How to Build Credit

What is credit, and why is it important?
What factors affect your credit score
How long does it take to build credit history?
Building credit from the ground up
How to achieve a good credit score
The importance of monitoring your credit score

Whether you're seeking a mortgage, taking out a loan or renting a new apartment, you should know how essential it is to have a good credit score. For many people, building credit starts by making timely payments on a student loan or credit card. However, to qualify for a credit card or loan in the first place, you often need to have a good credit history. This creates a challenging "chicken and the egg" scenario in which you need credit to build credit.

So how do you start building credit from the ground up — or try to re-establish your credit?

What is credit, and why is it important?

Before diving into how to start building credit, it's critical to understand what credit is and why it's important.

Credit enables people to borrow money for goods or services that they promise to pay back at a later time. Creditors (i.e., lenders, merchants or service providers) issue credit to people based on the level of risk they pose as a borrower. This risk, and conversely a creditor's confidence, is often determined by your credit score and credit report.

Credit report vs. credit score

A credit report is a record of your history managing and repaying debt. It works as a kind of report card lenders and other companies view when deciding to do business with you. Included in your credit report is a historical record of how and when you pay your bills, how much debt you have, and how long you have been managing credit accounts.

Lenders and other companies may use your credit report to learn more about your previous borrowing experience, which helps them make decisions about granting you credit. Credit reports are also used to calculate your credit scores. There are three nation-wide credit bureaus in the U.S. — Equifax, Experian and TransUnion.

A credit score is a 3-digit number based on information contained in your credit report that a lender uses to help them determine if they'll grant you credit and at what terms. While there are several brands of credit scores, the most commonly used are FICO® Scores. FICO Scores typically range from 300 to 850, where lower scores equate to a higher risk of not paying bills as agreed in the future. Your credit scores can fluctuate over time depending on the activity reported on your credit accounts.

What factors affect your credit score?

While the criteria for other scoring models vary, your FICO Scores are calculated based on five categories of information gathered entirely from your credit report. Each category represents a percentage of your FICO Score. These categories include:

• Payment history (35%) How you've paid your bills in the past — whether you've paid on time or late, or missed payments — is a very important category of credit data for the FICO Score. The more severe, recent and frequent the late payment information, the greater the impact on a FICO Score.
• Amounts owed (30%) The amount of credit you're using is a very important category of credit data for the FICO Score. FICO Scores consider the total balance owed, how many accounts have balances and how much of your available credit you're using.
• Credit history length (15%) FICO Scores take into account how long your credit accounts have been established, including the age of your oldest account, the age of your newest account and the average age of all your accounts.
• Credit mix (10%) FICO Scores consider the different types of credit accounts being used or reported, including credit cards, retail accounts, installment loans and mortgage loans. Your credit mix will be more important if your credit report doesn't have a lot of other information on which to base a FICO Score.
• New credit (10%) When considering your amount of new credit, FICO Scores take into account how many new accounts you've recently opened and whether you've been rate shopping for a single loan or applying for multiple new credit lines. Opening several new credit accounts in a short period of time indicates greater credit risk.

How long does it take to build credit history?

Now that we have a better understanding of what credit is, it's important to start thinking about how to build credit history.

In order to receive a valid FICO Score, the credit report must have:

• At least one account opened for six months or more.
• At least one account that has been reported to the credit bureau within the past six months.
• No indication of deceased on the credit report (Please note, if you share an account with another person, this may affect you if the other account holder is reported deceased).

The minimum scoring criteria may be satisfied by a single account or by multiple accounts on a credit file. So, if you are approved for new credit that is actively used and reported to the credit bureau, you should meet the minimum scoring criteria in six months.

Building credit from the ground up

When you first make the decision to start building credit from nothing, it can seem paradoxically difficult to get a credit card or loan without having any credit history. However, there are several options that could help you begin your credit-building journey.

Ways to build credit with credit cards

Credit cards make it easy and convenient to pay for things like goods, services, bills and more. Unlike a debit card, which takes funds directly from your bank account, credit cards essentially act as an ongoing loan from the credit card issuer. When you open a new credit card account, the card issuer sets a credit limit that you can spend against. The available credit is the amount of money you have left on the card as you charge it. Then, before the due date, you simply pay back the credit card company for what you spent.

Opening your first card account

If you have an existing relationship with a bank or credit union, they likely already value your business and that relationship could help qualify you for a credit card. Other credit card companies offer cards specifically designed for new credit builders.

How to get started as an authorized user

Becoming an authorized user on a family member's credit card account can be a way to start building credit from nothing. This is because it can allow you to take advantage of the benefits of their good credit history, even if you never use their credit card. The process for this is relatively straightforward; the primary account holder just needs to add your name to their credit card account.

However, this method doesn't have as big of an impact on your own credit score, and it doesn't come with all of the privileges of being a primary account holder. To start building your own credit score, you'll likely need your own credit card account. For many people, their first credit card is a secured card.

Secured vs. unsecured credit cards

Secured credit cards are a type of credit card that requires you to put down a security deposit to open an account. Typically, this amount then becomes your credit limit, protecting the card issuer if you're unable to make your payments. You can't, however, use this money to pay off your balance or make other purchases. Secured cards are often used by first-time card owners or those looking for credit repair, as they're typically easier to qualify for and are typically reported to the credit bureaus like an unsecured credit card.

Unsecured cards, on the other hand, are what you might think of as a traditional "credit card." It basically means that you don't have to pay a security deposit to be approved, however, qualification may be exclusive to a specific range of credit scores.

Loans, rent and service provider payments

There are other options to build a good credit history without using credit cards.

• Student loans: For many people, the first loans they receive go toward college or university tuition. By paying off these installment loans in regular intervals over a predetermined period, you can start building a credit history. Student loans also get added to your credit mix, which may help your credit score.
• Co-signed Loans: If you have trouble getting approved for a loan, you can ask someone close to you to co-sign. This means both parties share equal responsibility for the debt and the loan appears on both credit reports. As long as you don't miss any payments, this can be a great way to build a good credit history.
• Service providers: Utilities, cable, cellular service and internet all require you to sign contracts with the understanding that you'll pay for their services each month. Many modern credit scoring systems take these payments into account when generating your credit score.
  
• Rent payments: Sometimes, landlords will report your rental history with the credit bureau. While this is not common practice, it may be worth asking your property managers if they do this or if they can start.

How to achieve a good credit score

Achieving a higher credit score takes time, patience, and financial responsibility. While you can't get a perfect 850 overnight, you can focus on behaviors and practices that creditors look for in a borrower. This will hopefully form a habit that will help you maintain good credit in the long run. Here are a few educational tips that can help you start building credit now and in the future:

• Paying your bills on time is the most important rule of thumb when it comes to generating good credit. Your payment history accounts for 35% of your total credit score, so it's best to avoid making a late payment.
• Spending well below your credit limit is considered best practice as creditors typically view high spending as risky behavior.
• Read the terms and conditions of each credit card before you apply. Not only do you want to ensure it's the right card for you, but you also want to know if you'll qualify. If you apply and get denied, the inquiry may lower your credit score by a few points.
• Maintain a healthy mix of credit cards and loans to show creditors that you have experience managing different types of debt. However, remember to not open too many lines of credit in a short amount of time, as this can be seen as risky behavior.
• Finally, try not to close a credit account; only apply for credit cards you intend to keep and build a history with that account.

The importance of monitoring your credit score

Credit scores are a vital part of your overall financial wellbeing. Creditors use these scores to determine approval for new lines of credit, interest rates and fees and even utility deposits, so a bad credit score can have lasting financial impacts in many areas of your life. Knowledge of your credit score and credit history can help you better understand your current credit position before you apply for a new account. This way, you know what you need to work on before applying for a loan or card.

How to check your credit report and credit score

Under the Fair Credit Reporting Act, each of the three major credit bureaus has to provide consumers with a free credit report once a year at a minimum. However, free credit reports don't include your credit score. This means that you must go through an authorized FICO Score retailer, like myFICO or Experian, to check your credit score.

About myFICO

myFICO is the official consumer division of FICO, the company that invented the FICO credit score. FICO® Scores are the most widely used credit scores and have been an industry standard for more than 25 years.