In this article, we’ll deal with how to fix a low credit score. Your credit score will determine not only whether your loan application will be approved, but also how much you’ll have to pay for credit. Many people who have been through financial difficulties—illness or unemployment, for example—may have a low score because of late payments, collection accounts or judgments. Although it is not possible to change history, there are steps any consumer can take to raise his or her credit score quickly.
The most common credit scoring models come from FICO, originally Fair, Isaac Company. These models—and there are several of them for different uses—are used by lenders to evaluate the risk presented by a prospective borrower. The scores range from 300 and 850.
A “low” credit score is one that prevents you from borrowing money at a favorable rate. In the mortgage world, a score of 620 is the lower threshold for conventional loans, 580 for government-insured FHA loans. Technically, FHA will insure a loan for a borrower with a score as low as 500, but few lenders are willing to take on a borrower with such a low score.
The FICO model uses several important metrics:
Payment record (and the age of any derogatory entries)
Credit utilization (balance on revolving accounts relative to credit limits)
Number of recent inquiries (applications for credit)
Number of “unseasoned” (recent) credit accounts
Length of credit history
If your credit score is currently above the threshold for a mortgage, you can get a better rate by raising your scores. A borrower with a 620 score will get a rate roughly 3/4% higher than a borrower with a 740 score applying for the same kind of loan.
Getting and keeping a high credit score is theoretically easy: pay your bills on time, don’t rack up big credit card bills and maintain some active accounts. You don’t have to carry a balance to get the benefit of active accounts.
Steps to take now:
1. Get a copy of your credit report from a free site like www.creditkarma.com. This is a “soft” inquiry (one you do for your own use), so it will not affect your score at all. Once you have your report, review it carefully to determine where the problem errors are. Specifically, you will look for court judgments, collection accounts, past-due accounts high credit card balances and errors.
2. If someone sued you in Small Claims Court and won, the court will record the judgment with the county. Simply paying the judgment won’t automatically remove it from your credit report. You may have to record a Notice of Satisfaction of Judgment in your local jurisdiction.
3. If you have any recent collection accounts, you should contact the creditor to negotiate a settlement. Before making a payment at some reduced figure, be sure to get their offer in writing. We strongly advise against agreeing to a “check by phone” payment. Doing this will give the creditor (or collection agency) access to your bank account. Be aware that you’ll get a 1099 at the end of the year for the amount they agreed to forgo, and you’ll have to treat it as income when you file your taxes.
4. If you have an older collection account (two years or older) paying it off is generally not a good idea. The older a derogatory entry is, the less effect it will have on your score. Changing a 4-year old collection to a current “paid collection” could drop your score.
5. If you have any past-due accounts, bring them current as quickly as you can. If the account is for a store credit card, you may be able to persuade the credit office to remove the late payment in the name of customer relations. It is worth making the call.
6. If you have revolving accounts (credit cards) now, look at the balances. When you owe more than 30% of the credit limit, your score starts to go down. The effect is more pronounced if you happen to exceed your credit limit. Paying the balances below 30% will get you an immediate boost in your score. Paying the cards to a zero balance is even better since the interest on credit cards is so high.
7. If there are any items on your credit report that are simply incorrect, you should dispute them with the bureaus. By “incorrect,” I don’t mean those items you disagree with; I mean those things that you can document as incorrect. Under the Fair Credit Reporting Act, creditors have 30 days to respond to disputes. If they don’t respond, the item must come off your credit report. This is the basis of most credit repair services: they repeatedly dispute every negative item until (hopefully) they drop off. The catch is that your credit report will reflect each disputed item during the time it is being disputed and investigated, and mortgage lenders will require that the dispute is resolved. There is also the possibility that the derogatory item could drop off today, but reappear in six months.
8. Although having multiple active “trade lines” (open accounts) is a good idea for getting a good score, there is a caveat: many credit inquiries over a short time will lower your score, although not as much as some would believe. Having several “unseasoned” (recent) accounts will also lower your score for about 90 days, but not by a lot—probably 10 points or less. If you have open trade lines today, you should think twice before closing any of them, since doing so could your score. Older accounts in good standing are like gold from a scoring standpoint.
Many people have low scores for a couple of reasons: one is that they don’t understand how credit scoring works (or how important it is). The other is that they simply lose track of their finances and accrue late charges (a big waste of money!). You can avoid late payments by setting up automatic payments for at least the minimum. The best practice is to pay the accounts in full each month, but an automatic payment of the minimum will eliminate the possibility of missing a payment through distraction and wasting $30-$40 on a late charge.
A low credit score is never a hopeless situation. While fixing the problem areas is not a quick process, it is work that can ultimately save you thousands of dollars.