There are few financial milestones that you can hit in your life without first establishing credit. From buying a home, taking out a car loan, or paying for school, credit allows you to make a large upfront payment without having the total cash needed on hand. All of these important purchases rely on your credit score as a quick guide to your financial past. But what if you don’t have any credit to show for a loan?
The Consumer Financial Protection Bureau (CFPB), estimates 45 million Americans may not have a credit score at all. Those who are ‘credit-invisible’ might find it hard to get a good rate for a loan, or may not qualify at all. If you have a short credit history or are credit-invisible, now is the best time to start actively investing in building credit.
What is My Credit Score?
Before focusing on how to build good credit, it is important to understand what a credit score means. A credit score is a numerical representation of your credit history. This is not to be confused with a credit report, which represents the history of your borrowing from day one. Your credit score under the FICO scoring system, the industry standard, will between 300 and 850.
300-629: Bad credit
630-689: Fair credit
690-719: Good credit
720-850: Excellent credit
The better your credit report and history, the better your credit score.
6 Ways to Build Credit Responsibly
If you don’t have a credit score already, it might feel like an uphill battle to get started. However, Experian, one of the three major credit bureaus, estimates that it only takes between three and six months of regular credit activity for a credit score can be calculated. That’s no time at all! So what are some options for getting started and build your credit responsibly?
1: Become an authorized user on someone else’s credit card
If you have a willing friend or family member with good credit, becoming an authorized user on their credit card account is a great step to building credit. You don’t even need to use the card once your information has been added. As long as they continue to practice good credit habits your credit will grow alongside theirs. However, this also means that if the primary account holder is not practicing good credit habits, your score will reflect these poor practices. Be careful when considering who you ask to sign on with.
2: Co-sign on a credit card or loan
Similar to becoming an authorized user on someone else’s credit card, co-signing a credit card or loan agreement with someone who has strong credit is a great way to get started. You will again want to pick someone who you are close to and who has established strong credit habits already, as you will benefit with better rates. The co-signer has to agree to take on the card balance or loan if you are unable or stop paying. As a part of the Credit Card Accountability Responsibility and Disclosure Act of 2009, anyone under 21 is required to have an adult co-signer to open a credit card if they cannot prove an independent means of income.
3: Rent payments
Paying a mortgage on time each month is a great way to maintain a strong credit rating. Renters might have to do a little more legwork to confirm that their on-time payments get back to a credit reporting agency. Not all landlords report this information, so there are services like RentTracker or PayYourRent will help you report that information to the three major credit bureaus and allow you to build up your credit history. You could also use similar services to get credit for paying your utilities or phone bill on time.
4: Student loans
Often a student loan is someone’s first endeavor into establishing their credit. Paying off a student loan may not be the fastest way to establish credit, but it does mean you will have a longer credit history when graduating. The key is paying off each installment in full and on time. Graduates might consider setting up automatic payments so they don’t have to do this manually each month. As with other methods of credit building, there is the potential for student loan payments to have a negative impact on your credit if you are not paying off the balance in full and on time each month.
5: Use a credit-builder loan
Credit-builder loans are a nice option for someone who might not qualify for a personal loan, but who wants to build their credit, rather than making large cash payments for future purchase. After being approved for a credit-builder loan, the lender will place the loan amount in a locked savings account. The borrower will make payments towards the loan until it is completely paid off in full, and the savings account is unlocked to the borrower. At that time the lender will also report to the credit bureaus your payment habits, and start your credit history. This option is generally offered by credit unions, community banks, and smaller financial institutions, and the loan amounts can range between $300 and $1500.
6: Apply for a secured credit card
If becoming an authorized user on a family member or friend’s credit card isn’t an option, a secured credit card is a strong alternative. After being approved for the secured card you will deposit an amount of money into an account offered by the card company. Your line of credit will match the deposit amount you have made. While this might sound similar to a debit card, a secured credit card will count towards your credit history, and a debit card won’t. Some card issuers will include a ‘graduation’ component, allowing the holder to transition their secured card into a traditional credit card after establishing a credit history.
Build Credit With Good Habits
Your FICO is determined by the following factors, with the weighting for each factor in the calculation:
Payment History (35%)
Credit Utilization (30%)
Credit History (15%)
New Credit (10%)
Credit Mix (10%)
Once you have established credit, you have to have to maintain or improve your score. Some good habits for a healthy credit score include:
On-time payments—Not only is being on time a great professional skill, it will also establish trust with lenders. Late payments will also lead to fees.
Paying your balance in full—Rather than carrying a balance, whenever possible make a complete monthly payment on a loan or credit card. This will show lenders you are only spending what you can afford.
Credit utilization—Utilization is your balance when compared to your credit limit. The rule of thumb in the industry is to keep your credit card utilization below 30%.
Keep old account active—If you have an old account open that doesn’t cost you any money to keep open, keeping it open rather than closing could be a positive mark on your credit score. Even if you no longer use the card, it shows a longer history of your credit, and would be counted towards your utilization.
Open new accounts—Showing that you are continuing to open up new lines of credit is a positive sign for credit bureaus. However, do not open too many accounts at the same time, as hard requests for your credit score will actually bring it down.
Have both revolving and installment credit accounts—Revolving credit is credit that is automatically renewed as you pay off your debt, like a credit card. Installment credit is a loan for a fixed amount, like your student loan or a mortgage.
Check your credit report often—Each of the three credit reporting bureaus, Equifax, Experian, and TransUnion, offer a free annual credit check. Checking your own credit score does not impact your credit, so be sure to utilize these free checks.
Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide financial, legal, or tax advice.