Most Americans know that it's important to build credit but many don't know how. If you're one of those confused about how to build credit, you're not alone.
In 2019, CNBC reported that around 40% of Americans don’t know how credit scores work. This is a disappointing but not altogether surprising statistic since credit-building is still absent from curriculum at most schools. Good for you for seeking out this valuable information!
Today, let's cover some credit-building basics. In this article, I'll share some tips on how to build credit quickly and easily.
What is Credit?
Credit is simply the ability to use borrowed money.
When you think of credit, you probably picture credit cards and loans (student loans, auto loans, mortgages, etc). But you’re also using credit when you use services like utilities, rent, and your cell phone plan.
Companies provide these services with the expectation that you’ll pay for your usage each month. That’s why you need to have some established credit to qualify for an apartment or a cell phone. And if you’ve ever been asked to put down a deposit for your utilities, it’s because you didn’t have enough positive credit history to assure your utility provider than you would make your payments on time and in full.
To build credit, you have to prove you can be trusted to meet your financial obligations. The only way to do this is to start using credit. Not sure how to get started? No problem, we’ll get into that in just a moment. But before you start your credit-building journey, you deserve to know why good credit matters.
Good credit opens financial doors. When you have a positive credit history, you’re more likely to qualify for an apartment rental, credit card, auto loan, or mortgage when you have good credit. But, just as importantly, you qualify for better interest rates on your loans.
Interest is the cost of borrowing money. The better your credit, the lower your interest rate. And the lower your interest rate, the less you pay to borrow money.
Take a mortgage, for example. If your credit score is just okay, you might be able to get an interest rate at 4.997%, but with excellent credit, you could get a rate as low as 3.408% (using late 2019 rates). Doesn’t sound like a big difference, does it? But on a 30-year mortgage for a $200,000 home, that interest rate difference can save you $185/month in interest. Over the life of your loan, you save $66,754 in interest!
The bottom line? Good credit pays. Bad credit is costly.
How to Build Credit
Okay, so how do you start building good credit?
Using a credit card to build credit is a quick and effective option. But be certain you use your credit cards wisely. Never spend more than you can afford to repay. And if you can pay your balance in full every month, you’ll never have to pay a cent in credit card interest!
Here are four ways to use a credit card to build credit:
- Become an authorized user. Ask a parent or guardian if you can be an authorized user on their credit card. Because the parent or guardian will be responsible for your credit card spending, the credit card company isn’t taking much of a risk by allowing you to be an authorized user. So you’re extremely likely to be approved as a user so you can begin building credit.
- Secured cards. With secured credit cards, you have to put down a deposit before you can use your card. If you were to fail to pay your bill, the credit card company would keep your deposit.
- Student cards. Student credit cards come with low credit limits to help students learn to use credit responsibly without getting into too much debt.
- Store cards. Store cards are typically easier to qualify for than general credit cards because they generally have fairly low limits and can only be used for certain stores.
If you’re afraid you’d get into too much debt with a credit card (and good for you for being self-aware and honest!), there are ways to build good credit without getting a credit card.
Here are three options:
- Student loans. For many of us, student loans are the only way we can afford college. While student loans aren’t ideal, at least they help you build your credit.
- Auto loans. As with student loans, auto loans are a necessity for many of us. And while we hate the higher interest rates, at least they provide a way to purchase a car and build credit.
- Ask for service credit to be reported. Service credit is less about borrowing money and more about owing money for services. Utility bills, rent payments, and cell phone plans all fall into this category. In most cases, your on-time payments aren’t reported to the credit bureaus. But if they were reported, they would help you build good credit. So contact your providers and ask if they can report your on-time payments.
It typically takes about six months to establish credit. That may sound like a long time, but remember, lenders need to see a history of responsible usage before they will trust you enough to lend you money. In terms of your overall financial life, six months is a drop in the bucket.
Start small. Maybe get a secured or student credit card. Put just a few necessities on your card each month and pay the bill in full before the due date. Then, in six months to a year, apply for more credit, like a second credit card with a higher limit. Use this card in the same way as the first to demonstrate that you can be trusted to remain responsible even with more credit.
Continue making payments on time every month, and before you know it, you’ll have excellent credit!
How are Credit Scores Calculated?
A key part of your credit history is your credit score. Your credit score is the numerical rating you’re assigned based on your history of credit use. You’ve probably heard the term “FICO Score”. This is one specific type of credit score.
Your credit score is composed of five key factors:
- Payment history: do you pay on time? Aim for zero late payments.
- Utilization: how much of your available credit do you use? Try to use less than 30% of your available credit limit.
- Length of credit history: how long have your accounts been open? The longer, the better. That’s why you don’t want to close your accounts.
- Recent activity: have you applied for more credit recently? Applying for too much credit in a six-month period looks suspicious.
- Credit mix: what kind of loans do you have? You generally don’t want to have only short-term, high-risk loans. Lenders are more comfortable if you have a mix of credit cards and installment loans (like a student loan, auto loan, or mortgage).
These five factors aren’t weighted equally. Some matter more than others. Here’s the breakdown for calculating your FICO Score:
- Payment history: 35%
- Utilization: 30%
- Length of credit history: 15%
- Recent activity: 10%
- Credit mix: 10%
For more on this subject, check out our handy guide to your credit score (and why it matters).
How to Increase Your Credit Score
Once you open your first credit card or get your first loan, you’ll increase your credit score over time simply by making on-time payments each month. If you're worried that you'll forget to make payments, set up auto-pay so you never have to think about it.
And there are a few other things you can do to quickly and easily increase your credit score.
- Correct any errors on your credit report. Errors on credit reports are surprisingly common and can drag your score down. Get a free credit report online at least once a year to check for errors.
- Don’t apply for too many cards at once. Space out your applications by six months to a year.
- Don’t carry a large balance. Keep your balance under 30% of your available credit to show that you’re not overextending yourself.
- Don’t close your accounts. Even when a credit card is paid off, keep the account open and use it for necessities once in a while. This will increase your credit history length and your overall credit score.
Having good credit is critical to your long-term financial health. To build good credit, you have to use credit tools wisely. Consistently making your payments on time is the best way to increase your credit score over time.
Building good credit doesn’t happen overnight. But it also doesn’t take much time or effort. Just use your credit responsibly and make those payments on time every month. Within six months to a year, you’ll have an established credit record.
But remember: Just because you have a credit card doesn’t mean you need to incur interest charges or credit card debt. Pay your bill in full every month to avoid credit card trouble.
Author: Michelle Clardie
Michelle Clardie is the founder of Savings and Sangria, a financial blog dedicated to #HappyMoneyManagement. With 20 years of investment experience and an MBA in Management and Strategy, she's teaching young(ish) women how to make saving and investing more fun. Hint: a glass of sangria makes everything more fun 😉