Having good credit is a must-have to manage an easy financial lifestyle. If you do not have good credit, obtaining financing for the simplest things can be problematic. Some feel they don’t need credit, but access to credit can prove invaluable in our credit-driven society. If your credit is damaged, we will talk about how to rebuild your credit.
How Damaged Credit Happens
Many young adults destroy their credit within the first few years of adulthood. Perhaps it is because no one taught them the proper ways to manage credit, and another reason is lenders can be predatory to young borrowers.
A myriad of issues can cause a person not to have good credit. If you fall into this category, you should not be ashamed. We all make mistakes and let’s face it, some are better at managing money than others.
Damaged credit occurs when one establishes a pattern of defaulting on credit obligations. It also includes behaviors on how one manages credit. Life happens, and sometimes things like a divorce, poverty, or just plain lack of knowledge can cause damaged credit. I use the term damaged credit instead of bad credit because all credit is good when used correctly. Misuse of credit causes damaged credit.
What is Credit Rebuilding?
You can only rebuild credit after deciding to manage the debt you have defaulted upon. You must develop a plan to repay your debt, including budgeting, credit counseling, or a last-resort bankruptcy filing. Rebuilding credit is when you have lowered all your debts and are in a good position to begin reestablishing good credit habits.
Credit rebuilding is when you begin implementing new habits in managing credit and debt. To properly rebuild credit, you need to know how credit works. You need to understand what affects your credit score, and you also need to know how much credit you can comfortably juggle without placing yourself at risk.
How to Start
Before establishing new credit improvement behaviors, you must look at your financial health and determine if you can take on credit. Credit has almost always been backed by capital. Capital is wealth in the form of cash or other assets. You must assess your net worth to determine how you are fair regarding capital. Where do you currently stand? It concerns the amount of debt you have compared to the amount of capital you have.
Debt to Net Worth Ratio
Take a debt-to-net worth assessment to discover where you stand financially. This is a simple formula: Assets – Liabilities = Net Worth. The older you become, your net worth should go from negative to positive as your earning power converts into more asset building and liability reduction.
Finding out what your debt to net worth is will allow you to see the overall picture of how much debt you are in, and this should lead you to prioritize whether you should take on more debt or focus on paying down the debt you already have. Most young people will have a negative net worth due to student loans, a car, and, eventually, the initial purchase of a house.
Debt to Income Ratio
Determining how much debt is taking away from your capital is step one. However, some people may have negative net worth but still can manage additional debt due to their debt-to-income ratio. Calculate your Debt to Income ratio now. The debt-to-income ratio is what lenders will evaluate when deciding to extend new credit to you.
Keep this in mind. The debt-to-income ratio is for creditors to evaluate you, and your debt-to-net-worth ratio is for you to assess yourself. Both of these ratios will determine your ability to pay back the credit.
Once you’ve determined if your debt situation is resolved and you are out of debt or have a significantly low debt-to-income ratio, you can consider rebuilding your credit score if it has been damaged due to past mistakes.
Tools to Rebuild Credit
Your credit report will evaluate how well you manage credit and how well you manage to pay back credit on time over some time. Your credit activity is measured, and some factors weigh more than others. See below:
For a detailed explanation of the role each component of your credit plays, click here.
You can start rebuilding your credit by starting with a credit card account, a revolving account, or trying a personal loan. You should aim to have one of each for a healthy credit mix. Remember, when rebuilding, it is not your goal to obtain large amounts of credit but enough credit to establish a new pattern for creditors to look at.
Debt to Income: It’s a Game
If you open a credit card, you must always keep your credit utilization under 30% to maximize your rebuild efforts. Credit utilization is weighed under the “How much you owe” section of the pie chart above. That is almost as important as payment history, so please consider that heavily.
If you max out your credit cards, you tell creditors you do not know how to manage credit properly. Your score will drop and hurt you as you rebuild credit. This is a game you must learn how to play strategically. The debt-to-income game tells creditors you have the cash flow to pay your debts. Consider this: If you are maxed on credit cards, it suggests you are using them to pay and buy things without paying them down monthly. It paints a big red flag: “You don’t have enough cash flow,” or you are mismanaging your cash flow.
Ways Around the Dreaded No
Obtaining new credit when trying to rebuild credit can seem almost impossible when your credit is bad. Yes, cards out there will open accounts for bad credit profiles. Still, they usually carry morbidly high-interest rates with unnecessary annual fees with little to no benefits. If you will pay an annual fee on a credit card, pay it on a card like American Express or a prime card that offers rewards and cash-back incentives.
If you see that you are being turned down for traditional credit with reputable credit card companies or cannot secure a small installment loan, there are ways to get around the denials.
You can use your capital to secure lines of credit in revolving and installment forms. This type of credit is called secured credit. Secured credit is when a creditor allows you to deposit money with them, offering you a line of credit in exchange. The line of credit is usually equal to the amount of your deposit. You can do this with both credit cards and personal loans. Here are two secured credit cards that I would recommend beginning with.
DiscoverIt Secured Card
Discover offers a secured card that will allow you to provide a deposit in exchange for credit. I recommend this card because Discover is considered a major player in the credit game, and using this card will offer great additions to your credit-rebuilding process. While having a credit card is beneficial, some cards carry a much heavier weight than others and will grow your credit score much faster. Discover will convert your account to a traditional unsecured account after seven months of good history (although you have to continue to maintain your other credit accounts). What do you have to lose? Apply here.
Primor Secured Card by Green Dot
I used this card when rebuilding my credit from the damage I experienced during the recession. It was once managed by Berkshire bank but recently changed hands to Green Dot. It is not a major card, but I’ve included this as a good choice because it offers a very low-interest rate, even lower than what American Express offers to some of their very qualified clients. Their website offers 13.99%, but once you’ve opened the card, they will offer you 9.99%. This card is fully secured and will require a cash deposit in exchange for credit. They will never convert the card to an unsecured card, so keep that in mind. Your credit line will always back your deposit. There is no annual fee. Apply here.
Some secured cards still require a minimum credit score of about 530 or better with relatively low debt. This is why the conversation about debt to income ratio and debt to net worth is important. Creditors understand that even if you are high risk, they still will not lend to someone bankrupt, even if it is a secured product.
Secured Installment Loans
Another great way to rebuild credit is to use secured loans and credit cards. Your bank may have several secured products to use.
Certificate of Deposit Loan
If you seek a secured installment line of credit, you can go a popular route called a Certificate of Deposit. Visit your bank to obtain a certificate of deposit. The process involves you taking your capital and having them deposit it in an interest-bearing account. You should be able to borrow against your deposit as a loan. The loan will report to your credit report as you make monthly on-time installment payments. This is an age-old suggestion, modern banks may not allow this practice anymore, but it’s worth checking out.
SelfLender.com
Another available alternative is a website called SelfLender.com. I highly recommend this option because it is relatively easy to use to build credit. You are using your own money, forcing you to save.
Self-Lender will allow you to do the same thing you could do with a CD at your bank. Based on your income, they determine a loan amount you could safely afford for 12 months. You do not get a loan; instead, you commit to a fixed dollar amount per month that you feed into a savings account.
As you pay into the saving account, every payment is reported to your credit reports as a loan. After 12 months, you gain access to the money you’ve been storing away, and the loan is then reflected as paid in full plus, you earn interest on the savings account the same as a CD! You can apply for Self Lender, pay a small $12 processing fee, and start rebuilding your credit. This is like using your savings account to build credit.
One Day at a Time
There is so much information online through many reputable resources to help you manage your credit properly. Start with places like creditkarma.com and myfico.com. MyFico will offer you access to your actual FICO 8 score. Did you know lenders use different scores from Fico that you don’t see on CreditKarma and similar sites? MyFico.com has very robust community forums that discuss so many credit topics, and this forum is free to access!
You Can Rebuild Your Credit
Rebuilding your credit is difficult, but it is not impossible. It will take commitment, honesty, and education to make it happen. Be committed to meeting your goal. Be honest about your situation and make the cuts you need to make.
Sometimes, your credit is too damaged to repair. Perhaps your debts are much higher than your money can pay down. This situation is called bankruptcy. You may have to file for bankruptcy. Check out my advice on filing bankruptcy, when you must do it, and the pros and cons.
Learn about credit and how to use it properly to your advantage. Credit is not extra money, but it is another way to spend the money you already have. Just like money, credit is a tool, much like a hammer. You must learn how to use it when to use it, and why you use it. If used properly, it can provide you with financial success and leverage. You can take a hammer and build a sturdy dog house. You can take that same hammer and smash it to pieces. The choice is yours.