It would be an understatement to say that the world as we know it runs on credit. From used car loans to multimillion-dollar international business deals, credit, and the associated necessity of creditworthiness are essential pieces in the backbone of any economy. While it is wise to proceed into the credit world with caution, the fact is that, like it or not, it’s a necessity. Some people may be able to purchase everything with cash or live well on an inheritance, but for the ninety-nine percenters, the startup of a business, the purchase of a home, even the approval of a new job all require good credit standing. How do you build credit for the first time or repair a less than perfect history? The answer is not always simple or straightforward, but building credit is something any person with discipline and a steady income can achieve. The following article addresses ways to move your score skyward as fast as possible.
What is credit?
The concept of money lending is an ancient one, a business opportunity that was probably conceived not very long after the invention of money itself. In brief, credit is the receipt of money or valuables with the promise of paying it back later, usually with interest. Credit is a powerful tool in helping a person attend college, establish her business, or purchase important items, like a home. But it is also a double-edged sword, and the mismanagement of extended credit can result in a disaster, an expensive one that can take years to resolve. The establishment and maintenance of a good credit score are important for your future, and the essential foundation for obtaining the things you need.
How lenders assess creditworthiness
When lenders are determining your eligibility for credit, they are essentially gauging your level of risk as a client. They want to be sure that the money that they lend you will actually be repaid. Lenders use a formula for scoring your risk that takes into account several factors, including your income, your credit payment history (if you have one), and the diversity of the types of credit you have handled, such as mortgages, car loans, or credit cards. All of these factors are entered into a computer system that calculates the weight of each factor and generates your credit score. It’s also known as a FICO or Fair Isaac Corporation score, in reference to the organization that devised this simplified way of scoring potential borrowers.
Your score is a bit like the grades you received in school, with 90% equating to an “A”, 80% to a “B”, etc. FICO scores range from 300 (not good) to 850 (credit perfection, but almost no one has a score this high). Most of the country scores somewhere in the middle, between 630 and 680. The higher your score, the better your borrowing options and interest rates will be.
The two types of credit builders
Generally speaking, there are two types of people that need to work on their credit. There are those with little or no borrowing history who have not yet generated a score, and those that have had some financial troubles that may have damaged their FICO score. The two types differ a bit in what they need to accomplish as far as score building.
People that are new to borrowing, such as young adults or newcomers to the US, need to take a few steps and invest a few months in the establishment of a credit history. Conversely, those in credit recovery have their credit history working against them and have to take a different approach in proving their ability to manage credit and reestablish lender confidence.
Steps to building your score
1) Obtain a secured credit card – A secured credit card is one that requires a cash security deposit before a credit line will be issued. With these cards, the deposit will be a significant chunk, and the line of credit may not be very high at first. This might seem counterproductive, but remember that the purpose of the card is to prove your reliability as a borrower. The longer you hold the card and make timely payments, the more your credit line will increase along with your credit score. These cards are a great way for people with a thin credit history to get established. Likewise, embattled borrowers with a low score can begin to rebuild their credit file with this type of loan.
2) Become an authorized user – If you have a qualified parent, family member, or significant other that would be willing to sign on with you, ask them to add you on to one of their credit cards as an “authorized user”. This is a co-signing of sorts, giving you permission to utilize another person’s credit account for your own purposes. You will be issued a credit card with the same account number with your own name on it.
The advantage of becoming an authorized user is that since your personal information and social security number are fully attached, the activity on the account will be reported to the credit bureaus as your own. You can use the credit card per whatever arrangement you make with the card owner, or you can simply put the card away and let the owner’s activity do the work for you. The keywords here are trust and reliability. Be sure that you not only choose a cardholder that you trust will make financially sound decisions but also, if they allow you to spend in their name, be sure to reciprocate that trustworthy behavior. In this scenario, not only is your new credit score at risk, but also your relationship with that person.
3) Pay down balances quickly – One of the heaviest contributing factors of your credit score is the percentage of your available credit that you have in use. For example, if you have three credit cards with a total of $5000 in available credit and you’re carrying a total balance of $4650, your current credit use is 92%. For lenders, this is an indication that you have difficulty paying back your obligations, and maybe putting yourself at a higher risk of defaulting on a loan. Carrying a high balance on cards, even when you pay on time, significantly drops your FICO score.
Whenever possible, pay down the balances of your loans to less than 30% of the available credit line. Doing so will instantly raise your credit score by several points. This is actually a trick that is encouraged for people who are trying to purchase a home or car and are a few points shy of qualification. If you are having difficulty making this move, organize your credit balances and begin focusing on one card at a time, paying off the lowest balance first while making minimum payments on the others, then moving consecutively through the remaining cards.
4) Utilize a rent reporting service – This is a fairly new concept in the credit reporting world. Traditionally, the three credit bureaus, Transunion, Equifax, and Experian, only reported on the status of credit cards, mortgages, installment loans, or any collections that have been filed against you. In the past, people didn’t get credit for the bills they pay every month, like their rent or utilities. Although you can’t self-report these types of bills, new rent reporting services have been developed that can take up to twenty-four months of rent-paying history and apply them to your credit report, instantly pumping your score with on-time payment history. Note that different companies may report to different credit bureaus.
5) Monitor your credit reports – Don’t assume that what is being reported on your credit reports is accurate or that’s it’s being updated religiously. As consumers, we each hold personal responsibility to monitor our credit reports for errors and take action should we find any. You are entitled to one free credit report from each agency each year. Order an official report, and check the history thoroughly for erroneous missed payments, outdated information, and resolved accounts. You’ll be surprised how many errors actually go uncorrected on many reports.
The credit bureaus are responsible for reporting accurate information, but they are generally on the consumer’s side. You can not only correct errors quickly, but can often ask the reporting agency to request a dismissal of negative information early. Sometimes lenders are forgiving, especially if mistakes of the past were followed by diligent and timely payments. It takes some effort to do this, but it’s definitely worth it for the positive impact on your credit.
Also, once you have handled the bulk of your corrections through each agency, there are simpler ways to continue monitoring your reports. Many websites, such as Credit Karma, offer this service for free, and updated on a frequent basis, allowing you to keep on top of your hard-earned, squeaky clean reports.
6) Apply for a student credit card – If you’re a college student who has not yet established a credit history, apply for a student credit card right away. These cards are specifically designed to help young people get their credit scores off the floor and begin to develop the skills needed to manage the world of credit.
Don’t get carried away with spending if you get approved. Any errors that you make this early in the game will mar your record and set you back several years before you get a chance to set up a healthy credit history. Spend only what you know you can reasonably pay back within a month or so.
7) Use your credit card to your advantage – You can use your credit card to pay for virtually every cost of living. One trick that reflects favorably to your lender is to pay for all of your regular expenses upfront with the card, including gas, groceries, utilities, even car payments (sometimes), then immediately pay it off with the cash you would have used. This puts you well beyond the minimum monthly required payment and will save you a bundle on interest as well.
How to maintain your hard-earned score
Once you have begun to build a credit history, be sure to safeguard it. Make your payments early or on time every single month. It takes about six months to generate a credit score if you have no credit history, and may take years to reverse a damaged one. Paying every obligation on time without fail is the number one most important thing you can do to ensure a higher score.
The bottom line; Dos and don’ts of building credit
Remember, credit scores are generated by a number of unforgiving, semi-permanent factors. You want to use good credit hygiene early, and maintain a healthy and responsible approach to building your score and, eventually, better credit options.
DO:
- Pay as much as possible on your loans, every time, and keep balances as low as you can for maximal scoring.
- Partner with reliable, responsible people that are willing to help you achieve your credit goals.
- Use tremendous restraint and a conservative approach to credit usage to avoid costly setbacks.
DON’T:
- Use credit to have money because you need it, and don’t have any. Murphy’s law will apply to this scenario. This is a guaranteed way to end up defaulting on a loan. When you’re trying to build a credit history, use credit for things you can immediately repay to establish a foundation of trust with lenders. Credit is not free money, it’s a test of your ability to manage it.
- Rack up a bunch of credit cards in a short span of time. Doing so will negatively impact your score. Opening too many accounts too fast looks suspicious and unstable to potential creditors.
- Close your cards when you pay them off. Using self-discipline, simply let them stay open with little or no balance for the long term. The length of time that you hold your accounts is another vital piece of the FICO scoring system.
