When you're ready to open a credit card or take out a loan, the credit card company or lender will check your credit report and credit score to learn about how you've managed credit in the past.
If you have a long history of effectively managing credit and making payments on time, you're likely to have a good credit score and will be more likely to be awarded the credit card or loan with favorable terms and rates. If you've never used credit or have negative information on your credit report, like missed payments, you may be less likely to secure a loan or credit card. If you do get the loan or credit card, you may get less favorable rates.
Building credit takes time, so it's important to begin building your credit before you really need it.
How to Build Credit with a Credit Card
Credit cards are a very useful type of credit tool, and when used wisely, they can help you build your credit. However, it's important to manage credit card use, because credit cards can also be a route to debt if you misuse them. Here are four ways you can build credit with a credit card:
- Open your first credit card account. If you have already established some credit history, look for a card with a low spending limit, which may be easier to qualify for if your credit history is limited. Make small charges that you can easily pay off right away, and pay the balance in full every month. This will help build a profile on your credit report of responsible credit use and reliable payment.
- Get a secured credit card. If you have little credit history or negative history, it may be difficult to get a regular credit card. A secured credit card may be an option. Secured credit cards are usually tied to a savings account, and the limit on the card is typically the amount in the account or a percentage of it.Just as with a regular credit card, you build credit with a secured card by making responsible charges, keeping your balance low or at zero, and paying on time every month. Not all lenders report secured credit cards to the credit reporting companies, but the lender may be willing to convert the account to a traditional credit card after a certain period of time. You should ask these questions prior to deciding whether to open any account.
- Open a joint account or become an authorized user. If you're having trouble getting your own credit card, another option for building credit is to become an authorized user on someone else's account, or to open a joint account with someone who has a good credit history. Parents may choose to help a younger person with little credit history by adding him or her to the parents' existing credit card accounts as an authorized user, or by opening a new card jointly. For joint accounts, you are responsible for repaying charges on the card, and so is the other account holder. If you don't repay money borrowed on a joint account, the joint cardholder will have to, or you'll both feel the credit impact of late or missed payments.
- Request a credit limit increase. After you have paid down your debt and decreased your utilization rate, or if your credit is already in good standing, you may consider asking for a credit limit increase from your credit card provider. Your credit utilization ratio is a comparison between the total amount of credit available to you versus the total amount you're using, and it's an important factor in your credit score. A credit utilization ratio of 30 percent or less is often considered good by lenders and others; the lower the ratio the better it is for your credit score. For example, if you have $1,000 of available credit, and only owe $200, your credit utilization ratio is 20 percent. Increasing your available credit can lower your credit utilization ratio and positively impact your credit score, as long as you're careful not to charge up to your new limit. The lower your utilization rate is, the better your credit score will be. On the other hand, asking for a credit limit increase when you have high balances may not be the best approach, since it may be difficult to get a provider to agree to an increase and it could increase your risk for adding more debt if your spending is not managed properly. This in turn, would negatively impact your credit.
How to Build Credit without a Credit Card
Credit cards aren't the only option for building credit. Remember, your credit report is a snapshot of how well you manage what you owe. Whenever you use credit wisely, that information can be included in your credit report. Here are five ways to build credit without a credit card:
- Pay student loans diligently. If you've got a college degree, you probably have at least some student loan debt. Student loans are reported to the credit bureaus, so making your student loan payment on time every month can help build your credit.
- Take out an auto installment loan. Auto loans are among the easiest types of loans to obtain, although the interest rate and terms can vary greatly depending on who underwrites the loan for you. If you are planning to buy a vehicle, shop around for the best possible deal, secure the loan and make the agreed-upon payments on time every month. If you have trouble finding a loan on your own, you may need a co-signer to share responsibility for the payments. Other types of installment loans will also help you with builidng credit history, such as mortgages and personal loans.
- Obtain a secured loan. Banks and credit unions understand it's not always easy to build credit when you're starting out with little credit history or negative marks on your credit report. Some offer credit-builder loans, or passbook/CD loans — low-risk loans designed specifically to help you build credit. They work much the same way a secured credit card works; for a credit-builder loan, you deposit a certain amount into an interest-bearing bank account and then borrow against that amount. The deposit is your collateral, and you'll pay interest at a higher rate than your deposit earns it. For passbook or CD loans, some banks allow you to use an existing bank account or certificate of deposit as collateral for the loan. Before you take the loan, confirm with the lender that your on-time payments will appear on your credit report.
- Non-profit lending circles. Organizations such as the Mission Asset Fund (MAF) and its non-profit partners have been gaining popularity and have expended across the nation by providing low-income borrowers a way to get financing while building credit. Organizations such as these can provide affordable loans and report positive payment history to the credit bureaus.
- Ask for credit where credit is due. Just because you've never had a loan or credit card doesn't mean you don't know about paying bills. If you reliably pay your rent and utilities on time, you've demonstrated good money management habits and you can ask for credit for that good track record. Rental payments and utility bills don't typically appear on a credit report — unless you fail to pay and the leasing company or service provider sends the delinquent amount to a collection agency or files suit against you to recover the past due amount. However, recently some companies have been taking steps to change that. Experian was the first to include positive rental payment information on its credit reports, so you can ask your landlord to report your positive payment history to the credit bureaus. Experian also offers an Extended View score, which incorporates information from public records and sources beyond credit reports to help give lenders a more complete picture of an individual's money and credit-management habits. If you're having trouble getting approved for an auto loan, for example, you can ask the finance company to request an Extended View score from Experian.
How to Establish Credit When You Have No Credit History
It is possible to have no credit history at all, especially if you're young, which can make it hard to open a credit card or obtain a loan. In addition to the strategies outlined above, you can try the following tactics.
How to Establish Credit:
- Ask someone with established credit to co-sign a loan for you, open a joint credit card account or add you as an authorized user to an existing credit card account.
- Ask your landlord and utility companies to report your positive payment history to the credit bureaus.
- Ask a potential creditor to request your Extended View score from Experian, or Vantage Score from all three major credit bureaus. These scores incorporate more sources of information to build a better picture of your financial history.
How to Build Credit Fast
Building credit is a long-term investment and there's no single thing you can do to make that happen immediately. Credit history will gradually build as you continually increase the number of on-time payments. Even improving credit takes time, where the fastest change of bringing all accounts current, can take 30—60 days to reflect on your credit report. The best way to build and improve credit is to do so steadily, by paying all your bills on time every month, managing your credit utilization ratio and ensuring you use a mix of credit types wisely.
The Basics: How Credit Works
Your credit report and credit score reflect how well you managed your financial responsibilities over a certain period of time. Obviously, there are rewards for handling your credit well. Having a good credit report and credit score can give you the ability to:
- Obtain credit cards and loans
- Improve your lifestyle through purchases that are only possible with credit
- Obtain services more easily if you have a credit card, like renting a car. (Without a credit card, there could be additional requirements, including a credit inquiry.)
- Have the resources to pay for unexpected emergencies
- However, there are risks involved with credit. Poorly managed credit can land you deeply in debt, and recovery is not easy. You can't restore a good credit history overnight, but you can improve your credit record over time.
The rules of credit are few and simple. A lender extends you a line of credit. You agree to pay the lender back the amount you spend plus interest charges and perhaps additional service fees. A payment schedule is set up, and you are required to make payments according to that schedule. The most important advice is to pay your bills on time.
Types of Credit
Consumer credit (the kind of credit you use, as opposed to what corporations might) is generally available in four types:
- Revolving credit: This type of credit is open-ended; when you borrow, you'll agree to repay a certain amount each month, but you won't be expected to repay all the money by a definite end date. Instead, you'll be able to carry a balance and borrow more — up to a preset limit — each month. The longer the principle of the debt remains unpaid, the more interest you'll pay on it. Credit cards are the most common form of revolving credit.
- Charge cards: They look and work much like credit cards, but with charge cards you have to pay the balance in full each month.
- Service credit: Anyone who provides you with a service and bills you in arrears (after you've received the goods or services) is extending service credit to you. This type of credit includes your utility companies, landlord (if you rent an apartment), mobile phone provider, etc. Each month, you pay an agreed-upon amount. While this kind of credit doesn't typically appear on credit reports, if you fail to pay your bills on time, these creditors could report the late payments to the credit bureaus or send the account to a collections agency that reports late payments, causing the negative information to appear on your credit report and harm your credit score.
- Installment credit: This is the kind of credit most people typically think of as loans. If you have a mortgage or a car loan, it's installment credit. It's probably the most commonly used and easiest form of credit to understand. You borrow a specific amount from a lender, and agree to repay it with interest in installments of a specified amount over the life of the loan — usually ranging from months to years.
Understanding Your Credit Report
Your credit report is a record of your credit history over time. There are three major credit reporting agencies, or credit bureaus: Experian, Equifax, and Transunion. Each provides its own credit report. (You can check your 3-bureau credit report.)
Your credit report will generally contain the following types of information:
- Personal information: This will include your "vitals," such as your name (and any aliases or common misspellings that may have been reported by a creditor), social security number and any variations that may have been reported, birth date, current and previous addresses, and current and previous employers. It does not include information about marital status, bank account balances, income, education level, race, religious preferences, medical history, personal lifestyle, political preferences, friends, criminal records or any other information unrelated to credit.
- Trade account information: Here you'll find a list of your open credit accounts, including the creditor's name, your account number, the amount you owe, your available credit limit or original loan amount, and whether you've paid on time and are current on payments. You'll also find data on closed accounts, including the payment history on those accounts and whether or not they were closed in good standing. Negative information on credit reports can include missed or late payments and charge-offs. Learn more about the types of negative information that can appear on your credit report.
- Public Record Information: Credit reports also contain information from the courts, including bankruptcy filings, tax liens, and civil judgements. Public records can negatively impact your credit.
- Credit inquiries: Your report will show hard inquiries based on actions you have taken, such as applying for credit or financing or as a result of a collection. Soft inquiries are not shared with potential creditors. These include prescreened credit offers, employment requests, account reviews from creditors you already have a relationship with, and your own requests for your credit report. Soft inquiries on your credit report are only visible to you, except: (1) insurance companies may be able to see other insurance company inquiries; and (2) inquiries by debt settlement companies you have authorized to access your report may be shared with your current creditors.
If you're looking for ways to improve your credit, taking care of negative information can help. Contact the reporting agencies if you find any inaccurate information on your credit report, pay down high balances, and bring all accounts current if you've fallen behind on any payments.
You can also learn more about understanding your Experian credit report.
How Credit Scores Work
No campaign to build credit would be complete without giving some attention to your credit score. Before deciding to loan you money, potential creditors will probably consider your credit score.
A credit score is a number, generally between 300 and 850, that lenders use to predict how likely you are to repay money you've borrowed. The score is based on information in your current credit report, called credit score factors. It's intended to be an objective, reliable way for lenders to assess a borrower's potential creditworthiness.
Because there are multiple credit reporting agencies and many different credit scoring models (the equations for calculating credit scores), you have far more than one credit score. Credit scores are not included in a credit report and when separately requested, are calculated at the time of request. Generally, however, FICO and Vantage Score are the most commonly used types of credit scores in lending decisions.
Information on your credit report that can influence your credit scores includes:
- Payment history
- Credit utilization ratio
- Types of credit used
- How long you've been using credit
- Total balances on all debts you owe
- Public records like tax liens or bankruptcies
- The number and recency of credit accounts you've applied for
Financial Behaviors and Credit Mistakes to Avoid
Some financial behaviors can undermine your efforts to build your credit, so it's important to know what to avoid. Here are four common mistakes:
- Not understanding how much you can afford. In general, a 43% debt-to-income ratio should be taken into consideration when taking on additional debt. The debt-to-income ratio is all of your monthly debt obligations divided by your gross monthly income. The CFPB states that evidence from mortgage loan studies suggests that consumers with higher ratios are more likely to have difficulty making monthly payments.
- Not having a budget. A personal budget is a necessity for all aspects of money management. Knowing how much you're spending and saving every month can help you make better decisions about how to use credit and how to manage debt.
- Failing to shop around for installment loans. Choosing an installment loan, such as an auto or mortgage loan, should be like any other buying decision. You should comparison shop for the best possible deal. Comparison shopping can help you find the lowest available interest rates, fees and service charges. Lenders recognize this shopping behavior and credit scoring systems take this into consideration, as well, for inquiries made in a short period of time.
- Failing to protect yourself from fraud. Credit card companies already take measures to reduce fraud, and federal law protects consumers from some effects of credit fraud. However, it's important for you to take steps to protect yourself as well. Review your credit statements every month and monitor your credit report. Take care of cards by carrying only the ones you need in your wallet. Shred statements and receipts that have your account number on them, as well as any credit offers you receive in the mail.
- Applying for multiple credit cards in a short amount of time. Suddenly taking on a lot of potential new revolving debt is a strong sign of risk and could indicate that you may use more credit than you can actually repay. This could negatively impact your balance-to-limit ratio and increase the number of hard inquiries impacting your credit.
Credit can be a powerful tool to help you achieve your financial goals. It's important to understand how it works, how to build your credit and how to ensure your credit history always works for you.