Building credit is similar to training for a race. You won't start out with the discipline or skills needed to finish your race in your projected time. The same applies with establishing a good credit history. You'll start from scratch, so here's how you develop an excellent foundation based on responsible behaviors, which, in turn, helps you build your credit score and prevents you from making common errors.
Where Do I start?
The first place to start is understanding how credit works. This will give you a basis from which you can make the rest of your decisions. Remember, the more you know about what goes into a credit score, the better you understand how to build a high one over time.
According to FICO, there are five components that make up your credit score. Let's take a closer look at each, examining how much of the factor-in terms of percentage-accounts for your credit scores and why each is important.
Payment History (35% of your credit score)
The biggest factor affecting your credit score is your payment history with creditors. When you open a credit card or loan with a bank, it will report your payments monthly to each of the three credit bureaus.
If you make all your payments on time it indicates you are a responsible borrower. Since your credit score is a barometer of your ability to pay your bills in a timely fashion, a good payment history will raise your score faster than any other behavior.
Conversely, if you build up a high credit score then miss one payment-this is where you are delinquent for 30 days of more-it can drop your score by as much as 110 points according to data from FICO. This is why maintaining a good payment history is so important because one mistake can plummet your score, making it difficult for you to recover.
Amounts Owed (30% of your credit score)
Another method FICO uses for calculating your score is by examining your credit history for how you use debt. To illustrate, if you open a credit card with your local credit union, receive a $1,000 limit and carry a balance of $500, you are using 50 percent of your available credit-it's important to note that along with payment history a credit card provider will provide the balance owed, which is how FICO makes this calculation.
This is where the credit utilization ratio comes in. What this does is it calculates your total available balances on debts like credit cards then divides them by the total balances owed on all accounts.
Using the example above, if this credit card is your only open account you have a credit utilization ratio of 50 percent. FICO looks at this when calculating your credit score because they want to see how reliant you are on using a credit. If you are maxing out most of your credit cards, your ratio will be higher, indicating you are using too much credit. This will lower your score and make it difficult to obtain more credit-which in this situation is the last thing you will need.
Meanwhile, if you keep your ratios to 30 percent of the balances or less, it shows responsible behavior on your part. This can play huge dividends as a lower ratio typically leads to a higher credit score.
Length of Credit History (15% of your score)
Since you are starting out, this is one factor you won't be able to control for a while. The reason why FICO stresses its importance is it wants to see you have established relationships with lenders; this leads prospective lenders to see you as a more stable risk when you apply for credit cards or loans.
The goal when you open a credit card is to keep it active for as long as you can. It's also important to show some activity on it since FICO factors usage as part of this component. The best tip is to charge a budgeted expense-say Netflix-each month. Then, when your statement arrives, pay it off. That way you keep your card open and have activity on it, both of which aids you in building your score.
Credit mix in use (10% of your score)
Credit mix consists of the varying types of credit you use. There are two different types known as revolving and installment. Revolving accounts are where you have available credit to access-credit cards, home equity, etc.-while installment loans are where you pay a fixed amount monthly but don't have access to more credit such as a mortgage, personal or car loan. As you build your credit score, it's important to show you can manage both through excellent payment histories. While it is a small factor in the overall calculation of your score, managing both well will help you achieve the best credit score.
New Credit (10% of your score)
Say you want to apply for a credit card to build your credit. When you fill out an application the provider will check your credit history-this is known as an inquiry and will go on your credit histories. Since you are starting out, this effect will be minimal. Inquiries only account for your score for the first 12 months then come off your credit report after two years.
However, it's also important to apply for new accounts only when you need them. If you apply and open multiple credit accounts within a short period of time, it could signify you are relying on credit more-this is a red flag for prospective lenders. It could also lower your score in the short term since you have multiple inquiries within a short time.
Now that you understand the factors comprising your score, we will move on to the score itself. Your credit score is a three-digit number, ranging from 300 to 850. A higher score indicates you pay bills on time and you don't have an over-reliance on credit. Next, let me show you why your credit score is important.
Factors Your Credit Score Affects
Your credit score is a way others can gauge your financial behaviors. As such, your score encompasses many areas of your life including:
- Financing a car/home/college education: When you apply for a loan, lenders want to know you can make the payments. The lower your credit score is the riskier you are to them. This might result in you having to make a larger down payment-in the case of a car loan or mortgage- and have a loan with higher interest rates. Meanwhile, if you have a high credit score you could have access to low interest rates, meaning you'll pay less in total loan costs.
- Renting an apartment: Landlords check your credit score too. If you have a lower score, you might have to pay a higher security deposit, have a cosigner on your lease application or they might reject your application on the basis of your poor credit history.
- Insurance rates: Many insurance providers use your credit scores as part of their underwriting process. If you have a lower score, you'll pay more for insurance policies because you represent more risk to the company.
- Employment opportunities: Some employers check your credit. While this might seem strange to you for them it's a measure of your character. If you have a history with defaulted loans it signifies to them you are not responsible and it could be a factor that prevents you from earning the job.
As you can see, your credit score affects many different facets of your life. A good score ensures you don't overpay on everything from car insurance to interest rates on a personal loan.
Building Credit Safely
Here is a step-by-step guide to building your credit wisely.
1. Get a Credit Card
Since you are starting out and don't have a credit history, it will limit your options to opening an unsecured credit card-this type of card doesn't require collateral. Therefore, unless you have a cosigner with great credit who doesn't mind being on the account, the best option is to first do a secured credit card that way you don't start out with a card that carries higher interest rates.
Secured credit cards require a cash deposit that becomes your credit line. Since you have collateral for the card banks and credit unions won't charge you higher interest rates to use it. Moreover, as you charge and make payments, the provider notifies the credit bureaus of your timely payments, resulting in building your score.
Along with building your score it also achieves you building a relationship with that provider. After six months to a year of using the secured credit card, you can ask to see if you would become eligible for an unsecured credit card. If you have been making payments and keeping your balances low, they or another provider will be more apt to approving you.
2. Use Your Card for Budgeted Expenses
I cannot stress enough how important it is to use your credit card for budgeted expenses only. The reason for this is it eliminates the risk of you racking up a large balance due to impulse purchases. Compounding matters in this instance is the fact you charged items you didn't budget, meaning you might not have money to pay off the card when the statement arrives. As your balance rises thanks to interest rates, it makes it more difficult to pay off in a quick manner. Due to this, only use your card for a small expense such as to pay the cable or phone bill.
3. Set Up Automatic Payments
All credit card providers have online tools where you can access your account to change personal information and set up payments. From the outset, set up automatic payments to draw from your checking account on your provider's due date. This ensures you don't miss a payment, as one missed payment could raise your interest rate.
This is only one side of payments, though. The next tip is to avoid only making the minimum payments each month. This is why it's important to charge expenses you know fit within your budget. In turn, when it comes time to pay your credit card bill, you pay it off in full. This lessens the chance of you building a huge balance, which negates any credit building opportunities the card was for initially.
4. Keep Accounts Open
As you build your history and diversify by opening a personal/car loan and another credit card in the future, don't neglect the first card that helped you get there. Instead of closing that account when you open a new card, keep it open and charge small expenses such as Netflix each month. Credit bureaus document your continued relationship with lenders, so the longer you keep active accounts open, the more your score will improve.
5. Don't Open Too Many Accounts Too Quickly
Once you build your score up, you'll receive tons of offers for credit cards, car loans, and other lending opportunities. However, don't allow your momentum to derail you from your goal. If you take the mail bait and open a few accounts quickly, it will drop your score. FICO measures this activity as you needing more credit-an indicator you might be using it to pay regular bills.
Therefore, it is best to opt out of prescreened credit card offers. The Federal Trade Commission says you can do this for five years or permanently by visiting its website to complete the request.
6. Do Electronic Statements
Keeping your financial information safe is just as important as timely payments. With this in mind, you'll want to receive electronic statements for your credit card and loan statements. This ensures they won't be lost or stolen in the mail.
7. Monitor Your Credit
Lastly, you need to monitor your credit reports regularly for any errors. You can request a copy of your three credit reports for free annually to do this. If you notice errors, you can follow the credit bureau's guide to contesting them.
Building credit takes time and discipline, but you can do it. The goals are to learn how credit works and to develop the right behaviors by following these steps. When you do so, you'll build a solid foundation you can use for the rest of your life.