Build Credit from Scratch
Anyone in the very early stages of looking for a new house or buying a car will hear the term credit score thrown around. Having a good credit score is essential to getting approved for a mortgage. But what is a credit score? Why is it important? And how do you improve it?
People refer to a credit score as a financial report card, but that's not really true. Your credit score isn't a record of all your financial habits, such as budgeting or investing, but it is a record of how you borrow money.
Although I don't recommend taking on debt in general, there are occasions when it's necessary, such as when you buy a house. In order for the bank to lend you that money, they need to know that you'll be responsible with it. The way they know that is by looking at your credit report - i.e. your borrowing history.
How Does a Credit Score Work?
When you borrow money, the information gets reported to credit bureaus. They put it on your credit report, and it's then used to create your credit score. The credit score usually ranges between 300 and 850.
A score of 720 or higher is generally considered excellent credit.
A score of 690 to 719 is considered good credit.
Scores of 630 to 689 are fair credit.
Scores of 629 or below are bad credit.
Building Credit
Payment history: This makes up 35 percent of your credit history and is easily in your control. It's also the most important factor. If you always pay your balance in full and on time, you're doing all you can in this regard.
Credit utilization: This makes up 30 percent of your credit score. How much of your available credit are you using? Using too much credit can lead lenders to assume that you need all that money and will have a difficult time paying it back. The general rule is not to spend more than one third of your available credit, although some experts advise using even smaller amounts, such as 10%.
Length of history: This is 15 percent of your credit score. The longer your credit history is, the more reliable the data. Generally, the longer you have a credit card, the higher your credit score will be. To ensure that you have a long credit history, don't close any credit cards, especially if it's one of your first cards that extend the average age of your credit history.
If the card has a fee and you don't want to pay it anymore, see if you can downgrade it instead of closing it. Set up small automatic payments using the credit card you hardly ever use and make sure to set up automatic payments from your bank account as well. That way, you can keep the card in use.
Credit mix: This makes up 10 percent of your credit score and analyzes how well you manage different types of credit. If you have student loans or car loans, those will go here together with your credit card usage information.
New credit: This is 10 percent of your credit score and measures how much credit you recently requested, making it less likely that you'll be able to pay it back. Asking for new credit can lower your score by up to five points for 12 months, so keep that in mind if you're planning on buying a house soon. Similarly, don't apply for too many credit cards close together, since it makes you appear desperate for cash.
Starting the Process
If you don't have a credit card, how are you supposed to create your credit report? How do you get your first loan with no score?
The first step is to become an authorized user on a credit card of someone with good credit. This can be done when you're as young as 13. At this point, you're authorized to use someone else's card, preferably a relative's, and it can help you build your score. Make sure to only do this with someone in whose hands you're willing to put part of your financial future, since if their credit goes down, yours will too.
Parents can even add their children as authorized users just to raise their credit without actually letting them use the card. But first check if the credit card company reports the authorized users to the credit bureaus, because if they don't, it won't help them build credit.
Whether or not you're able to become an authorized user, apply for an unsecured card. This can be done as soon as you're 18. Look for something simple with no annual fee and no major perks, making it more likely that you'll get approved. And when you apply, do it on someone else's referral so they can earn money. If you aren't approved, call the reconsideration line.
If that doesn't work, try a secured or student credit card -i deally one with an upgrade option. A secured card is a card where you can only borrow up to the amount of money you deposit.
Getting Approved
In order to be approved, your income makes a difference. Find out what the company counts as income. Even if you aren't currently employed, the company may count tuition that's being paid on your behalf as income. After age 21, the bank may allow parents' and in-laws' incomes to be counted as well.
Monitor
Once you have the credit card, you can monitor your report from your credit company. Your score won't change much from month to month, but every once in a while, check it so see where you're holding. Having good credit can be an important tool for financial stability.
