It’s time to start building your credit, but maybe you don’t know where to start. People with good credit scores enjoy lower interest rates on credit cards and loans, a better chance for credit card approval, more negotiating power (if you’re refinancing a loan), and easier approval for insurance and housing rentals.
When it comes to financing a car, getting a mortgage or taking out a personal loan, the difference between a good credit score and a bad one can save you tens of thousands over the course of your life.
The good news is there are proven strategies to help you build good credit. If you’re looking for some practical ways to build your credit from scratch, here are some steps you can take.
How Credit Works
Before trying to build your credit, it’s important to understand how credit works. There are many myths and misconceptions about credit.
When someone refers to your credit, they are generally talking about a 3-digit number that determines how trustworthy you are as a borrower. The higher your score is, the more responsible you appear to be in the eyes of lenders, and the better the interest rate you will get on any loan.
If you get a credit card or a loan, the lender will report your payment history to the three major credit bureaus: Experian, Equifax, and TransUnion. FICO and VantageScore are companies that provide credit scoring models that calculate your credit score based on what is reported to them by lenders and institutions about your financial activity.
Payments for your rent, utility bills, or cell phone bills are usually not reported to the credit bureaus.
Know What Impacts Your Score
Your credit score is made up of the following factors:
- Payment History - 35%
- Credit Utilization - 30%
- Length of Credit History - 15%
- New Credit - 10%
- Credit Mix - 10%
Payment history and the amount of debt you owe make up over 60% of your score, so these are two important factors to prioritize.
Payment history just means making payments on time, so try never to make a late payment and your score will go up.
Credit utilization is the amount of credit you used divided by the amount of credit you were extended. If you had a $1,000 credit limit and you used $100, that would mean your credit utilization is 10%. A good rule of thumb is to keep your credit utilization below 30%.
Building Credit Tip #1: Get a Starter Credit Card
One of the best ways to build a good credit score from scratch is to get a credit card. This is because you can build positive credit history each time you make a payment. The longer you keep the card open, the longer your credit age gets which is also a good thing.
There are two types of credit cards: secured and unsecured. An unsecured credit card is what your probably familiar with. The bank extends you credit, you swipe the card, and then you have to pay the bank back every month. This is risky for the bank because if you don’t pay them back, they eat the cost. This is why if you’re new to credit or have a low credit score, it may be difficult for you to get an unsecured credit card.
With a secured credit card, you have to put a deposit down, which serves as your credit limit. The bank is taking no risk since if you miss a payment, they can keep your deposit. Secured cards are a great way to get credit from a bank, so that you can prove you are a reliable borrower by making your payments on time. Then in the future, you can get an unsecure dcard and take advantage of all the benefits and rewards that come along with it.
You can start with a secured credit card which may require a deposit of $200 - $300. Some of the best secured credit cards include Discover It and Capital One. Whether you’re using a secured or unsecured credit card, try to choose a card that doesn’t charge a lot of fees and keep your utilization below 30% at all times.
Building Credit Tip #2: Become an Authorized User
If you don’t want to get a secured credit card, another option is to become an “authorized user” on someone else’s card that you trust. Say a family member has a credit card and they add you as an authorized user.
You will get credit for their on time payments. But be careful. Because if you’re an authorized user on someone else’s account and they make late payments, your credit score will be impacted negatively as well.
Building Credit Tip #3: Credit Builder Loan
A credit builder loan’s sole purpose is to help build your credit. Similar to a secured credit card, the bank takes no risk when they give you a credit builder loan. This allows you to get a loan without having good credit to begin with, which helps you build your payment history.
With a credit builder loan, you are lent money into a savings account that you can’t actually use. Then, every month you pay installments to pay off the loan. Once the loan is paid off, you have access to the funds in the savings account plus any interest the funds have accumulated.
It’s a bit of financial engineering that allows you to demonstrate a payment history which improves your credit score. Each payment is reported to the credit bureaus as positive credit history. Once you’ve finished making payments, you’ll receive the savings minus fees and interest. Most banks and credit unions will offer credit builder loans.
What’s great about these types of loans is that you don’t need a good credit score to qualify. The downside is that interest rates for a credit builder loan may be high (since the bank wants to make money off the loan). You’ll also want to make sure the lender reports to all three major credit bureaus because some don’t.
Monitor Your Credit
Do you know what your credit score is and how it’s changing from month to month? It’s important to monitor your credit so you know where you stand and can track your progress. We recommend using sites like CreditSesame, CreditKarma, and Discover Scorecard which are free credit monitoring services.
These sites will also give you recommendations on how you can improve your score. You also want to make sure all the information on your credit report is accurate. Companies make mistakes all the time and you don’t want any errors to negatively impact your score.
Getting a great credit score won’t happen overnight, but with the right strategy you can build your credit from scratch over time. Focus on practicing healthy financial habits and understanding how credit works.
Then consider using tools like a secured credit card, becoming an authorized users, or a credit builder loan to build positive payment history.