Having good credit is one of the BIG wins of living a rich life.
Without good credit, everything gets harder. You might find it tough, if not impossible, to buy a car, finance a home, or get credit cards with the perks you want.
Of course, everyone has to start somewhere. We all have to build our credit from scratch. And if your credit score is low, you probably want to know how to go about rebuilding it.
We’ll show you exactly how to build your credit.
Credit Building Factors
If you’re new to the world of credit, the whole credit scoring industry can seem like a bit of a mystery. Learning more about it and what factors go into your score can be a big help.
While there are many different credit scoring models, 90 percent of lenders use the FICO model. So we can safely ignore the other models and focus on the factors that contribute to your FICO score:
1. Payment History – 35% of your credit score
Your payment history makes up 35 percent of your score, making it the most important factor in your credit score. Basically, do you pay your loans on time and how consistently have you been doing it for how long?
Unfortunately, even a single missed payment can cause your credit score to take a hit. And a couple of 30-day late payments will wreak havoc on your score. This is why you should do everything you can to pay your bills by the due date. Get your mortgages, car loans, and credit cards on time even when cash is tight.
2. Credit Utilization – 30% of your credit score
Your credit utilization is the ratio of how much available credit you have versus how much you’re currently using. For example, if you have a credit card with a $5,000 limit and carry a $2000 balance, your credit utilization is 40 percent.
Generally, you should aim to keep your credit utilization below 30 percent. If it gets any higher, potential creditors might see you as a bigger credit risk and decline to extend you new credit. They might also charge you a higher interest rate to offset their risk.
This is why it’s a good practice to call your banks and ask to get your credit card limit raised every 6 months. Over time, you’ll have a much higher credit limit and your utilization will gradually drop (assuming you don’t increase credit card spending). You can also reduce your utilization by making multiple payments to your credit cards every month to avoid going over 30%. This is particularly helpful in the early days when credit card limits are pretty low.
3. Credit History – 15% of your credit score
Your credit history is simply how long you’ve been using credit. If you’re a young adult who has never used a credit card, you probably don’t have any credit history to speak of.
Because this factor makes up 15 percent of your score, you should avoid closing the oldest credit card that you have. In most cases, it’s better to leave a dormant account open. Otherwise, you shorten your credit history, which can lower your score. You also want to open a credit card as soon as possible in order to start your credit history.
4. Credit Mix – 10% of your credit score
Potential creditors like to see some variety in your credit report, which is why they look at your credit mix. This factor makes up 10 percent of your score, and it’s a measure of the diversity among your accounts.
For example, if you owe thousands in student loans but don’t own a car and have never used credit cards, your lack of credit diversity could hurt your score.
5. New Credit – 10% of your credit score
New credit, which makes up 10 percent of your score, is the amount of new credit you’ve acquired within 12 months. After 12 months have passed, an account no longer counts as “new credit” on your credit report.
For example, if you recently shopped around for credit cards and filled out half a dozen applications, this can make it appear like you’re desperate for additional funds to pay your bills.
Building Credit From Scratch vs. Rebuilding Bad Credit
Building credit from scratch is generally easier and more straightforward than rehabilitating a bad credit score.
The reason is that credit newbies have a clean slate, which can make it easier for them to get approved for credit products designed for people who are just starting out. By contrast, folks with bad scores have already shown creditors they can’t necessarily be trusted with credit.
Of course, everyone makes mistakes. Fortunately, creditors know this. If you have bad credit, it’s definitely possible to rebuild it. However, you’ll need to clean up past mistakes as much as possible while using various strategies to establish new credit habits that can boost your score.
Building Credit With Credit Cards
The easiest way to build credit is by opening a credit card. Getting a card and using it responsibly not only makes you visible to potential lenders, it shows them you can be trusted to pay your bills.
However, it’s a catch-22 of sorts that you usually need credit to get credit. So how do you open a credit card when you don’t have a credit history, or when your credit score is on the low side?
Fortunately, you have a couple of options. You can either go through your bank or open a secured credit card.
1. Ask Your Bank
First, consider opening a credit card through your bank. This option typically only works if you’ve banked with the same institution for an extended period of time. Some banks offer credit cards with low credit limits for people who need to build credit from scratch.
2. Open a Secured Credit Card
A second option is a secured credit card. This is a type of credit card that requires you to put a certain amount of money down as a guarantee against default. In most cases, the down payment is the same as your credit limit.
Once you have your secured card, you can charge purchases to it the same as any other credit card. The idea is to pay off your balance on time each month. In exchange, the credit card company will report your on-time payments to the credit bureaus. Many secured credit cards also offer you the option to upgrade to a regular, unsecured card after a certain period of time. We have a full list of cards for building credit here.
Building Credit With Loans
If you have trouble getting a credit card or you just prefer not to use one, you can try taking out a loan to help build your credit. Here are four types of loans to consider.
1. Student Loans
As the cost of college continues to rise, the majority of graduating seniors can’t afford to pay cash for a university education. Instead, most end up taking out a student loan to finance their degree.
Once your loans go into repayment, they can actually help you establish your credit. However, keep in mind that your payment history makes up 35 percent of your credit score. To prevent your credit score from dropping, avoid missing any payments or sending a payment late.
2. Car Loans
A new set of wheels can help you get around and help you improve your credit. As with college, few people can pay cash for a car. If you need to finance your vehicle, make sure you can afford the monthly payments on your loan. That way, you won’t damage your credit score by making late payments.
A mortgage can be a great way to build credit and raise a struggling score. However, it might be hard to qualify if you lack credit or have bad credit.
Out of all the options for building credit, use a mortgage as a last resort. For most people, a mortgage is the single largest loan that they’ll take on. This is where a great credit score pays off, a better interest rate will easily save us tens of thousands of dollars. You want a great credit score before you apply for a mortgage, not after.
4. Credit Builder Loan
Another option is a credit builder loan. Like secured credit cards, credit builder loans are usually marketed toward people with no credit or bad credit.
Once the bank or other lending institution approves you for the loan, it deposits the loan dollars in a savings account. From there, you make on-time monthly payments toward the deposited amount, which the lender reports to the credit bureaus. Once you have paid off the balance in the savings account, you receive the money.
Many credit builder loans charge interest, but this is a relatively small price to pay for the opportunity to build your credit.
Building Credit Through Someone Else With Excellent Credit
If you don’t have any credit of your own, why not borrow someone else’s good credit? You can accomplish this by asking them to add you to one of their accounts as an authorized user, or by asking them to co-sign for you.
1. Authorized Credit Card User
If you know someone with a good credit score, ask if they’re willing to add you to their account as an authorized user. This is the best hack to improving your credit score quickly. Take advantage of it if you can.
For example, if they’ve had the same credit card for 25 years and they always pay their bill on time, it’s worth asking if they will make you an authorized user on the account
If you do this, however, ask the credit card company if it reports authorized user activity to the credit bureaus. Otherwise, you won’t get credit for making timely payments.
You can also “borrow” someone else’s credit by asking them to co-sign a loan for you. This is a much riskier prospect for your friend or relative, as they will be on the hook for the balance of the loan if you stop making payments.
Other Ways to Build Credit
Other ways to build credit include having your rent payments reported to the credit bureaus and using a utility account to establish a positive payment history.
While most landlords don’t report rent payments to the credit bureaus, they might agree to it if you ask them. If not, you can also sign up for an app that reports your rent payments to the bureaus on your behalf. These services charge a fee, but it can pay off down the road when your credit score improves.
If all else fails, you might be able to use a utility account to establish a credit history and a good score. For example, some mobile phone providers report users’ payment histories to the credit bureaus. If you have no credit to speak of, signing a phone contract could help get you on the credit map.
The True Cost of Bad Credit and How to Avoid It
Besides making it difficult to qualify for a car loan, buy a house, or open a new credit card, a bad score might even affect your job prospects.
Some employers check an applicant’s credit score before they offer a position. This is particularly true in jobs where workers must deal with financial matters. Companies want to know an applicant is mature and responsible, and checking credit scores is one way to find out.
Fortunately, bad credit isn’t the end of the world, as there are plenty of steps you can take to boost your score. Whether you’re just starting out in the credit world or you need to rehab your score, start by getting a copy of your credit report. You can get your report from all three major credit bureaus for free by visiting annualcreditreport.com.