Personal Finance 101: Building Up Credit

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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?

pf101Good 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.

Good luck!

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27 thoughts on “Personal Finance 101: Building Up Credit

  1. My credit card company automatically raised my limit to a little over 30% of my gross salary (and when my fellowship ends next year, it’ll be close to 40% of my gross salary). I’ve never gone anywhere near the limit (maybe 10%), and I pay off my balance every month. I also am on my mom’s card, which I don’t use but which is my oldest card. Should I ask for the card limit on my card to be reduced? I’ve never had any other debt and don’t plan on acquiring any anytime soon.

  2. Why would you ask for your credit limit to be reduced? That’s the dumbest thing I’ve ever heard!

  3. !wanda,
    That’s a valid question & my cc company also automatically raises the limit. I’m also confused on what to do when the advice is that the credit limit should not go over 20% of gross salary.

    jasonn,
    It isn’t necessary to be mean!

  4. One thing I don’t understand: I read on another blog how someone’s credit rating went down somewhat after he paid off his mortgage. Doesn’t paying off mortgage decreases total debt and should, therefore, increase the credit rating?

  5. jasonn,
    The advice given in the article was to not have a credit limit that exceeds 20% of gross income. My limit is considerably beyond that, which according to the post hurts me in the “types of credit” category. That advice was new to me, because I thought that the “types of credit” category was for giving you points if you had several different kinds of credit- a car loan, credit cards, a mortgage, etc. However, having a very high limit helps me in the “amounts owed” category, since the percentage of my limit that is my balance is lower for high limits.

    My guess is that because the weight given to “amounts owed” is higher than the weight given to “types of credit,” I should not ask for my limit to be lower. However, that wouldn’t be true if, say, the “amounts owed” points were calculated using a nonlinear function that gave me the same number of points for a $60 balance over a $(20% of income) limit versus a $60 balance over a $(40% of income) limit. Maybe I’m really, really overthinking this, or maybe there’s no easy way to find out what I should do. I’d like to know if there’s a simple answer.

  6. jasonn,
    The “amounts owed” category awards you points for having a low balance/total credit limit ratio. Therefore, for this category, a higher limit is better. The “types of credit” category hurts your score if you have a very high limit, though. I have inadvertently found myself having Trent’s definition of a very high credit limit and wonder how I should deal with it.
    My guess is that because the “amounts owed” category is weighted more heavily, I should leave my credit limit alone. However, that’s assuming, for one, that the “amounts owed” points are calculated using a linear function. If the function is nonlinear- if, for example, a $60 balance on a $(20% of income) limit is given the same score as a $60 balance on a $(40% of income) limit- I might want to reduce my limit, because it would increase my “types of credit” score and would not affect my “amounts owed” score. Maybe I’m overthinking this, and maybe there’s no easy way to figure out what I should do. I’d really like to know if there’s a simple answer, though.

  7. A fun trick I played back in college was to swipe my college loan checks from the bursars when they had me come in to sign them. I’d deposit them myself, transfer 90% to my card (so I had a enough total to pay my trimester fee), and the put the balance on my card. I’d then pay off the rest at the next cycle. After my first year, I had enough that I could just charge it and pay it the next cycle, and by the end of college I had platinum cards.

    And on lowering your credit limits: It’s not always a bad idea. Having a good ratio is fine, but having too much credit can make it hard to get loans. For example, mortgage companies can count your “potential” credit against you, since you could go out on a spending spree after buying the house, thus becoming a credit risk. If you lower them 6 to 12 months before you go looking, they’ll see a good ratio AND a low credit ceiling, making you a stellar candidate for a mortgage.

  8. Wanda – if you want to ask a CC company to lower your credit line, there’s nothing wrong with that. I had done it on several CC because I don’t feel comfortable carrying around $25,000 credit limit cards.

    On a different topic, what do you think about people who take out huge CC loan on 0% interest and put that money in online bank to gain 5% interest? I knew a blogger who does this and it seems pretty risky to me.

  9. Actually, paying the balance before it is due (thereby having $0.00 due when the statement cycle ends) DOES NOT help build your credit. You have to have a balance to report to the credit bureaus in order to ‘get credit’ for paying it off in full. This doesn’t mean you need to roll over balances month to month, though–just have some portion of your balance not paid off when the cycle closes, and then pay it off in full before it is due. Single Ma posted about this recently:

    http://singlemomandmoney.blogspot.com/2007/07/should-i-pay-minimum-to-prove-that-i.html

  10. Hello Trent,

    I am following your blog daily and I found two conflicting ideas you suggest that I have a hard time reconciling them:

    “Another tip is that by canceling credit cards, you’re actually hurting yourself in two ways.First, you’re reducing the total available revolving credit that you have without reducing the amount of current debt you have, thus raising your credit ratio. Second, by eliminating lines of credit, you’re shortening your credit history. Simply put, if you’ve already got a credit card and paid it off, don’t cancel it; put it away somewhere safe.”

    VS.

    “Keep the total amount of your credit cards’ available credit low ”

    So, if I cancel a card and/or if I have several cards – it’s bad BUT if I have several cards the combined credit limit reduces my debt ratio.

    What’s the right way then ?

    Thanks.

  11. 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.
    —————————————-

    How does the credit score algorhythm know your annual salary? I’m not aware that it’s tracked by CRAs.

  12. A fun trick I played back in college was to swipe my college loan checks from the bursars when they had me come in to sign them. I’d deposit them myself, transfer 90% to my card (so I had a enough total to pay my trimester fee), and the put the balance on my card. I’d then pay off the rest at the next cycle. After my first year, I had enough that I could just charge it and pay it the next cycle, and by the end of college I had platinum cards.
    —————————————

    Get a handout, then pyramid it into more and more credit. Is this a great country or what?

  13. Why would you ask for your credit limit to be reduced? To limit the amount of damage you can do to yourself by being careless. To limit the amount of damage that a scammer could do to you. To increase your borrowing power: a $5000 credit card isn’t an asset – it’s a LIABILITY and reduces the amount that you can borrow towards a home.

    Why would you want ANY credit? Answer: because every once in a while it’s handy to buy stuff online.

    —-

    Does it really happen in America that the bank just sends you a letter saying “Guess what?! We’ve just increased your credit limit!!” ? That’s criminal.

    It’s bad enough that I’ve spent the entire of the last 18 months with my card maxed out and barely making the payments, then the bank has got the nerve to send me a letter offering to INCREASE my limit!! When I was clearly struggling to service the debt I DID have!!

    You know what I did with my $5000 performance bonus this year? Nothing. I didn’t buy a single thing. Paid of my c/c’s instead.

  14. @min wage:

    uh… loans and credit cards aren’t handouts.

    You need to give that money BACK at some point.

    You know that right?

  15. Great article and great timing. I am diligently working on improving my credit score, which was bruised so after my divorce. The score is on the positive track and hope it will stay on that course.

    I have one question. I opened a Macy’s credit card to get the discount during the purchase for my kid. It is a small balance which I will pay off. Once it is paid off, is it worth keeping this card? I have other credit cards (frequently used) with much lower interest rates. Any advice?

  16. Well, noone actually knows how exactly the credit score is calculated. However, even sticking to the way you laid it out – higher credit limit would be beneficial, as it would reduce apparent utilization ratio on the card. So, lowering the credit limit on a card is not a good idea if you use that card.

    The cards that do not report their credit limit – just high balance – are also very problematic for the credit score. You then appear to have 100% utilization. Capital One is notorious for that, and I really wonder when Congress will do something about this kind of unethical reporting.

    As to how many cards to have – I think that depends on individual’s risk level. Credit cards don’t hurt the owner – it’s what one DOES with them that’s an issue. Some (disciplined) people make significant amounts from AppORamas (applying for a slew of cards at once, against which you caution); others can’t pay their balance on time with one, and hurt their credit score. To each his own – but I applaud your quest to inform people!

  17. kleanchap, I recommend keeping the Macy’s only if you get some kind of discount in store for it, and you use it to only buy things you NEED.

    I have cards that exceed 30% of my salary…doesn’t seem to have hurt my score at all. I think they give you “points”, particularly when buying a house, for having a large credit line AVAILABLE but not actually USING it. Your ability to restrain yourself and not max cards out is important. The higher your limits and the lower your balances, the better your “debt to available credit” ratio is going to be. When I bought a home they looked at this also.

    If you don’t have the self control to not use a big limit, by all means ask the credit company to reduce the limit.

    Also guard your credit carefully. When I shop online, I use those random-generated numbers that are one-time use or one-merchant numbesr so I never have to put my credit limit on the line. Discover and Bank of America has these. I’m sure others do as well.

  18. I ran up the credit card after about a 2 years of having it. In the past 6 months, it went down from about $2300+ to about $1400. That boosted my credit score by almost 20 points. I now have “excellent” credit.

    Trying to get to the point where i can pay off the card monthly though.

  19. so this might be a dumb question but…
    if i am listed as an authorized user on an acct. does that have the same affect on my credit rating as an acct. that is listed as an invidual acct?

  20. New credit: you mentioned that there is a negative for new cards. How many points are they deducting for each card? and how long does it take for my credit score to gain back the points?

  21. Does it really happen in America that the bank just sends you a letter saying “Guess what?! We’ve just increased your credit limit!!” ? That’s criminal.


    What’s criminal about it? It improves your score if you don’t change your spending habits. I would like them to give me a $1,000,000 credit limit if they would do it.


    Should I ask for the card limit on my card to be reduced? I’ve never had any other debt and don’t plan on acquiring any anytime soon.

    No. It will reduce your score to have your credit limit lowered. If you’re already being responsible and not carrying a balance, there is absolutely no reason to lower your limit. The only reason you would ever want to is if you think that YOU personally cannot trust yourself with more spending power.


    Why would you ask for your credit limit to be reduced? To limit the amount of damage you can do to yourself by being careless. To limit the amount of damage that a scammer could do to you. To increase your borrowing power: a $5000 credit card isn’t an asset – it’s a LIABILITY and reduces the amount that you can borrow towards a home.

    Why would you want ANY credit? Answer: because every once in a while it’s handy to buy stuff online.

    So many things wrong with this post. First off, having a lower limit will not reduce the “damage a scammer can do to you” – you already aren’t liable for that damage, by law. (And the limit may not actually limit how much they can charge to it anyway). Second off, it’s NOT a “liability” to have a large credit limit. It DOES NOT reduce the amount you could borrow for a home. It actually might INCREASE how much you could borrow because it would increase your credit score. The only situation where it might cause you problems with mortgage borrowing would be with a human being manually reviewing your report – and in that case, they would simply ask you to reduce your available credit during the application process, not deny you the loan just based on unused credit availability. Don’t live in fear of your credit limit just over this – it’s easily remedied if does become a problem (and it likely won’t be anyway unless you have massive credit lines). Again, it DOES NOT hurt you in the automated score reporting: actually, it does the opposite.

    And it’s good to have credit cards, for more reasons than just convenience. They give you free float, much better legal and practical protections against fraud than debit cards, and often lots of money back on rewards. They increase your credit score which could save you massive amounts of money on a mortgage. The only situation where credit cards are a problem is when someone has no self-control. And in that case, the problem is the person, not the credit cards.

  22. If you have good credit, the mortgage companies are not going to “hold it against” you if you have a large credit limit, especially if you have a history of NOT utilizing it. Now if you have marginal credit, and frequently max out your cards, then it would have a negative impact on your ability to obtain a mortgage.

    People worry too much about their score. I blame it on all the commercials.

    Instead of focusing on credit score, focus on paying your bills on time. Make this a top priority. No late payments – ever. Late payments show up on your credit report when they are more than 30 days delinquent. Keep your revolving balances below 40% of the available limit, or ideally, below 20% of limit. Like Trent said, don’t apply for credit cards on a whim.

    If you handle your finances responsible, it is reflected in the credit score and that is the purpose of scoring.

  23. @Minimum Wage:
    The “hand out” you speak of was a loan, complete with interest, which it took me over 10 years to pay back. Hardly a “hand out”. Reality was the money was going to the college either way, I just used my brain to leverage that money flow to give me good credit at the same time.

    As for the mortgage thing, I had high credit limits when I started looking at houses, with $0 revolving, since I always paid them off when I used them. I was told by my realtor AND my mortgage broker that I had to lower the limits on my cards or I’d have problems getting a loan. So while some of you may “think” it’s a non-issue, those in the know, that do this every day, say it is. Mind you, that was also 10 years ago before the sub-prime bubble. With the market being what it *was* my dog could have gotten a mortgage last year. But thats going away now. Be prepared!

  24. Brent – Sorry about that, I was just assuming you had grants (free money) like most of the people I’ve known in college.

    ————————————-

    My credit went in the tank several years ago (illness/hospital/unable to work/loss of income) and now I’m earning minimum wage but canb’t resolve my past credit proble,s on a minoimum wage income. I have two adverse items which won’t even start to go away until resolved, and I can’t resolve them on my income. So I guess I can’t restore my credit.

  25. Min Wage…
    What won’t even start to go away. Even defaulted student loans will drop from your credit report. What is the reporting time in your state? My understanding is after 10 years EVERYTHING clears. That is not to say you may still be morally obligated and sometimes legally obligated to pay them, but they won’t be on your credit report and thus don’t affect your score.

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