A few late payments on your credit report can send your credit score below 600, the point at which you'll pay double-digit interest rates on any loan, or get turned down altogether. But a low credit score isn't the end of your financial life -- credit scores are fixable, if you're willing to do a little work.
Here's how you can start rebuilding your credit score, completely free, with less than an hour of effort.
How to think about credit scores
A credit score is to your credit report what grades are to students' homework assignments and test scores. A credit score turns all the information on your credit report into an easy to understand number that ranges from 300 to 850. In the short term, getting a score above 720 -- the benchmark for a "prime" score -- is the goal.
Luckily, there is no such thing as a permanent record. In fact, as time passes, what's on your credit report becomes less important to your credit score. After seven years, the "bad stuff" on your report will completely disappear as if it never happened.
Yes, seven years is a long time to wait for things to fall off your report. But the truth is that your credit score will improve far more from a bad mark aging from one year to two years old than it does from aging from five years to six years old. The first day a bad mark appears on your credit report is the worst it will ever be. Every day thereafter, your score should start moving up.
This means that the road to a higher credit score is actually pretty short. People who are proactive can make a massive amount of progress in just a few short months by bulking up their credit report with a good account to dilute the negative impact of the bad accounts in the past.
How to start rebuilding your score
Unless you have the ability to time travel, you can't do anything about the past. What you can do, though, is show lenders you're capable of managing your finances in the present time. How can you do this?
You could go finance a car, or take out a personal loan you don't need. But that's a really costly way to rebuild your credit. With a credit score lower than 600, you'll pay at least 20% interest on most loans. That could mean paying $8,000 in total payments when financing a $5,000 car.
The best way to rebuild your credit is a free way -- opening a secured credit card that will report your good behavior to the three major credit bureaus. A secured credit card works just like any other credit card with one exception: You'll have to make a deposit in order to get the card, which protects the bank from the risk that you don't pay. The upside is that almost anyone -- and I really do mean almost anyone -- can qualify for a secured credit card.
There are a bunch of secured credit cards out there. Frankly, most are junk with high fees and punishing terms and conditions. You don't want those. A good secured card should offer the following features:
- No annual fees or monthly maintenance fees.
- A reasonable credit limit with a minimal deposit.
- A promise to report your activity to all three major credit bureaus.
We set out to find the best secured cards, thinking that it would be just as easy as finding really awesome top-of-the-line travel rewards cards. It wasn't. Through some diligent research, we found a few that made the cut and now appear on Fool.com's list of the best secured credit cards. Admittedly, it's a pretty short list.
At a minimum, the secured cards we like offer a $200 credit limit in exchange for a deposit ranging from $49 to $200 (the deposit depends on your creditworthiness) and don't have any annual fees or maintenance fees just for having an account. The key thing here is that they offer a free way to put a good account on your credit reports, which is what you need if your score is under 600.
Of course, there are probably a few good cards that we missed. But there are also a lot more bad cards that we missed, too. By all means, shop around. But be on the lookout for terms and conditions like those that appear in the image below.
This snippet was taken from the terms and conditions of a secured credit card that we put in the "bad" pile. It carries annual and monthly fees that add up to $216 per year, far too much, given there are no-fee choices to choose from.
Once you find a card you like, it's as simple as filling out the application. Because secured cards require a deposit, it's very likely that you'll be approved, no matter how bad you think your credit score is. That's the point of a secured credit card -- they offer people with bad credit a way to get back on their feet.
How to use a secured credit card to build credit
You know how secured cards work, what to look for, and why they can help you build credit. Now it's time to talk about how to manage your new secured credit card in a way that will provide the biggest boost to your credit score.
There are really just a few things you need to do:
- Use your card sparingly. It may seem a little weird, since the whole point of having a credit card is being able to use it, but we recommend you use your card infrequently. In fact, we'd recommend you use it for one small purchase (a tank of gas, or an inexpensive meal) just once a month. The goal is to use less than 30% of your credit limit at any given time in order to get the biggest boost to your credit score. On a card with a $200 limit, that means never having a balance more than $60. (For some backstory on why this is important, see this article on credit utilization.)
- Pay on time. The whole point of getting a credit card to boost your credit score is to show that you are capable of managing your finances and making on-time payments. Pay your secured credit card bill on time as if it were any other credit card. Your payment history, the good and the bad, will be reported to all three major credit bureaus.
- Pay in full. It is a myth that carrying a balance and paying interest is necessary to get a good credit score. You don't need to pay interest, and you shouldn't. Here's how to avoid all finance charges altogether: When your bill comes, pay the "statement balance." This is really important. When you hear "pay in full," it means "pay the statement balance," not "pay the minimum payment." If you pay the minimum payment, you'll incur interest charges. You don't want that.
If you do these three things, you'll be well on your way to turning a sub-600 score into a 700 score, and, eventually, an 800 credit score or higher. Most importantly, you won't pay anything -- not one dime of interest, fees, finance charges, etc. -- to improve your credit score.
Along the way, you'll also be rewarded. Often, after six to twelve months of on-time payments, the card company will send you a check to return your deposit, thus "graduating" your secured card to an ordinary unsecured card. If you're really lucky, they'll send news that they increased your credit limit along with the check.
You'll likely start to see offers for better cards (like travel cards) fill your mail box after you've made a few on-time payments. That's a good sign that your credit score is improving, since those pre-approved offers are chosen based on your credit score, among other factors. Realistically, it's advantageous to avoid the temptation to open another account for at least a year or two. Two cards won't double your progress toward a good score, but the application will cause a slight dip in your score due to having another lender do a "hard pull" to check your credit report.
It's worth the effort to rebuild your score
Boosting your credit score back to a prime score can have tremendous financial benefits, particularly when it comes to buying a home or car, getting a job (some employers check your credit score), and generally benefiting from the best terms and conditions on any type of financing.
For some motivation, consider this: Someone with a 760 score will pay less each month on a $200,000 mortgage and $15,000 car loan than someone with a sub-600 score would pay on just the mortgage. Put this way, improving your credit score is kind of like getting a free car. That would be nice, wouldn't it?