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Credit: How It Works and How To Rebuild Your Score

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In a Nutshell

Having good credit is an important factor in your financial well-being. It is not the only factor, but it is valuable to have a good understanding of what credit is, how it’s determined, what steps you can take to increase your score, and how it affects other areas of your life. Whether you have good credit or poor credit, there are ways to improve your credit score. If you have bad credit, don’t stress out about it. Read this article to learn more about how credit works and to learn several ways to start rebuilding yours.

Written by Attorney Eric Hansen.  
Updated August 23, 2021


Having good credit is an important factor in your financial well-being. It is not the only factor, but it is valuable to have a good understanding of what credit is, how it’s determined, what steps you can take to increase your score, and how it affects other areas of your life. Whether you have good credit or poor credit, there are ways to improve your credit score. If you have bad credit, don’t stress out about it. Read this article to learn more about how credit works and to learn several ways to start rebuilding yours. 

How Credit Works

Credit is essentially your borrowing ability. You build your credit by taking out lines of credit like personal loans, credit cards, installment loans, car loans, and mortgages, and making on-time payments until the credit account is paid off in full, often with interest. 

Your credit score is a reflection of your credit history, which is shown on your credit report. If you have a good credit score, your history shows that you make timely payments and pay down your debts without issue. If you have a bad credit score, then you might have missed payments, made late payments, or had accounts sent to collections. Your credit report may also include derogatory marks like a charge-off, repossession, or bankruptcy filing. If this is the case, there are steps you can take to repair your credit. It may take some time, but it comes with a lot of benefits.

Your credit report is generated by the three major credit bureaus: Experian, TransUnion, and Equifax. Your creditors, like your lender or your credit card issuer, give information to these credit reporting bureaus. Credit bureaus also search public records for negative marks like liens, judgments, and bankruptcy filings.

Lenders will look at your credit score and consider your creditworthiness when you try to open up a new credit line. This means they’ll look at your credit score and history to determine if they’ll loan you the money based on how likely they think you are to pay it back. Your credit score also will be used to determine your credit limit or your spending limit and the interest rate you’ll pay.

The Side Effects of Bad Credit

Having a bad credit score can feel like you’re pushing a boulder that somehow gets bigger up a hill. Bad credit can have a significant impact on many areas of your life, including but not limited to your finances. If you have a bad credit score, lenders might deny your loan applications. Or, if approved, you may get a loan with unfavorable terms like a high interest rate. 

Bad credit can also prevent you from being able to rent a home or get a job. Some employers get a copy of your credit report and your credit score when they do a background check. They want to see if you have high credit card balances or accounts that are past due. This can indicate that you don’t handle your credit responsibly. If they’ll be trusting you with financial responsibilities, having a glimpse into how you are budgeting your personal finances can give them a sense of how well you can perform financial tasks professionally.

Factors That Impact a Credit Score

Your FICO credit score is determined by five main factors:

  1. Payment history: This factor accounts for 35% of your FICO credit score. It includes information like whether you’ve been making on-time payments, if you’re past due on any accounts, and if you’ve filed for bankruptcy. Your payment history lets lenders know what you’ve done with loans and credit cards in the past. This helps them know what you’re likely to do with new credit.

  2. Amounts owed: This factor makes up 30% of your credit score. An important part of this is your credit utilization rate. That is the percentage of your total available credit that you’re presently using. To calculate your rate, you can divide the debt you currently owe by the total amount of credit available to you. Lenders prefer borrowers to keep this rate at or below 30%. This shows them you can use your credit responsibly. If you have maxed out your cards, your rate will be higher, which will likely result in a lower credit score.

  3. Length of credit history: This factor accounts for 15% of your total credit score. It looks at how long you’ve had your various lines of credit and if you’ve been in good or bad standing with those lenders and credit card issuers.

  4. New credit: This factor accounts for a smaller portion of your credit score at 10%. When you apply for new credit accounts, lenders will do a hard inquiry to check your credit. You might notice a drop in your credit score after a hard inquiry. This is why it’s not good to open too many new accounts at once.

  5. Kinds of credit: This factor is also a small percentage of your overall credit score, clocking in at 10%. Having a good variety and balance of credit accounts is important. It demonstrates that you can use different types of credit appropriately. For example, having an installment loan and at least one credit card but maybe two or three (perhaps a credit card with an annual fee for travel, one with a low interest rate for balance transfers, and one that has good cashback benefits) is a good credit mix.

Credit Rebuilding Approaches

Think of credit rebuilding like you’re training for a marathon, but for personal finance. Rebuilding your credit doesn’t happen overnight. It takes time and dedication. Implementing the right financial habits when dealing with credit accounts and debt will help you successfully rebuild your credit. But you have to stick with it and stay committed.

Keep the factors that affect your credit score in mind. Make sure that you are making timely payments, and if you can afford it, pay more than your monthly minimums. Develop a solid payment history and focus on lowering your credit utilization ratio. Keep old credit accounts open and maintain good standing with your long-term lenders and credit card issuers rather than opening a bunch of new accounts. Maintain a good credit mix and watch out for hard inquiries when applying for new credit.

Review Your Credit Report

The first step in rebuilding your credit is reviewing your credit report. Your credit report is sort of like a school transcript. It’s a record of the information lenders and other credit furnishers have reported to the credit bureaus. Your credit report will state your credit balances, any missed payments, who your lenders are, and other pertinent financial information. You can get a free copy of your credit report each year from all three major credit bureaus by requesting it. Also, you can obtain your free credit report from AnnualCreditReport.com

Dispute Any Errors Right Away

Once you have a copy of your credit report you should review it thoroughly. Credit reporting agencies sometimes make mistakes or misreport data. So your report may contain inaccurate or incorrect information. Examples of common errors include:

  • A debt amount is lower than what was reported

  • An on-time payment was reported as a late payment

  • A credit account that was paid off in full is being reported as past due and in collections

If you spot incorrect negative information on your credit report, you can challenge it by sending a dispute letter. The Fair Credit Reporting Act (FCRA) gives consumers the right to repair their credit reports by disputing inaccurate information.

Make On-Time Payments

One of the simplest ways to rebuild your credit is by paying all your bills on time. If you have past-due accounts, try to bring them up to date and keep them current. It may be helpful to set payment reminders or to set up automatic payments. 

Request a Higher Credit Limit

Another way that you can rebuild your credit is by requesting a higher credit limit. If approved, this could help decrease your credit utilization rate. Remember this rate represents how much of your available credit you’re currently using. If you are using 90% of your available credit, your credit utilization rate is high and this will bring down your credit score. A credit utilization ratio of under 30% is usually considered good.

When you request a credit limit increase you may see a slight drop in your credit score because of the hard credit inquiry. But, over the long term, it should help your credit score by lowering your credit utilization ratio, which is a more important factor in your credit score. This won’t work if you run up a balance on your increased credit line. So be cautious using this method if you have a problem with overspending. Just because you increased your credit limit doesn’t mean that you have to use it.

Get a New Credit Card

Getting a new credit card is another way you can build credit. With more variety in your credit accounts, you’ll have a better credit mix and you’ll be able to provide a more thorough payment history. Make your credit cards work for you to improve your credit score by making timely payments and keeping your credit card balances low.

Keep Your Old Accounts Open

If you’re able to pay off a credit card, you may be tempted to close the account. But keeping the account open is an easy way to help your credit score. The average age of accounts on your credit report is an important factor in determining your FICO credit score. Financial institutions want to see long-term lines of credit in good standing when you apply for new credit.

Get a Secured Credit Card

If you have poor credit, you may want to consider getting a secured credit card. A secured credit card is a lot like your typical card except that it requires a security deposit. This makes it less risky for your lender. Your deposit ends up being your spending limit, and if you don’t make your monthly payment, your credit card issuer will draw from your deposit. Other credit cards are unsecured debts, meaning there is no collateral backing them up. With a secured card, your deposit is used as collateral if you fail to pay.

It’s best to use your secured credit card for ordinary household bills that you can pay off each month. It helps build your credit because lenders report your payment history to the credit bureaus, just as they do with unsecured credit card accounts. If you’re able to keep the utilization ratio down, that will also boost your credit score.

Don’t Apply for Too Much Credit in a Short Time

While it’s wise to have a good credit mix, it isn’t always smart to apply for a lot of new credit in a short time. When you apply for new credit, the lender or credit card company does an in-depth review of your credit report to see your payment history, credit utilization ratio, length of accounts, and other information. This is called a hard inquiry or hard pull. These inquiries negatively affect your credit score. This hard pull will stay on your credit report for about two years.

Lenders will notice if there are multiple hard inquiries in a short time, and that can raise red flags. They may think you’re a credit risk, you’re strapped for cash, or that you intend to rack up a bunch of debt.

Tackle Delinquent Accounts

If you have past-due payments on an account, it is considered delinquent. Addressing delinquent accounts is important. These accounts can stay on your credit report for up to seven years and can bring down your credit score. If an account is nearing charge-off status you should really try to bring it up to date before it’s too late.

Become an Authorized User

Another great strategy to improve your credit score is becoming an authorized user. If you have a trustworthy friend or family member that has a good credit score, you can ask if they’ll add you as an authorized user on one of their credit cards.

An authorized user is not a co-debtor. Authorized users do not have to make charges or even use the card on the account to benefit from it. The main benefit is that the authorized user can make use of the primary user’s payment history, length of account, and credit limit to positively affect their own credit. The main downside of being an authorized user is that if the account holder makes late payments or misses payments, that will show up on your credit report as a negative item and bring your credit score down.

Try a Credit-Builder Loan

A credit-builder loan may be an option for those seeking to rebuild their credit. A credit-builder loan is different from an ordinary line of credit in that the financial institution (a credit union, member FDIC bank, or nonprofit) deposits a sum of money into an account and only releases the funds to you after you have made enough monthly payments. This helps build credit because it shows you can commit to establishing a good payment history.

Get a Loan or Credit Card With the Help of a Cosigner

You can also get a loan or a credit card with the help of a cosigner to help rebuild your credit. A cosigner can help you get a line of credit that you otherwise couldn’t get. The cosigner essentially agrees to be responsible for the debt if you don’t pay it off. The benefits of this are that you may be able to get a higher credit limit, more favorable terms, and a better interest rate. But there are some downsides, too. This credit account will show up on your cosigner's credit report, and they’re on the hook if you default. This could lower their credit score and damage your relationship with them.

Get a Mix of Credit

Having a good credit mix is important to building credit. Lenders want to see that you have diverse credit sources and that you can handle different types of credit. You’ll want to have a variety of revolving and installment credit accounts for your finances. Revolving credit accounts are credit cards or lines of credit. Installment accounts are personal loans, auto loans, or home loans, for example.

How Long Does It Take to Rebuild Credit?

Rebuilding credit takes time, and there is no one-size-fits-all solution or secret quick fix. Each person’s credit profile is different. The timeframe and the steps necessary to rebuild credit will depend on what damaged your credit score in the first place. More recent negative marks will hold more influence on your credit score than older entries. If you’re feeling lost or unsure about how to tackle negative information on your credit reports, you should seek credit counseling to get a better handle on things.

Let’s Summarize...

Rebuilding credit is not easy or quick, but it is worth it. Be realistic and try to continually improve by using whichever of the above strategies makes sense for your individual financial situation. You can start by addressing delinquent accounts, paying off an older credit account and keeping it open unused, or applying for new credit to help decrease your credit utilization ratio. You have many options. Take the process step by step.

Think of rebuilding credit like training for a marathon. Take small, incremental steps, stay committed to the process, and you’ll get there.



Written By:

Attorney Eric Hansen

Eric D. Hansen is an experienced Minnesota attorney within a number of varying and nuanced practice areas. He has operated his own solo practice as well as worked at small suburban boutique firms and large diversified downtown law firms. Eric has a wealth of experience in busines... read more about Attorney Eric Hansen

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