Whenever you apply for a mortgage, car loan or student loan, a lender will check your credit reports and your credit score. It happens, too, when you apply for a credit card. And if your credit reports are filled with late payments and your credit score is low? You might not qualify for those loans or that credit card.
Fortunately, building good credit isn’t complicated. You can build strong credit just by paying your bills on time each month and reducing your credit card debt.
What Is Credit?
When you hear about how important it is to build good credit, financial experts are actually talking about two things: your credit reports and your credit score.
You have three credit reports, one each maintained by the national credit bureaus of Experian, Equifax® and TransUnion®. These reports list your open credit card and loan accounts. They also list your payment history, including missed or late payments. These reports will also list any recent financial mistakes you’ve made, such as bankruptcies, foreclosures or accounts that have fallen into collections.
You have several three-digit credit scores, numbers that are made up of the information contained in your credit reports. If your reports are filled with late payments, high credit card debt and other financial mistakes, your credit scores will be low. If they’re not, your scores will generally be high.
The FICO®Score is the most important, and the one used by most lenders when determining whether you qualify for a loan.
What Is Good Credit?
FICO Scores range from a low of 300 to a high of 850. The higher your score, the more eager lenders and credit card companies will be to work with you. In general, a FICO Score of 740 or higher is considered an excellent one. One below 620 is considered weak. The higher your score, the lower the interest rate you’ll be charged on loans, too. So a higher credit score will not only gain you access to loans and credit cards, it will do so at a lower interest rate.
Young adults sometimes face a unique challenge: They don’t have enough of a credit history to have a credit score. They haven’t built a record of making car payments on time or sending in their credit card payments before their due dates. Many of the payments they do make each month – their cell phone bills, rent and utility payments – aren’t even reported to the credit bureaus, so these on-time payments don’t help them build a credit history. Without a credit history, you won’t have a credit score, and that can make qualifying for loans or credit cards a challenge.
How Do You Build Credit?
It can seem like you’re stuck when you don’t have a credit score: After all, it takes credit to build credit, right? Sure. But this doesn’t mean that you can’t build your credit enough to generate a strong credit score.
There are several options – everything from taking out a secured credit card to applying for short-term credit-builder loans – to help you grow your credit file over time. And as you build a history of making payments on time and managing credit card accounts, you’ll steadily build a credit score.
6 Tips For Building Credit
There is no single way to build credit. That’s good. The options below will give you plenty of choices. You might not be comfortable with each one but following just two or three of these strategies will help you build credit over time.
1. Get A Secured Credit Card
Banks and financial institutions take a risk when giving consumers credit cards: There’s always a chance these consumers will rack up debt and then not pay it back. That risk is higher when consumers don’t have a credit history showing a record of paying their debts.
But that risk is significantly reduced with a secured credit card, and it’s why this type of card can help consumers without a credit history build one.
A secured credit card works mostly like a traditional card, but your credit limit is tied to a cash deposit you make when taking it out. Say you deposit $500 with the bank when taking out a secured credit card. Your bank holds onto that money and that $500 becomes your new credit limit. This means that you can make charges up to $500 and no higher.
This also protects your bank. If you stop paying your credit card bill, your bank will take what you owe out of your initial deposit. This is why banks are more comfortable approving secured cards for consumers with no credit.
A secured card might seem limiting, but it’s a way to build your credit. Once you have this card, use it each month to make purchases, then pay them off in full every month. Do this over several months, and you’ll steadily start to build a credit history and a credit score. Just make sure to make your payments on time. If you don’t, missed or late payments – payments made 30 days or more past your due date – will cause your credit score to plummet. Also, pay off your balance in full each month. This way, you won’t have to worry about the high interest rates that usually come with credit cards.
2. Get A Cosigner On A Loan Or Unsecured Credit Card
One of the best ways to build credit is to take out a loan and then pay it off on time each month. Those regular payments are reported to the three credit bureaus and steadily boost your score. The challenge? Lenders might not approve you for a loan if you don’t already have a credit history.
But if you get someone, usually a family member, to cosign on a loan with you, lenders will usually be far more willing to loan you money and give you a chance to build your credit.
As the same suggests, a cosigner signs along with you on a loan. This cosigner then agrees to make your payments if you, for whatever reason, stop doing so. This provides added protection to lenders, who are then more willing to overlook your lack of a credit history. Once you’ve been approved for the loan, make those payments on time each month.
Be aware of the risks, though, specifically the risks to your cosigner. If you stop making your payments, your cosigner will have to. And if you are late on your payments, not only will this hurt your credit score, it will also cause the score of your cosigner to fall. This could create tensions between you and your cosigner, so make sure you are absolutely prepared to make those payments on time.
3. Become An Authorized User On A Credit Card
Another way to build your credit is to become an authorized user on someone else’s credit card. This happens when someone you know – again, usually a family member – adds your name to his or her existing credit card account. You can then make purchases as if this credit card account was your own. You have no responsibility, though, to make payments on this card.
The positive here is that as the main user of the card pays his or her bill each month, your credit will receive a boost. The negative? If that user misses payments or makes them late, it could hurt your credit. It might also prove challenging to find people who will add your name to their accounts. You’d have to work out some arrangement determining how much you can spend each month.
4. Get A Credit-Builder Loan
Smaller banks and credit unions might offer what are known as credit-builder loans which are designed to help people with little or no credit build a credit history.
If you sign up for one of these loans, you’ll make a small deposit with the bank or credit union providing it. You then pay back that deposit each month. When you make a payment, the financial institution behind your loan reports it to the credit bureaus. This helps build your credit.
Again, you do need to be aware of possible pitfalls. Don’t miss any payments. If you do, the bank will report your missed payment to the bureaus, and that will cause your score to fall. And when you make that initial deposit, make sure it’s not so high that you won’t be able to afford the monthly payments your bank or credit union will charge you.
You might also have to call several banks or credit unions before you find a credit-builder loan. Many financial institutions don’t offer this option.
5. Get Credit For Paying Your Bills On Time
The best way to build a credit history and credit score is to pay your bills on time. If you have an auto loan, student loan or credit card and you make your monthly payments on time, this information is sent to the credit bureaus, which boosts your credit score and adds positive information to your credit reports.
The challenge? It’s not easy for people without credit to qualify for credit cards or loans. And most of the bills that you pay each month already – your utility bills, cell phone bills, cable bills and, usually, apartment rent – aren’t reported to the bureaus. These payments, then, don’t help your credit.
If you have a secured credit card or credit-builder loan, though, those payments will be reported to the credit bureau and will help your score. Make sure to pay these bills on time each month.
Usually, your apartment rents aren’t reported to the credit bureaus. Your landlord might subscribe to a service that does report your rent payments, but most don’t. Fortunately, you can sign up with services such as PayYourRent, Rental Kharma or RentTrack. These services, for a monthly fee, will report your apartment rent payments to the credit bureaus. It’s no fun having to pay a monthly fee – some of these services will also charge you a one-time registration fee – but having your rent reported to the credit bureaus could help boost your credit history quickly.
6. Get An Unsecured Credit Card Without A Cosigner
Once you have taken the steps above to build your credit, you can sign up for a traditional, unsecured credit card. If you’re approved, use your card each month. But be sure to make your payments on time each month and to pay off your balance in full. Do this, and your credit history will grow quickly.
If you make your payments 30 days or more late, though, you’ll build the wrong kind of credit history and your credit score will tumble. If you don’t pay your balance off in full each month, you’ll be charged interest on the money you still owe. Because credit cards charge high interest rates, your credit card debt can grow quickly if you do carry a balance each month.
But using your unsecured credit card wisely? It’s one of the most effective ways to build your credit history and earn a strong credit score.
5 Best Practices For Building Credit
Once you’ve started building a credit history, it’s time to work on steadily improving your credit and your credit score. Fortunately, this isn’t complicated.
1. Make All Payments On Time
Your payments on credit cards, student loans, auto loans, mortgage loans and personal loans are all reported to the three national credit bureaus. Making these payments on time will help improve your credit. That’s because your payment history makes up 35 percent of your FICO Score, according to myFICO.com.
If you pay a bill late? That could cause your credit score to drop by 100 points or more, depending on the rest of your credit history. Fortunately, a bill is only considered late, and is only reported to the bureaus, if it is 30 days or more past the due date. If you are just a week or two late on your credit card payment? Make that payment today. Then it won’t be reported as late to the credit bureaus.
2. Avoid Hitting The Credit Limit On Credit Cards
The amount of money you owe makes up 30 percent of your FICO Score, making it the second most important factor. That’s why you never want to run up the balances on your credit card. The more of your available credit you are using, the worse it is for your credit score.
There is no magic number for how much of your available credit you should use. Your best bet is to never carry a balance on your credit cards from month to month. If you do carry a balance, devote as much extra money as you can to paying it down.
3. Don’t Apply For Multiple Credit Accounts Or Lines Of Credit At Once
MyFico.com says that lenders get nervous when consumers open multiple new credit cards or lines of credit in a short amount of time. Why? They worry that consumers who do this are ready to go on a spending spree, and might rack up more debt than they can afford.
Your new credit makes up 10 percent of your credit score, according to myFico.com. That’s not a huge factor, but it can have an impact. It’s best, then, to take breaks between opening new credit accounts.
4. Keep Existing Credit Card Accounts Open
Something called your credit-utilization ratio has an important impact on your score. This ratio, as its name suggests, measures how much of your available credit you are using. The more of your credit you are using, the worse it is for your credit score.
If you have four credit cards all with credit limits of $2,000, you have $8,000 of credit available to you. If you have $2,000 of total credit card debt, you are using 25 percent of your available credit, or $2,000 divided by $8,000.
What you shouldn’t do is close a credit card account after you’ve paid it off, even if you don’t plan on using that card again. That’s because closing a credit card account will automatically boost your credit-utilization ratio. Say you have that $8,000 of available credit and the same $2,000 in credit card debt. If you close a credit card account with a credit limit of $2,000, you’ve now reduced your available credit to $6,000. Without even making another charge, you’ve also increased your credit-utilization ratio. If you have $2,000 of debt and your available credit is just $6,000, you are now using a higher 33 percent of your available credit, or $2,000 divided by $6,000.
The lesson? Even if you pay off a credit card, don’t close it. Not using it is fine, but you want to keep that available credit intact.
5. Monitor Credit Scores And Credit Reports
You are entitled (and should order) one free copy of each of your three credit reports– one each from Equifax, Experian® and TransUnion®– every year. You can order these reports from AnnualCreditReport.com.
These reports list your open credit accounts and loans, how much you owe on them and whether you have any late payments. Check the reports carefully. If you see any errors, correct them with the appropriate credit bureaus. Fixing a mistake could quickly boost your credit score.
You can also check your three-digit credit score. You can order these scores directly from the credit bureaus, though they will charge you for it. You might also receive free credit scores from your credit card provider or bank. These scores might not be your official FICO Score, but they are still useful and will give you a good idea of how strong your credit is.
Building Credit Myths And FAQ
One of the challenges with trying to build good credit? There are too many myths about credit and credit scores out there. Here are some common ones and why these myths are untrue.
Do Student Loans Affect Credit Score?
Student loan payments are reported to the three credit bureaus. This means that these payments will affect your credit score. Make your payments on time each month, and your score will improve. Pay late or miss a payment? Your score could fall by 100 points or more.
Remember, though, a late payment isn’t reported until it is 30 days or more past your due date. Make sure, then, to always pay before that deadline if you want to avoid a credit hit.
Does It Help To Carry A Balance From Month To Month?
A truly damaging myth about building your credit is that you need to carry a balance on your credit card each month. This is not only untrue, it leads to unnecessary high interest payments to your credit card company each month. With the average credit card interest rate for new offers hovering close to 20%, carrying a balance could cost you significantly each month.
Instead of carrying a balance or paying the minimum on your card each month, it’s highly recommended to pay your balance in full. This practice helps you control your spending, live within your means and will increase your credit score. When you pay off your balance in full each month, you’re decreasing your overall credit utilization and increasing your score.
Will Closing Credit Card Accounts Will Improve Your Credit Score?
Paying off and closing credit card accounts sounds like it should be a great thing, but surprisingly it can negatively affect your credit score. A portion of your credit score is determined based on your average account age. If you decided to pay off and close a credit card you’ve had for five years and the other accounts in your credit report have only recently been opened, your average account age is going to look a lot younger.
While younger can be better with a lot of things, credit age is not one of them.
Since credit age only accounts for 15% of your overall score, don’t feel too bad if you’re paying off and closing up your debt accounts. By paying your other bills on time and in full, you’ll build your score back up in no time.
Will Your Credit Score Decrease When You Check Your Credit?
Checking your credit is a smart move and it does not negatively or positively affect your credit score. These types of inquiries are neutral actions that leave your score unchanged.
In fact, checking your credit is a smart financial habit. This helps you review your current debts and any disputes you may have over a closed account or one that was potentially fraudulently opened.
When you apply for credit and the lender needs to do a “hard inquiry” on your credit report, this may hurt your score, but only by a tiny amount. And the small drop is just temporary. Just know that there is a big difference between you checking your credit and you applying for credit.
Will Paying Debts Will Clear Up Your Bad Credit History?
Of course, it’s always a good idea to pay off your debts. In fact, your payment history makes up 35 percent of your credit score, so it’s no surprise that late payments have a strong impact on your score.
However, late payments still appear on your credit report after you pay them off, staying on your reports for seven years before finally falling off. The more late payments you make, the more your credit history will be damaged.
A common credit misconception is the belief that paying your bill on the day of the due date is acceptable. But make sure you’re checking the payment posting date. Oftentimes, the payment doesn’t get posted right away and could result in a late fee.
Can You Pay An Agency To Improve Your Credit Score Fast?
You might get email pitches from companies promising to rebuild your ailing credit score instantly or in just a few days. Ignore these. There is no way to instantly rebuild a credit score. It takes time, a new history of on-time payments and a reduction in your debt. Companies promising to fix your credit quickly? They are usually charging you for actions you can easily do yourself.
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