How Can I Clear Up My Credit History?
Reader Question: "I want to purchase a home sometime during the next year, but I have a few negative entries on my credit report that's hurting my FICO score. I have heard that mortgage lenders are being really strict right now, as far as this stuff goes. So I'm guessing I need to clear up my credit history before moving forward. Is this correct? And if so, where should I start when trying to clear up the derogatory entries on my reports?"
Let me start with your first question, regarding mortgage lenders. Yes, it's true that lenders have become stricter over the last few years. It all started when the housing market began to collapse, back in 2008. Ever since then, lenders have been looking for ways to reduce their risks. One of the ways they do this is by requiring higher credit scores from borrowers.
After all, your score is basically an indicator of risk. It shows your history of borrowing and repaying money, going back several years. Lenders use it to determine how risky you are, as a potential borrower.
Your FICO credit score is based on the data compiled in your credit reports. I say "reports" -- plural -- because you actually have three of them, one for each of the companies that gather this data (Experian, TransUnion and Equifax). So if you want to clear up your credit history in order to improve your score, you'll need to start with your reports. It seems you already realize this, given the nature of your question. I'm including it for the sake of other readers.
So, if you truly have bad credit right now, it's going to create obstacles for you when applying for a home loan. Depending on how low your FICO score is, you might not even qualify for a loan. You didn't mention exactly what your score is, so I can only speculate at this point.
On a side note, you'll probably need a 600 or above to qualify for a home loan in 2012 - 2013. This is true for FHA loans, as well. But don't take that number as gospel. Some lenders are still working with borrowers with FICO numbers down to the upper-500 range. But I digress. Let's get back to the question at hand.
How to Clear Up Your Credit
Let's move on to what you really want to know: How can I clear up a bad credit history before buying a home? While we are on the "clear" subject, I'd like to start by clearing up some of the terminology here. When people talk about their credit histories, they may be referring to one of two things:
- The financial decisions and actions they have made over the years.
- The way this financial activity has been captured and reported on their credit reports.
Item #1 leads to item #2. The actions you take when borrowing and repaying money is basically what drives your credit score. So both of these things must be considered. The image below reinforces this point. It shows how your financial activity is used to produce a credit score.
So your reports are used to compute your credit score. Mortgage lenders use this three-digit number when considering you for a loan. It shows how you have borrowed and repaid money in the past. So it helps lenders assess the risk associated with giving you a loan. A higher level of risk will hurt your chances of getting approved for a loan. It will also make the loan more expensive if you do get approved, because the lender will likely charge you a higher interest rate.
The scoring models themselves are fairly complex (here's how your FICO number is calculated). But the thing you need to realize is that it all starts with you, and how you manage your debts.
So if you want to clear up a bad credit history, you need to change the behavior that caused the problems in the first place.
You Can't Rewrite History, But...
Obviously, we cannot erase our financial past. But we can certainly correct the behavior that led to bad credit in the first place. For example, let's say that in the past I had a bad habit of neglecting my bills. I've missed payments for my credit cards, my car loan, and other bills for a period of several months. By law, this negative information can stay on my credit report for up to seven years.
Now let's assume I've become more responsible with my bill payments. It's four years later, and I am planning to buy a home. I want to clear up my credit history so I'll have a better chance of getting a mortgage loan. What can I do?
- I cannot change the past, so my delinquent payment situation will still be on my credit report (for a few more years anyway).
- If my financial behavior has improved since then, and I haven't had any delinquent payments in several years, my credit report will reflect this as well.
- It's still wise for me to request copies of my credit reports and clear up any errors that might be on there. Such errors can actually drag my FICO score down.
- Side note: I might want to consider reducing the amount of credit card debt I have, as well. This can have a positive effect on my FICO score, which will improve my chances of getting a loan even more.
- Most importantly, I should continue to pay all of my bills on time and make sure I don't rack up too much debt. Over time, this kind of good financial behavior will improve my credit score.
That last item on the list is the most important of all. Even if you have some negative information on your credit reports, it will eventually go away. There are laws that limit the length of time those things can follow you. So if you are financially responsible in the meantime, your overall credit score well steadily rise over time. This makes it easier to qualify for a loan, and it helps you get the best interest rates at the same time. This is the real "secret" to clearing up a bad credit history.
So what have we learned by all this? For one thing, we have learned that you cannot wave a magic wand and clear up your credit history instantaneously. You can (and should) review your credit reports for errors, and dispute those errors to have them removed.
You can also change your financial behavior for the better. But the financial mistakes of the past can follow you for 7 - 10 years, depending on what they are. You can certainly improve your credit score over time, by changing that behavior. But you cannot change the past.
Unfortunately, a lot of companies will lie to you and say that they can repair your credit and clear up any bad items from your credit history. Most often, this is just a scam designed to elicit payments from you.
The only thing these companies can do is (A) help you remove errors from your credit reports and (B) offer advice on how to change bad financial habits. But you can do these things for yourself -- and for free.