Everyone is constantly talking about how important it is to build a good credit score but very few people can actually tell you why and how. If building credit is that important, then there should be more reasons than simply that it will help you get a loan or a credit card easily, right? Trust us on this one, there is a lot more to why building credit is so important than just those reasons.
The process of building credit, the length of the process, and the steps you need to take to ensure you build credit correctly are also not talked about as often as they should be. If you are new to the credit world, all this information is absolutely essential for you.
Without knowing how to properly build your credit, you could be exposing yourself to several risks that could end up hurting you more than helping you.
Luckily, we’re here to walk you through the credit building process.
Why is it so Important to Establish Credit?
The current state of your credit history determines your credit score. A credit score indicates how financially responsible you are to your banks, lenders, landlords, employers, etc.
A good credit history and good credit score gives you access to money to purchase things you need in life. If you learn to build credit and maintain it well early in your life, it will help you gain more leverage when you set out to buy a house, purchase a car, rent an apartment, or get an offer for that job you applied to.
Here are some real-life situations where a good credit could be beneficial for you:
1. Applying for a credit card
This is probably the most obvious situation in which a great credit score can be beneficial. This is because credit cards are the easiest way to build up your credit score and also the easiest way to destroy your credit score. Credit card companies will check your credit because they want to make sure that you will pay them back for the money you spent all month on the credit card. They are essentially giving you a loan for the month and expecting you to pay them back for it at the end of the month. If you have a poor credit score, they will charge a higher interest rate to compensate themselves for the extra risk you provide.
2. Renting an apartment
Often times when you rent an apartment, the landlord will require you to pay an application fee. This is because the landlord is going to take that application fee and use it to run a detailed background check, including your credit history and score. Landlords want to see your credit history and score because they don’t want to rent to someone who has a history of not paying their debts. They don’t want to be on the losing end if you stop paying your rent.
3. Buying a home
When you decide to buy a home, you may escape the landlord looking into your credit history, but you won’t escape lenders looking into your credit score. Unless you have loads of cash stashed away, you’re probably not going to pay for your house in cash. You’re going to need to go to a bank or some other lender and take on debt in order to pay for the house. These lenders or banks want to make sure that you have a history of paying back your debts before they dish out a huge sum of cash to you.
4. Getting a job offer
Most employers will do a background check, some even do a credit history check, before offering you a job. Employers may get a modified credit report showing debt and payment history. You’re probably asking, why does my potential employer care about my credit history? They care because if you show signs of financial distress or have a poor credit history, you are more prone corporate fraud or theft.
5. Obtaining a personal or business loan (or any other type of loan)
If you ever need to take out a small personal loan or are trying to start a business and need to get a loan, the lender or bank will definitely run a check on your credit report. This is for the same reason as when you apply for a mortgage. The lender wants to make sure that you are going ot pay back your debts before they give you the cash.
6. Applying for utilities
You probably wondering how your credit history can possibly affect your utilities. Seems strange, right? Well when you think about it, utilities are almost a form of loan. The utility company is providing you with water, electricity, gas, etc. and at the end of the month, you make a payment for what you used. They’re extending you services without payment for the entire month. So just like a loan, if you have poor credit, you may end up paying more for your utilities because you are riskier. There is a greater chance that you won’t pay the utility company back so they want to be compensated for that risk.
How Long Does It Take to Build Credit?
Building a good credit score is a slow process. You have to be conscious of your spending habits make sure that you are paying all of your debts on time – this includes credit cards, mortgages, personal loans, rent, utilities, etc.
According to Experian, an account will need to be open for 3 – 6 months before a three digit credit score can be calculated. A common myth about credit scores is that you start with a credit score of zero, however, a credit rating of zero does not exist. If you have never established credit, your score will just be non-existent.
Credit scores range from 300 to 850. Here’s a breakdown of how each score is looked at on the scale according to Experian:
300 - 579
Credit applicants may be required to pay a fee or deposit, and applicants with this rating may not be approved for credit at all.
580 - 669
Applicants with scores in this range are considered to be subprime borrowers.
670 - 739
Only 8% of applicants in this score range are likely to become seriously delinquent in the future.
740 - 799
Applicants with scores here are likely to receive better than average rates from lenders.
800 - 850
Applicants with scores in this range are at the top of the list for the best rates from lenders.
Why Does It Take Time to Build Credit?
Your FICO credit score is calculated based on your overall financial behavior. When calculating your score, FICO assigns weight to 5 criteria:
1. Payment history
2. Total debt
3. Length of credit history
4. New credit
5. Credit mix
According to FICO, the value assigned to each of these criteria is:
Your credit score takes time to build because of the criteria FICO used to calculate your score. When you look at the largest part of your score, payment history, that doesn’t happen overnight.
You are likely making monthly payments on all of your credit products and your score (your trustworthiness) isn’t earned from making one or two on time payments. It takes months and months, even years of repeated and consistent good credit behavior for your score to become very good or exceptional.
This is why it is so important to start building your credit as soon as you possibly can.
How to Start Building Credit?
Choose the right card for you
If you are just starting to build your credit, you probably shouldn’t be applying for the top of the line card with the $100+ annual fee. Remember, you are just starting to build credit. Get a simple card with decent rewards and a low credit limit. Use it for only absolutely necessary purchases and pay it off in full every month. Your credit score will thank you.
Look for low interest rates
Some credit card companies will have special offers or discounts for new credit users or for students. Take advantage of lower interest rates if you can find them. In reality, it shouldn’t matter because you should be paying off your balance every month, but in the event something happens and you are unable to make your payments, you want to make sure you are paying the least amount of interest possible.
Get a co-signer
Having a co-signer with good credit will almost certainly get you approved for a card. A co-signer is essentially someone guaranteeing to the credit company that if you don’t pay your bills, they can force the co-signer to pay them back. Most times, your parents will be a cosigner on your first credit card, but you need to make sure you are being responsible and paying your bills so that you don’t destroy your co-signers credit history.
Get a secured credit card
A secured credit card is a credit card that requires an initial deposit. Similar to a security deposit when you rent an apartment, credit card companies will require you to deposit a certain amount into an account that you cannot access. This way if you stop making your payments, the credit card company will take the deposit and close your card. It is a great way to start building your credit history because it is unlikely for lenders to deny you for this type of credit.
Become an authorized user
Becoming an authorized user is another great way to start building your credit. As an authorized user, you are not required to pay the bill, but you can still use the credit card. Most times, this will parents putting their kids on as authorized user if they are not able to apply for their own credit card because they are under 18 years old. This can help your credit score, but can also destroy it if the primary user stops paying the bill so it is important to weigh the pros and cons.
Get a Credit Builder Loan
A credit builder loan is also commonly referred to as a fresh start loan or a starting over loan. It is intended for someone who has poor credit or no credit and does not require good credit to get approved. Often times these will be offered by credit unions or other local smaller banking institutions. A credit builder loan is a loan that is held in a bank account while you make payments. Therefore, you need to have enough income to make these payments on time (or no later than 30 days late). The payments will be reported to the major credit bureaus and you will start to see an improvement in your credit score.
When Should You Start Building Credit?
Ideally, you should start building credit as soon as you can – at 18 years old. Now, you have to be responsible enough to handle having credit and make sure you make your payments on time. It is probably smart to get a card with a low credit limit and have your parents as co-signers if they will do it.
One of the greatest factors in your credit score is your length of credit history. Starting to build credit as soon as you can will set your credit history up for success as long as you are responsible enough to handle it.
What Harms Your Credit Score The Most?
Some financial habits can harm your credit history. The following are some habits that you need to avoid to boost your credit score:
Be punctual with your payments. Delaying your payments has a huge affect on your FICO credit score – more so than any other factors. Missed payments show a lack of funds or a general carelessness about paying your debts, both of which are poisonous to your credit score.
Pro Tip: Set a reminder for paying your bills a few days before the due date. Or better yet, automate your payments if you have the savings to do so.
Using too much credit
Lenders see a red flag when you use too much of your available credit. Using a large percentage of your available credit suggests that you are biting off more than you can chew and eventually you won’t be able to make your payments.
Pro Tip: Using under 30 percent of your available credit is considered good. Try to not cross the 30 percent limit unless it is absolutely necessary. You should really shoot for using under 10 percent of your available credit if possible.
Applying for more credit
Another bad financial habit is applying for several lines of credit in a short period of time. When you apply for a lot of credit very quickly, lenders, banks, landlords, etc. will take caution to this. Applying for a lot of credit quickly will give the impression that you have burned through your cash savings and are trying to get access to as much credit as you can to make your payments. Only apply for more credit if it is absolutely necessary.
Pro Tip: Space out your credit applications with a minimum duration of 6 months. However, try to keep your new lines of credit to 2 or less over a 2 year period.
If things like bankruptcy, charge offs, foreclosure show up in your credit reports, they stay there for many years. These negative records will make it very hard to get approved for new credit and it will be very difficult to improve your credit score. So, be careful to not get into these situations.
Pro Tip: Don’t take on more debt than you can handle. This is especially important for large chunks of debt such as mortgages.
3 Ways to Raise Your Credit Score in 30 Days
Even though building your credit score is a long-term game, there are a few tips that could help you boost your credit score in 30 days or less. Just remember to keep in mind, these are just band aids and maintaining a healthy credit history requires good, consistent credit habits.
Pay down your balances
If you are using a large percentage of your available credit (30 percent or more), paying down your balance to below 30 percent, or better yet, zero, could give you a quick boost. This is the best and most responsible strategy to quickly improve your credit score.
Increase your credit limits
If you are continually using over 30 percent of your available credit limit but still able to pay it off every month, then you might consider requesting an increase in your credit limit. An increased credit limit could help you stay below that 30 percent threshold. However, this is not recommended if you are having trouble paying your bills as it will only expose you to greater debt.
Get a late payment erased
Sometimes, we all make mistakes and forget to make a payment. If you have a history of making on time payments and have been a good customer for some time, your credit card company or lender will more than likely work with you. Often times, all it takes is a simple phone call asking them to remove the late payment and as long as you pay them the money they are owed immediately, most times they will erase the late payment.
Building your credit score is definitely a long-term game. You will likely be able to build a pretty good credit in a year or less, but if you want to build strong and stable credit, then maintaining good credit habits over several years will do the trick.
The most important thing to remember is that maintaining your dedication towards building a good credit score and never losing sight of the goal even in the face of adversity. Stay away from anything that could damage your credit history in the long term no matter how attractive they may seem to be now.