Simple Guide to Building Credit

By Janet Berry-Johnson, CPA

Whether you’re looking to build credit for the first time or rebuilding credit after a few money missteps, you're probably facing a common conundrum: you need credit to have a credit score, but you need a good credit score to get approved.

In this guide, we’ll explore why it's important to build good credit and how to build it responsibly.

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Why is it important to build good credit?

Good credit plays a vital role in your financial life. Most people think of good credit for obvious reasons like getting a credit card, car loan or mortgage. But it can also be necessary for less obvious things like renting a car, apartment or home; getting approved for a cell phone contract, and perhaps even getting a job.

When you apply for a loan or lease, the lender typically wants to see a credit reference. Some employers check credit references as well, particularly when the job you’re applying for involves handling money or dealing with confidential financial information.

The most common type of credit reference is a credit report from one of the three major credit bureaus, TransUnion, Equifax, and Experian. Your credit report includes information about your past and existing credit accounts. It outlines how much you owe, how long you’ve been using credit, and whether you consistently make on-time payments. Your credit score is like a grade that’s given to your credit report.

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A good credit score not only makes it easier to get credit, but it can also save you thousands of dollars over your life. For example, say you are a borrower looking to take out a $250,000, 30-year fixed rate mortgage. According to myFICO’s Loan Savings Calculator, with a FICO score of 760 to 850 (and Excellent score), the APR on your mortgage would be around 4.291%. If your score dropped to somewhere between 680-699 (a Fair credit score), your APR would be 4.695%. That doesn’t seem like a huge difference, but over the term of a 30-year loan, the lower credit score would cost you $21,595 in additional interest payments.

The good news is that building solid credit is not difficult, as long as you understand the fundamentals of building credit and managing it responsibly.

How do I build credit responsibly?

The first step in building credit is to apply for your first credit account. The very first time you apply for credit, the lender will order a credit report. That first inquiry establishes your credit report.

For many people, this first credit application is for a credit card. But without any credit history, you may have a hard time getting approved by one of the major credit card issuers such as Visa or MasterCard. Here are a few alternatives:

  • Store card. Retail store cards have a reputation for approving applicants with no credit. You’re more likely to get accepted for a card that can only be used at one store or a group of stores than a card that can be used anywhere.
  • Secured card. Secured credit cards require a security deposit and give you a line of credit equal to your deposit. Once you start using the card, the issuer will send you monthly statements. If you don’t pay your bill, the issuer can take the money from your deposit. Once you’ve demonstrated that you can handle your card responsibly, the issuer may allow you to have a higher credit line than your depoosit or upgrade to an unsecured card and refund your deposit.
  • Credit builder loans or accounts. Although they’re not widely advertised, some credit unions and banks offer credit builder loans or accounts. Similar to a secured credit card, these lenders collect a deposit and give you a credit limit equal to the deposit amount. Your deposit goes into a savings account that you cannot access until you’ve fully repaid the loan. As long as you pay as agreed, the lender will send a favorable report to the credit bureau.
  • Certificate of deposit. A certificate of deposit (CD) is a financial product similar to a saving account, but you agree to keep your money with the bank for a fixed period of time. In return for letting the bank hold on to your money, you receive higher interest rates than you would from a savings account. Many banks will let you use that CD as collateral for a loan. The loan will show up on your credit report as a secured loan, helping you build credit when you make on-time payments.
  • Student card. Student credit cards used to be available to any student who could provide proof of enrollment at a qualified college or university. But after too many college students found themselves with mounting credit card debt and no way to repay it, a law was passed to ban credit card companies from issuing credit cards to anyone under 21 unless they have an adult co-signer on the account or can prove they have enough income to repay the debt (known as the CARD Act).
  • Student loan. Getting approved for federal student loans does not depend on credit, but managing your student loans well will positively impact your credit score. See more about how student loans can affect your credit score.
  • Co-signer. If you can’t get approved for credit on your own, you may have a parent or another close relative who is willing to co-sign on a student loan, car loan or credit card in your name. Having a co-signer with excellent credit may help you get a lower interest rate than you would on your own. As you make on-time payments, you will build your credit. If you default on your account, the lender will go after your co-signer to collect the debt.
  • Authorized user. You typically have to be 18 years old to get a credit card on your own. However, if you’re under age 18 and want to start building credit, your parents may be able to add you as an authorized user on their credit card. This is also known as credit piggybacking. Banks have their own minimum age requirements for adding a minor as an authorized user, so parents should call the number on their back of their card to ask about age requirements. See our guide to establishing credit when you're 18.

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Can accounts that aren’t on your credit report affect your credit score?

You might be wondering about two types of cards that aren’t included on the above list: debit cards and prepaid cards. These look like credit cards, but they won’t help you build your credit.

Do debit cards or prepaid cards help credit?

When you use a debit card, the funds are taken from your bank account, so the transaction is treated as a cash purchase, even if you choose “credit” instead of “debit” at the time of sale. When you use a prepaid card, you are spending money that you loaded onto the card in advance.

Both debit cards and prepaid cards may have a card network logo like Visa, MasterCard, American Express or Discover on them, but you’re not borrowing money. They are not reported to the credit bureaus and won’t have any effect on your credit score.

Do rent or utilities affect credit?

Other bills you pay may not affect your credit score, either. Monthly payments for rent, lawn services, utilities and more typically don’t appear on your credit report because the company doesn’t report information to the credit bureaus. However, if you don’t pay your bill and your account is turned over to a collection agency, that collection will impact your credit score.

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How do you build credit for the first time?

Once you’ve been approved for your first credit account, how do you get a strong credit score? It begins with understanding how credit scores are calculated. According to myFICO.com, credit scores are based on five factors:

  1. Payment history. The most significant factor in your credit score calculation is payment history, making up 35% of your score. A history of late payments will drag your score down, as will negative marks from bankruptcies, foreclosures, and accounts being referred to collections.
  2. Amounts owed. The amount of credit you’re using in relation to your total available credit accounts for 30% of your credit score. This is called your credit utilization. Credit scoring agencies view using a large percentage of your available credit as risky behavior.
  3. Length of credit history. The length of time you’d been using credit accounts for 15% of your score. It considers the age of your oldest account, the age of your newest account, and an average age of all accounts. In general, the longer you’ve been using credit responsibly, the higher your score will be.
  4. Credit mix. Your credit mix accounts for another 10% of your score. This is the mix of credit cards, installment loans, mortgages, and other types of credit you’re using at any given time.
  5. New credit. The number of new accounts in your credit report accounts for about 10% of your credit score. Lenders view opening several new credit accounts in a short period of time as risky, especially if you do not have a long credit history.

With those factors in mind, the best way to build credit from scratch is to:

  1. Open a credit account. You may have to start with a secured card or a credit builder account.
  2. Pay your bills on time. This includes everything from credit cards and loans to rent payments, utilities, and cell phone plans. Even accounts that aren’t normally reported to a credit bureau can negatively impact your credit score if they’re referred to a collection agency.
  3. Apply for new credit cautiously. When you apply for new credit, the lender will check your credit, resulting in a “hard inquiry” on your credit report. Hard inquiries bring down your credit score, especially if you open several new lines of credit within a short time frame. However, if you are shopping for a loan, such as a car loan or mortgage, credit rating agencies expect you to shop around for the best rates. For that reason, they ignore multiple inquiries for the same type of loan made within a 30 day period.
  4. Don’t close accounts. Closing credit card accounts lowers your available credit and increases your overall credit utilization rate.
  5. Monitor your credit. Get in the habit of checking your credit report regularly. Analyze it for inaccurate information and dispute any incorrect information with the credit reporting agency immediately.

How long does it take to build credit?

There’s no one answer for how long it will take you to build your credit. It depends on a number of individual factors, including the types of credit you’re using, the balances owed and the credit scoring model in use.

According to Experian, it can take at least three to six months of activity before a credit score can be calculated. But once you have a score, it can fluctuate often. According to TransUnion, your creditors will likely report to the credit bureaus every 30 to 45 days. So every month your credit score can go up or down depending on how well you manage your credit.

How can I build credit fast?

If you’re trying to buy a home or get a car loan, waiting three to six months for a credit score may seem like a lifetime. You might be looking for a way to speed up the process.

Your ability to build credit fast will depend on your starting point. If you have no credit, building an excellent credit score quickly may be difficult because you may have to apply for a secured card and demonstrate your ability to make on-time payments for a few months before you can apply for an unsecured card.

If you’ve been using credit for a while, how fast you can improve your score will depend on whether your credit report contains negative information and the age of those adverse events. In other words, a late payment within the last three months will have a greater impact than a late payment two years ago.

Assuming you already have a credit file and don’t have any recent negative marks on your credit report, here are a few ideas for improving your score quickly.

  1. Review your credit report. Dispute any errors that might be dragging your score down, like late payments or credit limits that are lower than they actually are.
  2. Pay your bills on time. Your payment history accounts for 35% of your credit score, so make your payments on time every month.
  3. Pay down your balance. If you have revolving credit accounts with high balances, pay them down as soon as possible. Thirty percent of your credit score is based on the amount you owe, so paying down large credit card balances can have a big impact in a short period of time.
  4. Get a credit card or two. If you don’t have any open credit cards, get apply for one or two. Get a secured card or become an authorized user on a relative’s account if you can’t get approved for one on your own. Be sure to pick a relative that has a strong credit score, a history of on-time payments and low credit utilization. Becoming an authorized user on an account with a history of missed payments could actually harm your score rather than improve it.
  5. Use your cards sparingly. Remember, most credit experts recommend keeping your utilization rate below 30% - both on a per-card basis and in total. So use your cards, but don’t use them too much. For example, let’s say you have two credit cards with a credit limit of $1,000 each. You might charge up to $250 on each card and pay the balance in full each month. This will keep your utilization rate under 30%.
  6. Raise your credit limit. If you already have a credit card, try calling the company and asking them to raise your credit limit. This will automatically decrease your credit utilization rate and improve your score.

How long does it take to rebuild credit?

Rebuilding a damaged credit score can be tougher than starting with a blank slate, but it is possible.

The first step is to find out where you’re at financially. Check your credit report to see exactly where you need to improve. If you’re trying to rebuild after bankruptcy, you may need to apply for a secured card to start rebuilding.

If your issue is a lot of missed or late payments, work on bringing your accounts up to date and set up reminders to make sure you pay your bills on time going forward. If your credit utilization it too high, create a plan to pay down your debt and get your credit utilization rate down to 30% or less.

A bankruptcy will remain on your credit report for seven to 10 years, but you can see an improvement in your credit score much sooner. Put in the work to rebuild your score, keeping in mind the five factors that go into a credit score calculation listed above, and you could be eligible for a mortgage in as little as one to four years.

Whether you’re new to credit or trying to undo the damage caused by past credit mistakes, building credit takes time. Don’t charge more than you can afford to repay, keep balances low and set up reminders to pay your bills on time. These actions will demonstrate that you know how to use credit responsibly and you’ll be rewarded with a strong credit score.

About the Author

Janet Berry-Johnson is a Certified Public Accountant and personal finance writer. Her work has appeared in numerous publications, including CreditKarma and Forbes.

Written on February 1, 2018

Self Lender is a venture-backed startup that helps people build credit and savings. Comments? Questions? Send us a note at hello@selflender.com.

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