There is often a stigma attached to having bad credit. This doesn’t mean anyone set out to be irresponsible; sometimes medical bills or other unexpected items come up, putting us in difficult financial positions. Other times, the mistakes of youth stick with us on our credit reports much longer than we would like.
Regardless of how you got there, if you are dealing with poor credit, it’s a good idea to make sure you understand the effects it can have on your financial freedom. Once you understand the effects, you’ll want to know how to go about fixing it, and we have some tips for you there as well. But before we go any further, let’s make sure you have an idea of some of the basic terms you might see relating to your credit.
Credit Score vs. Credit Rating
You may see the terms “credit score” and “credit rating” used interchangeably. When using these terms, people are usually talking about an individual’s credit score when they refer to someone’s credit rating.
They’re actually two separate concepts.
While a credit rating is similar to a credit score, it’s for a business as opposed to an individual. In the most common rating system, businesses are graded on a scale from AAA on the high end to D (for “default”) on the low end. The system is meant to rate how likely businesses are to repay their debts. The three major business debt raters are Fitch, Standard & Poor’s and Moody’s.
Credit scores and reports help lenders make the same decision on likelihood of repayment as credit ratings, but for individuals. The most common rating system used by lenders is from the Fair Isaac Corporation (FICO). A FICO score can range anywhere from 300 to 850. With this rating system, higher scores are better.
There are three major credit bureaus that keep a record of your credit history in the U.S. – Equifax, Experian and TransUnion. Your credit score can vary a bit from bureau to bureau because they may have slightly different information regarding your credit history. They also have different algorithms that score you differently based on the information in your report.
In recent years, the credit bureaus have partnered to create another credit scoring system called VantageScore. The more recent versions of this scoring system follow the same score range as FICO. While it’s not used as often by lenders yet, it features clear explanations of why your score is the way it is. It’s also the score and report commonly given when you check your own credit on a website.
How Can Having Bad Credit Hurt You?
Having a poor credit history or a low credit score can seriously impact you financially. One thing that can happen is you could be denied a line of credit. A low credit score indicates to lenders that you are a high-risk borrower and they may not be willing to lend you money.
Another issue that could arise from having a low credit score is that even if you aren’t denied credit, it could be more expensive for you to get credit. You may have to pay more in fees or a higher interest rate, which increases your monthly payment. Loans of this type are known as “subprime loans.” Even though they usually come with a higher interest rate, they can help you consolidate debt and pay off credit cards.
What Does Bad Credit Mean for Your Mortgage?
If you’re applying for a mortgage, less-than-perfect credit isn’t a total deal breaker. However, there are some things you should be aware of in order to make the mortgage process smoother.
Different Credit Scores Needed for Different Loan Options
In order to get an FHA loan through Quicken Loans, you’ll need a credit score of at least 580. It’s possible to get a mortgage with a lower credit score than this, but these loans are considered subprime. This means they may come with a higher rate and other less favorable terms like a higher required down payment.
To get a conventional loan, you’ll need a credit score of at least 620. One of the primary advantages here is that the mortgage insurance can be dropped from the loan once you reach 20% equity. If you make the minimum 3.5% down payment on an FHA, mortgage insurance is required for the life of the loan. If you make a down payment of 10% or more, mortgage insurance drops after 11 years. That being said, you can always refinance into a conventional option.
USDA loans through Quicken Loans also require a minimum credit score of 640, and this is a 0% down mortgage option if you live in a qualifying rural area.
There’s no required industry-wide minimum credit score for VA loans, but different lenders have different policies. At Quicken Loans, we require a minimum credit score 620 or higher. Instead of mortgage insurance, you can pay a one-time funding fee, which you can choose to finance into the loan. No down payment is required on VA loans.
Negative Credit Items
If you have certain negative items on your credit report, this could also affect your mortgage process.
For example, when you’re applying for a mortgage, your current and past mortgage payment history will be reviewed. There’s a limit to how many times you can be late with a mortgage payment in a 12- or 24-month period. The exact criteria vary by the type of loan you’re applying for.
It’s common that open liens or judgments and collections have to be paid off before you can move forward with a mortgage.
Finally, if you’ve had a bankruptcy, there’s usually a waiting period before you can get another mortgage. This depends on the type of loan you’re applying for and the type of bankruptcy that was filed.
What Does It Mean to Have a Low Credit Score?
Now that you know the score ranges, let’s go over how to determine how your credit stacks up. I’ve split these up into ranges based on how they would potentially affect your mortgage rate. The standards for other types of loans or credit may vary.
Your mortgage rate is affected by not only your credit score, but also the size of your down payment or – in the case of a refinance – how much equity you have in your home. Here’s the breakdown:
- 300 – 579: new or poor credit
- 580 – 620: OK credit
- 621 – 740: good credit
- 741+: excellent credit
If you have new or poor or OK credit, we’ll look at what you can do to improve your score. We’re going to be talking about what to do if you see items on your credit report that you don’t recognize. Then we’ll go a little deeper and talk about understanding the makeup of your credit score so you know what to do to take it to the next level.
New or Poor Credit
If you’re at the lowest end of the credit score scale, you may be new to credit. If your score is right around 300, you’ll need to start somewhere to build up your cred it before you apply for credit cards, auto loans and a mortgage. But how do you start?
One common way to get started with credit is to open a secured card. With a secured card, your credit limit is based on a deposit of your own money. This means that if you failed to make the payment, the lender can just take the money out of your deposit. They’re not really taking a risk, and as you pay off the balance every month, you’re building up a credit history. In 6 to 12 months, you can apply for a regular unsecured credit card where the bank is the one giving you the credit limit.
Another way to build good credit early on would be to become an authorized user on the credit card of someone else who already has good credit. That way, your credit score starts to build every month when the payment is made on time.
If you have a poor credit score, take a look at your credit report so that you can dig deep and truly understand what any issues are and then come up with a plan of action.
Collections and Charge-Offs
When an account goes into collections, it generally means payment is between 90 and 120 days late. At this point, many companies rely on a collection agency to try to secure payment from you. The credit bureaus also list the collection on your credit report for seven years.
A charge-off begins as an account in collections would and then escalates because the creditor or service provider has given up on trying to collect the debt. This doesn’t mean you’re free and clear from the debt, though. The debt is often sold to an agency that will pay the creditor something less than what you owe and then try to collect the debt from you: They could try to collect the entire amount, or you may be able to negotiate a lower price with them. As with collections, charge-offs remain on your credit report for seven years.
Paying charge-offs and collections off can help boost your credit score, but you need to make sure you’re going about it the right way. If you pay off a collection or charge-off, it will show up as paid, but they still remain on your credit report. The pay-off may help improve your score but not as much is having the item removed.
The way to go about paying off collections and charge-offs is to call the creditor or third-party agency that purchased your debt, tell them you’re paying off the outstanding debt, and ask them if they’ll remove the item from your credit report. This will make it like the item never existed and can significantly raise your credit score. Some creditors and agencies won’t do this, but often if you’re settling your debt, they’ll work with you.
When you’re looking at your credit report, one of the most important things to do is to look for any information you don’t recognize. It may indicate that you’ve been the victim of credit fraud. This could affect anyone, whether your credit score is 300 or 850.
If you spot anything suspicious, immediately file a dispute with the credit bureaus to have the information removed. You can also place a fraud alert on your credit report so that all lenders have to call you to confirm you’re applying for credit before extending new credit to you or approving new loans in your name.
Understanding Your Credit Score
If you’re in the range where your credit is OK but you’re looking to take it up a notch to good or great, there are a few things you can do once you know how your finances are being scored.
FICO uses several different factors to determine your score. Each has a different weight.
Payment history makes up 35% of your credit score weight. This is pretty straightforward. On-time payments help; late payments hurt. One thing to note is that creditors and lenders usually don’t report your payment late until the 30-day late mark.
The next biggest influencer on your credit score is how high each account’s balances are relative to your credit limits on revolving accounts like credit cards. This makes up 30% of your overall score. The idea is to keep your card balances below 30% of your overall limit in order for it this segment to have the most positive effect on your score.
One way to improve your credit score is to pay down the balances on your revolving accounts. It’s a bit of a myth that you should carry a $0 balance in order to maintain a high score. While it won’t necessarily hurt your score to carry a small balance, you’re only putting money in the pockets of credit card companies by paying interest charges.
One of the things I do is treat my credit cards like debit cards. In this way, I can pay off my entire balance at the end of every month. My credit score steadily rises, and I can take advantage of the credit card rewards. At the same time, I make it my mission to never pay a dime of interest on the credit card accounts.
The length of your credit history makes up 15% of your score. The idea here is that the longer you have your accounts open, the more time you are able to prove you’re a responsible custodian of your credit. Even if you don’t use a credit card, it’s a good idea to keep it open because you’ll have more accounts with a longer history.
Many secured cards charge a monthly fee for the administration of accounts. You may decide to cancel that one and get your deposit back once you have a couple of other credit cards open. However, in general, you don’t want to close accounts.
Your credit mix accounts for 10% of your score. Basically, what creditors are looking for here is a mix of installment debt (like mortgages, personal or auto loans) and revolving debt (any credit card or line of credit).
The last piece of your credit score is credit inquiries, accounting for the remaining 10%. Your credit score takes a small hit when you apply for new credit. The credit bureaus take your credit inquiries into account because applying for too much credit is one sign you could be financially overextending yourself.
There are a couple of caveats to this: If you’re shopping around for the best rate, say on a mortgage, any credit pull for the same type of loan within 30 days all counts as one hard inquiry, so your score won’t plummet.
Additionally, when you pull your own credit to check your score and report, this is considered a soft inquiry. When lenders or potential creditors pull your credit to evaluate your qualification for a loan or credit line, that’s a hard inquiry. Only hard inquiries affect your score.
If your credit is less than perfect, we hope these tips can help you improve it. We also have lots of other advice on how to prepare your credit for your mortgage application. If you have any questions, you can leave them for us in the comments.
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