When people ask how to build credit, the “chicken or the egg” conundrum often comes up. Having a solid credit history and credit score are important parts of your financial future. Here’s the problem: To get a loan for a house or car, you need to show a history of responsible use and payment of credit. However, in order to build a credit history, you need a loan to begin with.
So how do you get a your first loan without any credit history? The answer is usually a credit card.
Although that might sound like an impossible position to be in, you can start to build your credit inch by inch with the right credit card or secured loan. It might take some effort in the beginning, but building a positive credit history is something that can pay off handsomely down the road.
Before we talk about how to build a positive credit history from scratch, let’s first define a few important terms and talk about why your credit history is so important.
The Foundations of Building Credit
Before you get started building your credit, it’s crucial to understand what your credit history is. Simply put, your credit history is a summary of all of the places from which you have borrowed money over the past seven to 10 years.
Another term you have probably heard is your credit report. A credit report is just a detailed listing of this information. There are three companies (credit bureaus) that are in the business of collecting the information for credit reports – Experian, Equifax, and TransUnion. While each of these companies collects as much information as they can, they don’t always offer the exact same reporting. One credit card might report your information to Experian only, for example, while another reports your credit movements to TransUnion.
Your credit score is a “three-digit numeric expression of your credit worthiness.” And in every case, the higher the better. According to credit reporting agency Experian, your credit score will usually fall between 300 and 850.
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:
As you can see, the majority of your credit score is based on your payment history and how much money you owe, while the rest is made up of details like the length of your credit history, how much new credit you have, and your mix of loans.
While some of this may seem out of your control, especially at first, the biggest components of your score — your payment history and how much you owe — are well within your scope of responsibility.
Why a Good Credit History Is Important
Building credit is about more than just buying stuff. It’s actually about risk. Whether it’s true or not, a bad credit history and low score make you appear less responsible and more likely to miss payments or default on a loan.
And it’s not just about loans. Landlords, employers, and insurance companies can all take your credit into consideration when making a decision about you. Take a look:
Buying a home or car: When you go to buy a new house or your first car, your credit score can either help you or stand in your way. Borrowers with good credit receive the lowest interest rates, while those with poor credit scores may have to pay a steep premium — or be shut out entirely. Likewise, if you want to rent an apartment and have no credit history, or worse, bad credit, you may have to get a cosigner or find a different place to live.
Employment opportunities: And as if that weren’t reason enough, certain employment opportunities may not be available to you if you have bad credit. According to Experian, federal law allows potential employers to view a modified version of your credit report in order to determine eligibility for employment. Any negative marks — long-overdue bills, loans in default — may lead a potential employer to believe you’re less than reliable, which can surely impact whether or not you get the job.
Insurance rates: Many insurance companies also use your credit score to determine the premiums you’ll pay, because they assume a creditworthy customer is also a less reckless one. So if you’re stuck with a bad score, you’ll also be stuck paying more than your friends for the same coverage. That’s never fun.
No matter how you cut it, a good credit score and a positive credit history is your ticket to everything most people want in life. And that’s why it’s so important.
How to Build Credit Safely
Building credit takes a little bit of time, and there is more than one “right way” to get the job done. These steps can help you build the positive credit history you need for everything you want out of life.
Step 1: Get a Credit Card
One of the easiest ways to build credit is to sign up for your very first credit card. The most popular type of credit card — the type you should get if you can qualify for one — is an unsecured credit card. This type of card doesn’t require a deposit for use, but comes with the agreement that you will pay the money you borrow back over time.
However, unsecured cards might be difficult to qualify for if you have no credit history at all. On the other hand, you might have a leg up if you have a stable job history and verifiable income or any type of positive reporting on your credit report. If you don’t have any of these things you may need a cosigner.
Applying for an unsecured credit card may be the only way to test the waters. However, if you apply and face a denial, don’t despair. The good news is there are different types of cards made for people with little to no credit.
One type of card you may be able to get with little to no credit history is a secured credit card. A secured card is one that requires a cash deposit to use it. In many cases, the “deposit” is commensurate to the credit limit. In other words, you put down $500 in order to have a $500 credit limit on your card.
This may sound counterproductive, but secured cards can give you the chance to prove your creditworthiness. And once you do, you can usually upgrade your card to an unsecured card and recoup your initial deposit right away.
Student credit cards are also popular with people trying to build their credit from scratch. Although they don’t typically require a deposit, they usually come with much lower credit limits and fewer perks than traditional credit cards. If you’re under 21 years of age, you may also need a co-signer in order to get a student credit card.
Step 2: Use Your Card for Small Purchases
Once you’ve qualified for an unsecured, secured, or student credit card, you need to show that you’re able to use credit responsibly. Start by making small purchases with your card that you know you can pay off right away.
For example, use your new credit card for small purchases at the grocery store, or use it to pay a utility bill or phone bill.
No matter what you do, start slow. Using your card for anything and everything can backfire if you get into the habit of charging more than you can pay in full every month. Ease into the process and you’ll be better off in the end.
Step 3: Pay Your Credit Card Bill on Time – Every Month
Paying your credit card bill on time is the best way to build a good credit score, according to Experian.
Ideally, you’ll also want to pay your bill in full each month to avoid paying interest. That’s because, with secured cards and beginner credit cards especially, interest rates can be quite high – as much as 24.9%. That means carrying a $1,000 balance for a year might cost you upwards of $250 in interest.
To get into the habit of paying your bill on time each month, come up with a foolproof process that includes marking your calendar with your due date and/or setting a reminder on your phone. If you’re sending your payment through the U.S. mail, make sure to allow seven days for your check to arrive and be processed. The easiest way is to set up automatic payments from your bank account.
Step 4: Don’t Open Too Many New Accounts (or Close Old Ones)
Experian suggests applying for and opening new credit accounts “only as needed.” You may be tempted to open as many accounts as you can in order to improve your credit mix or take advantage of signup bonuses, but it’s unlikely to help.
Building credit safely also means building it slowly. Rushing into too much credit too fast may actually have a negative impact on your score if you end up with too many new inquiries – or worse – with debt you cannot pay off. Using one credit card while you build excellent credit habits is a great way to build credit safely while also staying out of trouble.
And once you have a credit card, keep it open — even if you no longer use it. This helps your credit score in two ways:
First, 15% of your score is determined by the length of your credit history. If you get a new credit card but close the one you’ve been using for the past five years, your credit history is suddenly much shorter.
Second, by closing that account, you lose the available credit that came with it. This will negatively impact your debt-to-limit ratio. That figure, which accounts for 30% of your score, simply refers to how much of your credit limit you’ve used up.
For example, if you have a $200 balance and a $2,000 credit limit between your two cards, your debt-to-limit ratio is a very respectable 10%. However, if you close your old credit card, and it had a $1,500 limit, you’ll suddenly have a high 40% debt-to-limit ratio, which can hurt your score.
Step 5: Keep Balances Low
If you’re tight on cash one month, it might be tempting to carry a balance for a while. But what happens if you’re tight on cash the next month? And the next?
This is how people get into trouble. They carry a balance from month to month until it snowballs into something entirely unmanageable. If you want to build credit safely, you have to avoid this trap. The easiest way to do this is to pay your balance in full each month, or more than once per month. At the very least, you should try to keep your balances as low as possible at all times.
And remember, your debt-to-limit ratio — the amount you owe against your credit limit — makes up 30% of your credit score. Keeping balances low won’t only save you from going into debt, but it will also help you improve your credit score almost immediately.
Step 6: Stay the Course
Once you have a new credit card and get into the habit of using it responsibly, all you need to do is stay the course. That means all of the steps mentioned above – making small purchases, paying your bill on time, keeping your balance as low as possible, and avoiding the urge to open too many new accounts.
You may also want to check your credit score periodically in order to stay abreast of any changes. One way to do that is to take advantage of free credit management sites.
Some credit cards are starting to offer a free FICO score on your monthly statement as a cardmember perk.
Once your credit becomes established, you might be able to qualify for a card that offers this benefit.
Building credit safely takes time. You not only have to establish a credit history, but you also have to prove that you can handle it. Those things won’t happen over the span of a few months. So get started right away, but then take it slow. You’ll thank yourself later.
A Safe Credit Building Checklist
To recap, if I were trying to build credit from scratch starting from today, here’s what I would do:
- Get a credit card, preferably an unsecured one. If I found that an unsecured credit card was not an option, I would opt for a secured card. If you can’t get a credit card on your own, you can also ask a parent or adult you trust to add you as an authorized user to their credit card account. If that happens, all of their credit movements on that card will also be recorded to your credit history. Ideally, the person who adds you as an authorized user will have excellent credit that will help boost your score over time.
- Use your card for small purchases. Pull it out of your wallet only for merchandise or bills you know you can pay off immediately. Using your card for small purchases will also help keep your balance as low as possible. Since 30% of your credit score depends on the amounts you owe, this is important.
- Pay your bill right away until you get in the habit of paying it on time. Set reminders on your phone or mark your due date on your calendar for extra insurance. Remember, 35% of your credit score depends on your ability to pay your bills on time.
- After some time, apply for a different type of loan or credit card in order to improve your credit mix, which makes up approximately 10% of your credit score. Only take this step when it makes sense to do so. Also keep old accounts open – even if you aren’t using them. The length of your credit history makes up 15% of your credit score.
- Look for other areas where your credit movements might be reported. A handful of companies have built entire businesses around helping people get certain bills reported on their credit. Rental Kharma and RentTrack are two that focus specifically on rental reporting. With either service, you can get bills that wouldn’t normally get reported – like rent payments – listed on your credit report. If you’re unable to qualify for a credit card, these services offer another avenue to get credit for any on-time payments you’re making.
- Check your credit report yearly with the only government-approved site, AnnualCreditReport.com. You are entitled to a free credit report from all three credit reporting agencies once per year. If you find any errors, report them right away to avoid damage to your score.
Follow these steps and your credit score will have no choice but to improve over time. It’s true that you have to use credit to build credit, but it’s important to remember that a little credit goes a long way.