintain credit card debt from month to month and have an average balance of $6,506, according to CreditCards.com.
If you aren’t financially stable and responsible enough to pay each credit card balance in full every month, you shouldn’t have a credit card. Credit cards allow freedom and flexibility, but they come with responsibility. Know yourself well enough to know if you should leave your credit cards in a drawer, unused except for a single recurring charge with an automatic monthly payment you can easily pay off each month. For example, I keep one of my cards open with just my Audible membership charge hitting it every month, with a recurring payment from my checking account to pay that small balance in full.
10. Open a Credit-Builder Loan
A relatively recent addition to the world of personal finance, credit-builder loans report to the credit bureaus like normal installment loans. But instead of borrowing from a lender, you effectively lend money to yourself, held in an escrow account by the “lender” for you.
When you create an account with the lender, you choose a loan term and amount. You then agree to make regular monthly payments to the lender over that term, which the lender sets aside for you in your escrow account.
At the end of the loan term, you get your money back, minus a small fee the lender keeps for the trouble of creating your escrow account and reporting your on-time payments each month.
Some credit-builder lenders, like the ones you can get from Self, allow you to set up automated monthly payments to make it even easier to establish credit through a reliable payment history.
Pro tip: Once you sign up for a Self Savings Builder account, you will also have the opportunity to receive a Self secured credit card.
11. Pay Down All Unsecured Debts
Although credit card debt tends to cost the most in interest, and therefore is your first priority to pay off, most unsecured debts charge high interest. So if you carry student loans, personal loans, or other debts not secured by collateral such as a home or car, pay them down as quickly as possible.
Paying down these debts helps improve your credit by lowering your balance ratios and eventually leading to closed student and personal loan accounts reported as “paid in full” to the credit bureaus. It also improves your overall finances by removing high-interest debts.
It’s hard to build wealth when you’re saddled with high-interest debts. For example, it makes little sense to invest money for an expected 10% return while carrying debts costing you 15% interest.
Commit to either the debt snowball or debt avalanche methods of paying off your debts. They remain staples of personal finance because they work.
12. Avoid Unsecured Debts Moving Forward
Don’t take out personal loans. They’re expensive, and they indicate a lack of financial stability. By maximizing your savings rate, setting aside an emergency fund, and investing money each month, you put yourself in a position where personal loans become unnecessary.
Also, although student loans present a viable option for affording college, you should first explore the dozens of other options to pay for college without student loan debt. From scholarships to grants, summer jobs to passive income sources, find your own way to cobble together funding for your higher education.
It’s rarely quick or easy to rebuild your credit. It requires you to make changes to your spending habits, as well as your mindset around money. Even after you start doing everything right, it typically takes at least a year to accrue a good payment history that will have any effect on your credit score. It can take up to 10 years to remove black marks like legal judgments and bankruptcies.
But you’re not alone on this journey. If you want support in your efforts to rebuild your credit, contact your local Consumer Credit Counseling Service office. This nonprofit organization provides free or low-cost assistance to those in need.
The effort will pay off. When it comes time to apply for your next apartment or take out a secured loan, such as a mortgage or auto loan, you’ll be able qualify for a low interest rate, low or no fees, and a small down payment.
Are you currently working to rebuild your credit? What strategies are you using? What do you plan to do to speed up the process moving forward?