How to Build Your Credit from the Ground Up
From a young age, many of us are taught not to take on any debt — that it’s best to pay in cash and only spend what you already have. A big issue with the cash-only mindset, though, is that it doesn’t help you build your credit. When you reach the point in life where you’re ready to buy your first home and get your first mortgage, you may be in for a rude awakening if your credit report doesn’t have much to show. A solid credit score is a necessary component when you’re applying for a mortgage.
Your credit score is the heartbeat of your financial health. Just as a yearly check up is important to maintain good health, a yearly check of your current credit score is a must. Scores range from 300 – 850. The higher the score, the lower the risk for the lender. The better the score, the more credit, and better terms will be available to you. In order to build a solid credit report, it’s important you understand how your credit score is determined and what factors can make it rise or fall.
What Is a Credit Score?
Your credit score, often referred to as your FICO® score, was introduced by Fair Isaac and Company in 1989, and was designed to provide lenders with an objective assessment of a potential borrower’s ability to repay debt. The FICO® Score doesn’t take into account race, ethnicity, religious affiliation, national origin, gender or martial status. It doesn’t consider age, current salary, occupation, or employment history — although mortgage lenders will take these and other factors into consideration as part of your overall financial picture.
Understanding Credit Scores
According to Experian, these are the credit score ranges and what they mean:
300 – 579 (Very poor)
Credit applicants may be required to pay a fee or deposit, and applicants with this rating may not be approved for credit at all.
580 – 669 (Fair)
Applicants with scores in this range are considered to be subprime borrowers.
670 – 739 (Good)
Only 8% of applicants in this score range are likely to become seriously delinquent in the future.
740 – 799 (Very good)
Applicants with scores here are likely to receive better than average rates from lenders.
800 – 850 (Exceptional)
Applicants with scores in this range are at the top of the list for the best rates from lenders.
How Your Credit Score Is Calculated
Your credit score is a mathematical calculation determined by a number of factors. Each of these five factors are given a certain weight in determining the amount of risk a lender would be taking in offering you a credit card, a car loan, a student loan, or a mortgage.
- Payment history (35%) This includes all credit cards, retail accounts, installment loans, finance company accounts, and mortgage loans. Also, bankruptcies, foreclosures, lawsuits, garnishments, public records, items in collection, liens, judgments, and late or missed payments.
- Amounts owed (30%) On all types of accounts, how many accounts have balances? How much of the total credit line is being used on revolving lines of credit? What are the remaining amounts due on installment loans?
- Length of credit history (15%) A longer credit history is a positive in determining your score, so don’t wait to build your credit. Other factors include how long accounts have been established, specific accounts, and how long it has been since you used them.
- Types of credit (10%) The kind of credit accounts you have and how many of each type. They’re looking for a good mix.
- New credit (10%) Are you taking on more debt? This includes how many new accounts you have by type, how long since you opened a new account, and how many recent requests for credit you’ve made. Inquires remain on the report for two years, but the score looks at the past 12 months.
Note: These percentages are based on the importance of the five categories for the general population. For particular groups — for example, anyone who hasn’t been using credit long —the relative importance of these categories may be different.
The 4 Types of Data that Can Impact Your Credit Score
There are four types of data that can impact your credit score as you build your credit and it is important that each of these has correct information. The credit agencies do make mistakes, but it’s up to you to find them and make sure they are corrected.
- Personal information – Name, address, social security number, date of birth, and current employment
- Account summary – Types of credit you use (credit cards, car loan, mortgage, etc.), length of time your accounts have been open, whether bills were paid on time, how much credit you’ve used, current amounts owed, new credit
- Inquiries – There are two types of inquiries: voluntary and involuntary.
- Voluntary inquiries are those authorized by you at the time you’ve applied for a loan, lenders who’ve inquired within the past two years, and any inquires you’ve made. You are not penalized for checking your credit through the three major agencies or other organizations authorized to provide credit reports such as freecreditreport.com, www.myFICO.com
- Involuntary inquiries are credit checks by an employer or pre-approval credit inquires. While they don’t affect your score, a large number of inquires can suggest you’re a greater risk.
- Negative items – These include delinquencies, unpaid or overdue payments sent to a collection agency, bankruptcies, tax liens, foreclosures, garnishments, legal suits, judgments, and public records from state and county courts.
Behaviors to Build Your Credit and Maintain a Good Credit Score
In order for a credit score to be calculated, your credit report must contain enough payment history. Generally, this means you must have at least one account that has been open for six months or longer, and at least one account that has been reported to one of the credit reporting agency within the last six months.
To establish credit
- Start by applying for a secured credit card that requires a deposit as collateral should you fail to make payments
- Apply for a small credit-building loan
- Have someone cosign a loan for you
- Have a family member add you as an authorized user on their credit card
Once you have established credit
- Don’t open a lot of new accounts quickly if you have only recently established credit
- Don’t open new credit card accounts or take on new loans of any kind that you don’t need
- Always pay all your bills on time. This includes utilities and other bills, not just credit cards and loans.
- If you can’t pay the full amount, pay at least double the minimum balance on credit cards and work out a payment schedule with utilities, etc.
- Keep balances low on credit cards and other sources of revolving credit. This is called your credit utilization, which is your balance owed compared with the limit up to which you can borrow.
- Don’t move debt from one credit card to another
- Don’t close unused accounts that make up your credit history. Doing so won’t get you a better score
- Avoid opening new credit card accounts which can lower your average account age
- When shopping for a loan, do so within a short period (7-14 days) to avoid accumulating too many inquires on your credit report
To maintain a good credit score
- Check your credit report once yearly and contact agencies to fix any incorrect information
- Look for clerical errors, credit card accounts and loans that may have applied in error
- If a bill shows as unpaid and you know you’ve paid it, contact the service and ask for a copy of your check or other receipt to confirm payment and follow-up with the credit agencies
- If you find yourself in debt, contact creditors to negotiate a payment schedule or consider consulting a credit counselor
- Avoid credit repair agencies that charge to improve your score
U.S. Credit Reporting Agencies
There are three major credit bureaus: Experian, Equifax, and TransUnion. Each of these agencies monitor your credit, which means you actually have three different credit scores. Lenders may utilize one or all of these agencies when evaluating you as a credit risk. So, it’s a good idea to get a credit report from each and report any errors as soon as possible as you build your credit and before applying for a home loan. You can also dispute any errors by contacting the credit reporting agencies directly:
- Equifax: (800) 685-1111, www.equifax.com
- Experian (formerly TRW): (888) 397-3742, www.experian.com
- TransUnion: (800) 888-4213, www.transunion.com
Credit is a convenience when managed responsibly. Use common sense, and stick to your budget. Eventually, you’ll build your credit and have the credit score you need when you’re ready to purchase that first car, pay for college, or buy a home.