Learn How to Establish a Solid Credit History
Credit is one of life’s Catch-22’s: It is hard to get credit if you don’t already have it, and if you already have it, then you might not need it. But there are several ways to establish your credit, and with patience, you can work your way up to high credit scores.
Why You Need Credit
If you don’t have a credit history, nobody knows whether or not you have repaid loans in the past, and lenders tend to be hesitant about lending to new borrowers (or those who have fallen on hard times recently).
Good credit can help in several areas.
Borrowing: The most common use for credit is loan approval. When you apply for a loan, lenders primarily look at your borrowing history and your income available to repay the loan. If you’re an experienced borrower with a solid history of paying on time, it’s easier to get approved. Over time, you can get approved for increasingly large loans, including home loans.
Renting: Good credit can help you when renting a house or apartment. Landlords don’t know you, so they use credit scores as a way to evaluate you as a renter. This isn’t always an accurate gauge, but some landlords put a lot of faith in those scores, so you’re better off with good credit (or at least a lack of negative items in your credit history). Some landlords use specialized scores look at more than just your borrowing history and public records that are included in standard credit scores.
Applying for jobs: Credit can also affect your ability to get a job. For many positions, your credit isn’t an issue. But if you want to handle funds or work on high-security projects, bad credit can hurt your chances of getting an offer.
Insurance scores: When buying auto insurance, your credit can affect your ability to buy and the rates you pay.
As with renting, there isn’t a direct parallel between your credit and your driving behavior, but insurance scores are a reality.
Who Needs to Build Credit?
To live in the mainstream modern world, you need credit. Sure, you can live without a credit score, but certain things will be more difficult, and if you change your mind someday, you’ll have to start from scratch. There’s no need to borrow unwisely or pay more interest than you need to — credit and borrowing are simply tools that you have available to use when appropriate.
No history: If you’ve never borrowed in the past, or your previous loans are not on file with the three major credit reporting agencies, you need to establish a credit history. This may be the case if:
- You’ve never borrowed before (whether you’re young or you’ve just avoided debt).
- You’ve recently arrived in the United States.
Negative items in your history: If you’ve borrowed in the past — but missed payments or even defaulted on loans — you can improve your credit using the same techniques as somebody who’s starting out. Collection accounts, foreclosure, and bankruptcy can all be overcome. The key is to start rebuilding and add positive items that eventually outweigh those negative items.
How to Build Credit
To establish a credit history that will be attractive to lenders and others, you’ll need to borrow money and make all of your payments on time. It’s that simple, but it’s not necessarily easy. You can certainly see improvements in a short time period, but significant changes take time.
The strategies below will help you get short-term momentum and establish a solid credit history that will serve you for the rest of your life. You don’t have to move through these in order, but the easiest approaches are listed first, especially if you’re on your own (without parents or others helping). Depending on your needs and your resources, some of these options might not be a good fit.
If they don’t, you won’t improve your credit. Ask your lender if they report to credit bureaus before borrowing, and then verify by checking your credit reports after at least 30 days.
Cash-secured loans: One of the easiest loans to qualify for is a loan that you’ve already paid off. With a cash-secured loan, you borrow against money that you have in a savings account or certificate of deposit (CD) at your bank or credit union. As a result, the lender takes very little risk – they can just take the cash if you fail to make payments – and it’s easier to get approved. As an example, you might deposit $500 at your bank, and you’d get a loan for $500. You’d make small monthly payments on the loan, and over time your credit would improve. These loans go by a variety of names, including credit-builder loans.
Secured credit cards: A variation on cash-secured loans, a secured credit card also allows you to borrow against money that you’ve deposited with a lender. The difference is that you’ll get a plastic payment card that you can use for in-person or online purchases. You can also keep your loan balance at zero (you don’t have to keep a balance on the card), which helps to minimize interest costs. Note that a secured credit card is not the same thing as a prepaid debit card.
Help from a cosigner: A cosigner is somebody who signs your loan application with you and helps you get approved. The cosigner should have good credit and enough income to qualify for the loan because they’re basically the ones getting approved (although the loan proceeds will go to you). If anybody is willing to do this for you, that loan will help you establish credit as long as you make all of the payments on time. Cosigning is a huge favor, and it’s risky. If you fail to make payments, the cosigner is 100 percent responsible for repaying the loan, even though you got all of the money.
Authorized user: If somebody already has a credit account open, they can add you as an authorized user. You’d get a card printed in your name, and you’d have the ability to use the card for purchases. However, you’re not responsible for repaying the loan.
Retailer programs: Instead of borrowing directly from banks and credit unions, you can borrow through retailers, who fund loans using finance companies or banks. You’ve probably seen offers to buy merchandise on a monthly payment plan or “same as cash,” and those programs can help you build credit. The same goes for cards issued by stores and gas stations. They may be easier to qualify for than standard credit cards, but you need to make sure that the loan activity will be reported to credit bureaus. Just be sure to pay off your balances quickly. Don’t get caught in the trap of paying minimum payments or you’ll end up paying more for everything you buy.
Personal loans: You can also just apply for “signature” or personal loans at your bank or credit union. Using an unsecured loan helps you move beyond credit cards and loans from retailers. Instead of paying as you charge, you’ll make a regular monthly payment (which the credit scoring programs like to see). With an unsecured loan, you don’t pledge anything as collateral, so the lender takes more risk and charges higher interest rates.
Keys to Building Credit
Check your credit: Make sure that your credit reports are free of any errors that will hold down your credit scores. Especially when you have thin credit or you’re recovering from a rocky past, errors prevent you from getting the scores you deserve. Fix those errors so that somebody else’s mistakes don’t prevent you from getting the credit you deserve. The US Government requires the credit bureaus to provide a free credit report to you annually, and you should take advantage of that right.
Always pay on time: One of the most important pieces of your credit score is your payment history. If you pay on time, your credit will improve. Late payments on loans will prevent you from making progress, and it’s probably better to skip borrowing altogether unless you’re confident about making payments.
Set yourself up for success: Get financially prepared to ensure that you’ll afford your payments and get them in on time.
- Open checking and savings accounts if you don’t already have them, and learn how to use online bill pay.
- Understand your income and your expenses, and build a budget so that you stay on track.
- Balance your checking account regularly to avoid any unpleasant surprises.
Borrow in moderation: There are several reasons to borrow less than your lenders will allow you to.
- Credit utilization. Credit scores look at how much you’re currently borrowing compared to how much you’re allowed to borrow (your maximum credit limits, for example). If you use a small percentage of your available credit – less than 30 percent or so – you don’t raise many red flags. But if you consistently max out your credit accounts, it can look like you’re struggling financially, and your credit scores may drop. Even if you pay off your credit card every month, running up the balance can be problematic.
- Borrowing costs. You pay interest and other finance charges when you borrow, so you effectively pay more for the things you buy on credit. In some cases, you’ll pay more in interest than you did for an item you purchased. Borrowing can make sense when it brings a long-term improvement in your life or your financial situation, but borrowing for “wants” is dangerous for your finances.
Diversify your loans: As you build credit, use different types of loans. Credit scoring models reward you for having a variety of loans for different purposes, including revolving credit (credit cards), auto loans, home loans, and student loans. Don’t take on debt unnecessarily, but use the right type of debt when borrowing makes sense.