James wrote in and asked the following question:
I just read your article: WHAT’S IN MY WALLET regarding credit cards. You mentioned that you pay your entire balance weekly. Would this work if you were trying to build credit also? How does building up credit work?
Good question. The technique of paying off your card every week certainly works for building up credit. Let’s start at the beginning, though.
The idea of building up credit refers generally to making a series of financial choices that results in positive growth of one’s credit score. So, in order to do that, one needs to understand the elements of the credit score. I discussed this in detail before, but here’s a refresher:
FICO scores are calculated based on your rating in five general categories: Components of the FICO score
Payment history – 35%
Amounts owed – 30%
Length of credit history – 15%
New credit – 10%
Types of credit used – 10%
So how can one build up credit? By looking for improvements in each area:
Payment history Make sure always that the minimum payment is paid before the due date on any bill. You can do this however you wish, but whenever you receive a bill with a minimum payment, make sure you pay that much before the bill is due.
Amounts owed The actual dollar amount isn’t as important as the percentage of your total credit limit that is used on your last set of statements; the lower the percentage, the better. The way to keep this part low is to simply avoid carrying large balances on a card.
Length of credit history Your credit history generally starts the first time you acquire a credit card (or other source of credit). This is why it’s generally a bad idea to cancel your oldest card.
New credit Whenever you first apply for a source of credit, it provides a negative for your card. This is why it’s a bad idea to apply for several cards at once – your better solution is to apply for just one. Never apply for a credit card on a whim.
Types of credit Basically, if you have a lot of revolving credit out there (say, more than 30% of your annual salary), it will hurt your credit report. Keep the total amount of your credit cards’ available credit low – the best way to do this is, again, stick with just one or two cards. Credit comapnies like to keep lifting your credit limit if you carry a balance on the card but pay it off faithfully, so if you have several cards, the limits could skyrocket and end up hurting you.
Here’s a recipe for building credit that works in all respects:
Apply for just one credit card. Spend the time to research a number of them by visiting the sites of various credit card companies (Citi, Chase, Bank of America, etc.). Find one card with a rate and a bonus program that seems to fit you and apply for it. Don’t worry about a low credit limit – that’s good.
Use it for only small purchases for a year. Each month, buy two or three small things on it that you could have otherwise paid in cash. Don’t use it to finance things you can’t afford.
Pay off the balance in full by the time the next payment is due. You can do this in pieces online if you wish, or all at once by check. Just avoid carrying a balance from month to month.
After six months, request a credit limit increase, but don’t go above 20% of your gross salary. If you’ve used the card and paid it back, they’ll usually be glad to bump it up.
If you follow those steps and avoid carrying a balance on your card, your credit will start to steadily improve. Stick with making small purchases (try to keep your balance at any time less than 20% of your credit limit) and keep paying them off. You’ll end up having pretty solid credit when you go to apply for things.