Whether you're a recent college graduate hoping to secure your first credit card, an entrepreneur hoping to get a loan to start your business, or a would-be home-owner trying to get a mortgage on your first home, your credit will factor in. Your credit score plays a starring role in your ability to secure any financial loan.
But establishing credit is a bit of a Catch-22, because in order to secure a financial loan, you must demonstrate that you already have good credit. In order to have good credit, you must have secured loans. So, how do you build your credit?
What is credit history?
First, let's look at what exactly lenders mean by credit history. Most lenders use your FICO score, calculated based on a model established by Fair, Isaac and Company, a data analytics company. FICO's scale ranges from 300-850, the higher the better.
In order to have any credit rating, you need to have had at least one account open for six months or longer, and one that has been reported to credit bureaus (Experian, TransUnion, and Equifax are the three major credit bureaus), which can be the same accounts.
Having a good credit history signifies to lenders that you will be likely to pay off your debt in the future, so you're considering a low-risk lendee. If you have a poor credit history, they will question your ability to make payments and be less likely to lend to you.
How is your credit score calculated?
The formula for calculating your credit score is complex, and you won't be able to do it on your own; you'll have to obtain a credit report, usually from one of the credit-reporting agencies mentioned above. These days, many credit card companies and other lenders allow you to see your credit score through your online account, although it's not the same as a full credit report. Still, being aware of your credit is important, so it's a good idea to check your score occasionally, particularly if it's free and easy to do through a credit card or bank account.
Your FICO score is comprised of the following:
• Payment history (35%)
Your ability to make timely payments is essential for having a good credit score. Any late payments, collections, bankruptcies, repossessions, and other demonstrations of inability to pay debt will conversely affect your score.
While a few late payments on your credit card are unlike to affect your score in any major way, it's important to make every effort to pay off your debts in full by the deadline, because you'll incur penalty fees, which can snowball into something greater, every time you make a late payment. You could end up carrying much more debt than you had originally, which will take a toll on many aspects of your life, including your financial health.
• Credit utilization/debt (30%)
The amount of credit available to you (the credit lines assigned to you by lenders) and the amount you're using also play a factor in your credit score.
You may have revolving debt from credit cards, meaning it's different from an established loan in that you don't need to reapply and be vetted every time you want to use your card. When you make a payment, that amount becomes available as part of your credit line for that lender again. One type of revolving debt is open debt, which has a fixed amount within a fixed period. The monthly payments you make on your cell phone are an example of open debt.
An installment debt, meanwhile, is a loan that is repaid over a fixed period of time, such as a mortgage.
• Length of credit history (15%)
Banks and other lenders want to see that you've demonstrated an ability to repay your loans. As we've discussed previously, both the age of your oldest account and the average age of all your accounts play a role in determining the length of your credit history.
• Credit diversity (10%)
Having a mix of different types of credit in your history, such as mortgages, installment loans (such as student loans), and different types of credit cards demonstrate that you're able to handle different types of credit. For instance, if you've been making regular, timely payments on your mortgage, as well as making monthly payments on your credit card, that demonstrates that you're able to juggle different types of credit and make on-time payments for each.
• Credit inquiries (10%)
At times, business agencies and lenders will look into your credit. Soft inquiries can be made be agencies such as credit card companies for prescreening purposes, insurance companies, employers, yourself, and others. Soft inquiries appear on your credit report for six months, but do not affect your score.
Lenders will perform hard inquiries when you apply for a loan. These types of inquiries can affect your credit score.
How to establish credit
1. Open a bank account.
Opening a checking account or savings account itself won't help you establish credit, but it can allow you to create a relationship with the bank that might be more willing to lend you money in the future if you're already a customer.
Opening and maintaining a checking account or savings account demonstrates that you can manage your money, and since the bank already knows you, you'll be more likely to secure a loan or credit card later on.
2. Apply for a credit card.
While you may not be able to secure a personal, points-bearing card with no credit history, there are some types you can obtain to build credit.
• Secured card: A secured card is like a debit card in that you'll make an initial payment upfront, which serves as your credit line. However, a debit card won't help you build credit, while a secured card will. It works like a regular credit card, in that you must make payments by the due date or incur interest if you don't. If you are unable to make payments, you deposit will be used to pay off debt.
Keep in mind that you must proactively pay off your monthly bill; it's not just drawn from your deposit. Your deposit is used as collateral if you fail to make timely payments. When you close your account, you will receive your balance. While a secured credit card isn't something you should have forever, it is a useful way of establishing credit initially.
• Department store cards: In general, you should avoid getting credit cards from stores, because they usually have high interest rates. However, they can be helpful in establishing credit, because they're relatively easy to get. Just make sure you stay on top of your payments, because missing one could cost you severely.
3. Apply for a credit builder loan.
A credit-builder loan is exactly what it sounds like: a loan that specifically helps you build your credit. A lender places your money into a savings account or CD until you've fully repaid the loan. Then, you'll have access to the money in the account.
Credit unions and banks generally offer these loans in small amounts, usually $500 to $1,500. There may some requirements, such as having been a member of the credit union or bank for a specified amount of time.
4. Find a co-signer.
Asking someone, such as a parent, to co-sign a loan for you can help you obtain the loan and establish credit. However, keep in mind that the co-signer is responsible for the amount of the loan, and her credit is on the line. If you opt to use a co-signer, make sure you both understand the risks and have a discussion about your responsibility and what this entails.
5. Become an authorized user on someone else's account.
Becoming an authorized user on someone else's account entitles you to her credit limit and line. You'll receive an unsecured credit card in your that you can use to make purchases.
Make sure the person who is responsible for the account reports your activity to credit bureaus. You also need to use the card responsibly, understanding that your failure to make payments will affect the account holder, not you. As with a co-signer, becoming an authorized user warrants a frank discussion about responsibility and what you will do if you're unable to make a payment.
6. Use a rent-reporting service.
Some businesses, such as Rental Kharma and Rent Reporter, will report your rental payments to credit bureaus, which can help you establish a good credit history. Many of these services charge a small fee to report your rent payments, but it can be worth it to help build your credit, especially since you can't report your own payments.
Not all credit reporting agencies include rental payments in your credit report, but the three major credit bureaus do. Some of these services may need to verify payments with your landlord.
7. Develop good credit habits.
Once you have credit accounts, it is essential to develop habits that will bolster your credit score and financial health. A good credit score can affect your entire livelihood—even employers may check your credit history—so developing responsible habits now can help you for the future.
• Make on-time payments.
Although your payment history doesn't account for your entire score, it does represent the largest portion of it. Stay on top of payments and try to pay off statements in full, so you don't carry debt. If you keep making the minimum payments, lenders will charge you interest, which will push you further into the hole.
On-time payments aren't limited to credit cards. You should also make an effort to pay your students loans and other debts. That's right: Even your student loans factor into your credit history.
• Avoid opening too many accounts.
While it may be tempting to open a bunch of new accounts in an effort to establish good credit immediately, doing so can actually have a detrimental effect on your score by lowering the average age of your accounts. Make sure every account you open now and in the future is truly necessary and worth it. Once you've established credit, you'll be able to compare offers and deals, so be judicious about it.
• Carry a low balance.
Your credit utilization is the amount your using compared to your overall limit, and it plays a large role in your overall score. You don't want to rely too heavily on credit cards, because lenders might see that as a red flag that you're not able to make payments. That doesn't mean you should use your credit—you should. But make sure you carry a relatively low balance at all times and aren't close to maxing out your limit with any one card.
• Monitor your credit.
Keeping track of your credit by checking your report regularly allows you to both be aware of your credit score and whether your efforts are paying off and catch any errors. (Reporting errors do happen.)
Most credit cards allow you to check your report for free via your account. You can also access your reports for free through websites like Credit Karma and Credit Sesame. (A note to the wise: these sites are great for checking your score for personal use, but some businesses and lenders may perform a hard inquiry or ask you to send a report issued from a credit bureau.)
Building your credit takes some time, but everyone starts somewhere. Being responsible with your money is an important skill that affects most areas of your life, so it's essential to start now.