How to build a credit history from scratch
Posted
Nov 07 2008, 12:09 PM
by
Karen Datko
Rating:
This post comes from Trent Hamm at partner blog The Simple Dollar.
Several high-schoolers and college students have asked me for advice on how to build a credit history in a safe and responsible manner. One of them is "Jenna":
I'm currently a freshman at Washington University. I know I need to build up some good credit for the future, when I have to get a car loan and such, but I don't know where to start. I'm worried about getting way into debt like some people I know.
Building a positive credit rating was one of the things I did right during my college and early professional years, and it has paid off time and time again with low insurance rates and good terms on student loans, car loans and our mortgage.
How do you go about building a positive credit history if you have never applied for any form of credit?
Knowledge is power
The first step is to know exactly what you're trying to build. Your credit history is a summary of all the places from which you have borrowed money over the past seven to 10 years. A credit report is a detailed listing of that information. Three credit bureaus are in the business of collecting the information for credit reports -- Experian, Equifax and TransUnion.
A credit score is a number based on the information in your credit report. The most common type of credit score is the FICO score. While the exact formula for calculating your FICO score isn't publicly available, MyFico does provide some basic information about how your score is calculated:
FICO scores are calculated based on your rating in five general categories:
Payment history -- 35%
Amounts owed -- 30%
Length of credit history -- 15%
New credit -- 10%
Types of credit used -- 10%
In other words, they provide a template for building good credit. All you have to do is take care of each of those areas.
Step No. 1: New credit
The first thing you need to do is actually get some credit. The easiest way for most young people is to apply for a credit card -- but just a single card.
Depending on the conditions of the credit market (and as I write this, the credit market is tight), you might not be able to easily get an unsecured credit card. If that's the case, save up your nickels and dimes and get a secured credit card.
Get one issued by a major credit card issuer -- Citi, Chase, American Express, or Bank of America -- and make sure they report this card to the credit-reporting agencies. Contact these financial institutions directly -- don't use any sort of middleman. Here's more information about secured cards, which you should read before getting one.
In fact, getting a secured credit card is a brilliant way for anyone to start building credit, no matter what the conditions. A secured credit card is one where you secure the card by paying a specific amount in advance -- often $500. Then, whenever you use the card, the bill is automatically paid from the amount you've paid in advance. When you receive a bill, you're actually replenishing that amount you paid in advance to secure the card.
A secured card has several advantages. First, because you've secured it with money, almost anyone can get a secured card at any time. Second, because you've already effectively paid the bill, you can't get into debt trouble with a secured card. Third, because it is a credit card, it helps establish your credit history.
As I mentioned before, you should open only one line of credit at a time, and wait a while before opening a new one. A line of credit refers to any time you borrow money, from a credit card to a payment plan, from a student loan to a car loan. If you open up several lines in a short period of time, you appear to be a risk to people who would loan you money. In terms of your credit score, the "new credit" portion will go down.
An effective way for a college student to manage this is to get a card exclusively for buying textbooks. Use this card to buy books online or at your school's bookstore and then put it up until the next time you need to buy books.
You can also begin to build up credit through your student loans, if you're the primary borrower. You'll likely need a co-signer in order to get the loan, but that student loan will count on your credit report, establishing your credit history.
Step No. 2: Payment history
Once you have this line of credit, keep the payments up. Don't be late on a single payment.
Each month, the credit bureaus request the status of your payments from your creditors. Are your payments up to date -- or at least less than 30 days past due? If everything is good, it helps your credit score. If negative reports come through -- more than 30 days late, more than 60 days late, in default -- your credit score will start to take a serious hit and those negative marks will show up on your credit report.
Don't let it happen. Keep those bills paid.
Step No. 3: Amounts owed
It's never a good idea to charge up those credit cards. You should always strive to keep your actual balance at 30% or less of your credit limit, as that keeps the amount owed under reasonable control.
The best method of all is quite simple: Never use credit for an impulse buy. If you live by that, you'll be in much better shape than many people.
Step No. 4: Length of credit history
If you follow the first three steps and keep them up over a number of years, your credit will be in good shape. Even better, the longer you keep it up, the better your credit score will be.
What does that mean? Pay the bills, steadily but surely, and keep that first credit card, even if you decide to stop using it, because it establishes the length of your credit history.
I still have my first credit card, tucked away. It has had a zero balance for years, but when I was getting my mortgage, the underwriter pointed out that it was a good sign that I was reliable with available credit.
It has a similar positive effect on your score. Keep up the good work -- and you'll be rewarded for it.
Step No. 5: Types of credit used
A minor factor is the type of credit you have. If your entire credit history is based on unsecured credit cards, for example, you'll get a small negative mark on your score simply because all of your credit is "revolving" credit.
How can you alleviate that? Balance credit cards with other forms of debt, such as student loans, a car loan or a mortgage.
Remember, though, that the type of credit used is a very minor factor compared with the other pieces of the puzzle. Focus first on getting credit and keeping it paid. That will be enough to get you in position for car loans or student loans, which will provide diversity in the types of credit you have.
Checklist
If I were starting over today in building my credit, here's what I would do:
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Get a credit card, preferably unsecured. If I couldn't get an unsecured card, I'd contact a major bank and attempt to get a secured one.
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I'd lock the card up in a safe place and use it only for a small number of purchases. It wouldn't be in my wallet so I wouldn't be tempted to use it without reason. I'd also keep that first credit card, even if I zeroed out the balance and stopped using it.
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I'd pay every bill as it came in.
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After some time, when it became reasonable in the course of my life, I'd apply for a loan of some sort -- a student loan, a car loan or a housing loan.
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I'd check my credit report regularly from AnnualCreditReport.com, not through a middleman operation like FreeCreditReport.com. If anything incorrect showed up, I'd do the follow-up work, contact the credit bureau in question, and get the issue resolved.
Follow those steps and you'll be fine. Your insurance rates will be lower and when it comes time for big loans, like a mortgage, you'll be eligible for good rates.
Other articles of interest at The Simple Dollar:
I have a wallet full of credit cards -- Which ones should I keep?
A reader on the cusp of a great credit rating
Personal Finance 101: Getting credit without a credit card
