May 6, 2017

How to Build Credit for the First Time

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Building credit without credit is not impossible. Here are 7 smart ways to establish credit for the first time.

What You Need to Know

Credit is essential. We all know that by now.

Nowadays, you need credit for just about everything you do. And not only for getting credit cards, buying a car, or renting an apartment. Your future employer may even run a credit check on you. Even simple things like trying to get a new cell phone service could depend on your credit!

If you're trying to build credit, you probably realize the conundrum: You need a credit card to build credit, yet you can't get a credit card without good credit.

Don't worry, everyone starts out from nothing. There are several ways to build credit from scratch or from a limited history. And it doesn't matter what your income is.

We're going to go over several options for building credit the smart and safe way. Read on.

UNDERSTANDING THE BASICS: WHAT IS A CREDIT SCORE?

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Your credit score is the most important 3-digit number for your financial life. To put it simply, it tells a lender the likelihood of you paying back a loan. If your score is bad, the lender will be less willing to give you the loan. Or you will be charged a high interest rate, which could translate into thousands of dollars more over the course of the loan.

Here's what determines your credit score:

  • Payment history (35%): do you pay your bills on time and do you have a balance?
  • Credit utilization (30%): how much credit you're using compared to what you've been given.
  • Length of your credit history (15%): length of time you've had credit accounts and activity.
  • Types of credit (10%): what kind of credit you have (credit cards, car loan, student loan, etc.).
  • New credit (10%): number of new applications for credit or inquiries.

Tip: Age, occupation, income, employment history and marital status don't matter for your credit score. However, note that a lender may take these things into account when deciding to give you a loan or not.

The most popular credit score is the FICO score, developed by the Fair Isaac Corporation. There is also a Vantage Score developed by the three major credit bureaus (TransUnion, Experian, and Equifax). A lender may choose to look at either score to determine your risk.

Did you know? Every year, you are entitled to one free credit report from each of the 3 credit bureaus. You can get it at annualcreditreport.com.

HOW BUILDING CREDIT WORKS

Your credit score is how a lender determines your ability to pay back a loan. So the only way to build credit is by paying back loans.

In other words, you can't just have a checking account and pay for everything in cash. This may mean you're debt free, but it also won't get you a credit history. The only way to build credit is by showing that you can pay back loans responsibility.

There are two types that can help you build credit:

  • Revolving credit lines, which means an open-ended line that allows you to keep on borrowing as you pay (up to your credit limit). This means credit cards.
  • Installment loans with fixed monthly payments. This would be things like a student loan, car loan, mortgage, etc.

Ideally you want a mix of both credit lines and fixed loans. This tells the credit bureaus that you're capable of managing different types of debt.

Now let's go over just how you can start building credit

USING CREDIT CARDS TO BUILD CREDIT

If you have no credit at all, you probably know it's very hard to get approved for a credit card. However, there are some ways to get plastic in your wallet to start building credit.

SECURED CREDIT CARDS

A secured credit card is one of the best and fastest ways to start your credit card building journey. You don't need a credit history to obtain a secured credit card.

Here is how it works:

To open an account, you need to put down a security deposit. This reduces the risk to the lender in case you don't make your payments. In exchange, you'll get a credit card with a credit limit (usually the amount of your deposit). You can then use your secured credit card to make purchases as normal and pay off the bills as normal. But if you don't make the payments, the lender can choose to withdraw money from your deposit to cover the defaulted amount.

If you have no outstanding balance and are in good standing, you can get your security deposit back when you close your account.

Secured credit cards report to the 3 major credit bureaus to help you build (or rebuild credit) with responsible use. The concept may sound kind of like a pre-paid card to you, but pre-paid cards don't report to credit bureaus.

Watch out: The downside of secured credit cards is that you'll have to save up the money first. So if you want an $1,000 credit limit, you'll need to save up $1,000 for the deposit. And you won't get that money back until you close the account (assuming you have no outstanding balance).

Check out our top recommended secured credit cards.

STUDENT CREDIT CARDS

If you are still in college, getting a student card is a good way to start building credit. Just about all major card issuers offer student cards. However, some will require a parent co-signer (someone who agrees to be responsible for your debt).

Generally, student cards have a lower credit limit. This is good because it prevents overspending. You should only be using it for necessities and emergencies.

This is a great way to start building credit before you fully enter the "adult world." If you are responsible with using your student card, you can get ahead and have an easier time buying a car or renting an apartment later.

Check out our top student credit cards.

BECOME AN AUTHORIZED USER

This is perhaps one of the easiest ways to start building credit. Simply ask to become an authorized user on someone else's credit card account. You will get a credit card with your name (but same card number), which you can use for purchases.

Of course, this agreement means you need to have a lot of trust in each other.

  • As an authorized user, you are not responsible for payments. Only the main account holder is obligated to pay the balance. So don't go wild with your spending.
  • For you, you need to make sure this person has a low credit utilization and pays their bills on time. If the account owner is often late with payments or only pays the minimum, then your credit score could be hurt as well.

If the person has good payment habits, it'll help your score too. You don't even have to use your card to reap the benefits.

One thing to watch out for: Before you sign on as an authorized user, make sure your authorized user status is reported to the credit bureaus. Some card issuers don't report authorized user activity, which does absolutely nothing for your credit.

MAINTAIN GOOD CREDIT CARD HABITS

The MOST important thing is to use your card responsibly. This means:

  • To start, never miss a payment. Missing payments puts a serious dent in your credit score. Plus, many credit cards have a penalty rate of 29.99% that kicks in after a late payment. And it may be hard to climb your way out.

  • It's also best to pay off the entire balance each month. If you can't pay off your card, it sends a message to lenders that your income cannot support your spending habits. But if you do run into a few cash flow issues one month, still pay off as much as you can (never just the minimum).

  • Maxing out your credit is also a huge red flag. Again, this tells lenders that you spend more than you can afford. Instead, try to keep your credit utilization at around 30%. This means that if you have a $2,000 credit limit, don't use more than $600 of it at any time. Even more ideal is to keep it under 20%.

Tip: If you have been really good about making payments on time and paying off the entire balance, it never hurts to call your bank and ask for a credit line increase. This could help your credit score. Because now with a higher limit, your credit utilization is lower. So if you do get approved for an increase, make sure you keep your usage the same.

BUILDING CREDIT WITH LOANS

The second way to build credit is through installment loans. Some options include:

STUDENT LOANS

If you took out a student loan for college, then you're already on your way to building credit without even realizing it.

Student loans are considered installment debt, so it's reported to the credit bureaus. You don't need a credit score or a parent co-signer to take out a federal student loan for education. As you start to pay back the loan (on time, that is!), you'll start to build credit.

CREDIT BUILDER LOAN

These are personal loans specifically designed to help you build credit in a safe, responsible way. No credit score is required. They work by giving you a loan in a secured savings account that you pay back in installments. Usually, credit unions or community banks will offer them.

One such online company that offers this is Self Lender. Here's how it works:

Self Lender lends you the money and holds it for you in a 1-year CD account in your name. You can pick the loan amount. Every month, you make a set monthly payment to repay the loan. At the end of one year, you have paid off this loan and can get access to your money (including the interest earned!). There is a small administrative fee.

This is almost like if you just put money into a savings account, except Self Lender reports to all three credit bureaus every time you make a payment. This is considered an installment loan and shows that you are able to make timely payments.

This is very well worth considering because it's a responsible way of building credit. There's no danger of overspending and then getting stuck with interest that you can't pay off. And at the end of a year, you'll have established credit AND have a nice little savings fund.

Watch out: Before you apply for a credit builder loan, make sure you are fully able to make the monthly payments (and on time!). If you cannot, the late and default payments will be reported to the credit bureaus and hurt your credit.

CO-SIGN A LOAN

Even if you like paying in cash, you will probably need a loan at some point in your life (such as for a car). If you have no credit, you'll need a co-signer to take out the loan with you. This is a person who agrees to pay back the loan if you default.

The good news is that as long as you have a co-signer with good credit, you'll most likely get the loan with no problem. And you can start building credit.

The bad thing is that the co-signer will become liable as well if you're not responsible with your payments. Their credit score will also be affected if you're late with payments. And if you default on the loan, the debt become their legal responsibility. So this needs to be a person very close to you to be willing to take that risk (such as a parent).

Watch out: We don't recommend taking out a personal loan just for the sole purpose of building credit. Loans come with interest plus origination fees (the cost to process the loan), so you'll be paying extra as you repay the loan. Only take this route if you actually need the loan, like an auto loan.

Did you know? If you need another way to build credit, you could report your rent payments too. Typically, landlords don't report your rent to credit bureaus. However, with a service like Rental Kharma or Rent Reporters, you can build credit for paying your rent. Here's how it works:

  • You fill out an application with your past rental payment information
  • They verify with your landlord that you have been paying rent on time
  • Then they will report your rent history to the credit bureaus

There is a fee for the service.

BOTTOM LINE

Everyone starts out with zero credit. So building credit is really nothing to worry about! There are a lot of ways you can establish credit responsibly, whether it's through a secured credit card, credit builder loan, or with the help of someone trusted. The biggest thing to remember is to always, always make your payments on time. And pay off the entire balance on your credit cards. Your credit will surely go up as you make timely payments.

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About CreditDonkey®
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