As we emerge from the financial downturn, there’s one thing that I know a lot of us would love to unload: bad credit. Roughly 50% of all US consumers were considered to have “bad” credit (i.e. a FICO score below 620) at the height of the recession, and even more important than this dubious classification are the far-reaching financial implications that come with it.
Our credit scores affect any number of things, including the loan and credit card rates we can get approved for, our ability to lease a car or rent an apartment, insurance premiums, and even the jobs we can land. It’s therefore not an exaggeration to say that the difference between below- and above-average credit could end up being well into four, five, or even six figures when all is said and done.
In other words, it truly pays to know what affects your credit standing and how to go about trading in that bad credit score for a good one.
What Impacts Your Credit Standing?
Given that your credit score basically represents how responsible you are in paying back money that you borrow, it is comprised mostly of information relating to loans and lines of credit. More specifically, the most widely-used credit score – the FICO Score – is made up of the following five factors, which are each weighted differently:
- Payment History (35%): Basically, you’ll benefit if you make on-time payments toward certain financial obligations. Things like late payments, bankruptcies, and foreclosures will be detrimental to credit building efforts, however.
- Amounts Owed (30%): Credit scoring companies want to see that you’re not overly reliant on credit card debt or spread thin financially, so it’s best to only use a portion of the credit you have available to you.
- Length of Credit History (15%): This essentially gives credit scorers an idea of the kind of sample size they’re dealing with. If you’ve used credit responsibly for a long time, you’re a proven commodity. If you’ve consistently mismanaged credit or have gaps in your history, you may need to prove yourself again.
- New Credit (10%): If you open a number of credit accounts within a short period of time or repeatedly submit applications, it will indicate that you are desperate for credit, and banks have found that this is often a precursor to financial mismanagement.
- Types of Credit Used (10%): According to FICO, this won’t have a major impact on your credit score, unless there isn’t much information to base your score on. Consumers who have used credit cards responsibly are viewed more favorably than those who don’t have any.
How to Build a Solid Credit Score
One of the worst things people with damaged credit can do is nothing. After all, whether your credit standing was diminished as a result of late credit card or loan payments, defaulting on debt, declaring bankruptcy or some other reason, the fact that there is negative information in your files at the major credit bureaus remains the same. Simply eliminating previous bad habits therefore won’t do much more than prevent your financial situation from worsening. You need to devalue the negative information in your credit reports with positive information.
A credit card is the only type of financial product that will report information to the three major credit bureaus (i.e. Experian, Equifax, and TransUnion) every month without requiring you to incur debt. This might at first seem ridiculous to those of you who view credit cards as nothing but trouble, but it’s true. Whether you use a credit card to make purchases or not, information about your account maintenance is relayed to the major credit bureaus on a monthly basis, providing ample opportunity to methodically outweigh the negative info that dragged your score down. You just have to make sure to pay your bill on time every month or lock your card in a drawer.
The best type of credit card for people with bad credit to use is a secured credit card. Secured cards offer as close to guaranteed approval as you can get and have lower fees than other credit cards for people with bad credit since they require that you place a refundable security deposit of at least $200, which protects the issuer financially when providing credit to even the riskiest of consumers. The fact that your deposit serves as your credit line also means that you can increase your credit line at will – a good thing, seeing as available credit is a component of your credit score. Perhaps more importantly, you won’t be able to spend beyond your means either.
Information about your credit card accounts isn’t the only thing that determines your credit score. Some landlords will also report rent payments to the credit bureaus, so it might make sense to at least inquire whether this is possible in your situation or not. Prepaid cards and debit cards do not impact your credit standing.
In addition, one cannot overstate the importance of simply checking your major credit reports for inaccuracies or signs of fraud, as these things can result in your credit standing being undeservedly low. You’re entitled to a free copy of your Experian, Equifax, and TransUnion credit reports once every 12 months, and you can take advantage of this right by visiting www.annualcreditreport.com.
At the end of the day it’s important that you remember credit building is a process, and a decidedly worthwhile one at that. There are no quick fixes or shortcuts; calling one of those credit repair companies you hear about on the radio will only cost you money. You need to prove to financial decision makers that you can be trusted with a loan or line of credit, and the best way to do so is to use one of those financial products responsibly for a prolonged period of time.
The good news is that if you remain committed to this process, you should see credit score gains within about a year’s time.
This is a guest post from Odysseas Papadimitriou, CEO of CardHub, a leading website that helps consumers find the right credit cards.