Consumer credit scores are basically a risk-analysis tool. Mortgage lenders (and other creditors) use them to evaluate the level of risk a particular borrower brings to the table. Generally speaking, they charge higher interest rates for borrowers with bad credit, and lower rates for those with excellent credit.
Borrowers with low scores also have a harder time qualifying for home loans. So, if you fall into this camp, you may need to rebuild your credit before you can buy a house. Here are five steps to success:
1. Identify the Source of the Problem
Low credit scores are the byproduct or “symptom” of a broader financial problem. To correct the symptom, you must first determine what is causing them. Perhaps you’ve gotten behind on paying your bills, or maybe you have a bankruptcy in your past. These are scenarios where the core problem is fairly obvious. And in that case, you can move on to the next step in the path to better credit.
2. Review Your Credit Report for Errors
In a perfect world, the three companies that maintain credit reports in the U.S. (Experian, Equifax and TransUnion) would be 100% accurate 100% of the time. But this is not the case. Mistakes are fairly common. So the next step in the process is to order copies of your credit reports from each of the companies mentioned above. You can do this for free by visiting AnnualCreditReport.com, a website that is jointly owned by Equifax, TransUnion and Experian.
It’s important to do this as soon as possible, because it can take a while to have your reports corrected. If you find errors, you can submit a request to have it corrected through the website of the company that produced the report. Visit their website and look for a link that says “disputes.” There are laws that require them to process disputes in a timely fashion. The last thing you want is for erroneous information to drag your credit score lower than it should be.
3. Consider Reducing Your Credit Card Balances
Paying down your credit card balances could help you boost your score, especially if you are using a high percentage of your available limit (or you’re actually maxed out). When you combine this with item #4 below, you will be on the road to recovery in no time.
There are good kinds of debt and bad kinds. A mortgage loan with a reasonable interest rate might be considered a good debt. It keeps a roof over your head and helps you build equity in the asset. But those high-interest credit card balances don’t do you any good. So work out a budget that allows you to start paying them down. You’ll have to pay more than the minimum amount due each month, and you may have to scale back on certain luxuries. But nobody ever said this process would be easy.
Note: If your card balances are fairly low in relation to your limits, you might be able to skip this step. In this scenario, the balances might not be hurting your score at all.
4. Pay All Bills on Time
This is one of the most common reasons for bad credit situations — falling behind on bills and missing payments. Think about it from a lender’s perspective. Why would they want to loan money to someone with a documented history of not paying things back?
Your “payment history” also weighs the most when it comes to credit scoring. It accounts for 35% of your overall score, more than any other factor.
If you are missing payments because you can’t afford to pay them, then you have a budgeting and debt problem. In this case, you should try to reduce your spending as much as possible, or perhaps consolidate your debt into a lower rate.
If, like a lot of people, you simply forget to pay your bills on occasion, you need to create a system that makes it easier for you. Instead of putting bills aside when you get them in the mail, handle them right away. Better yet, get set up with auto-pay so you don’t even have to think about making the payments on time.
5. Get Your Spending Under Control
When you spend more than you earn, you acquire debt. It also makes the other steps listed above much harder to manage. You can’t get caught up with your finances until you get your spending under control. And in this context, “control” means having a clear picture of your monthly spending, your monthly income (after taxes), and how the two of them relate. Develop a budget so you can see where your money is going each month. Then look for items that can be eliminated or reduced.
Improving a credit score is all about discipline and awareness. You must have the discipline to make payments on time, reduce unnecessary spending, and pay down your credit card debt as much as possible. It’s hard work. But it can seriously improve your financial picture, and your chances of qualifying for a home loan.