More often than not, banks and credit card companies inquire into your credit history before granting your request for financing. But what happens if you’ve reached adulthood without ever needing a credit card or loan, and are just now looking to establish credit? Here are some tips to help you start on the road to creditworthiness.
How Credit is Determined and Why It’s Important
Those new to the concept of credit may be wondering what it is and why it’s become such a relevant aspect of western society. As it happens, the notion of credit has been around since the dawn of the earliest complex civilization in human history, the Sumerians of ancient Mesopotamia. Today, credit has become one of the foundations of modern society and a precipitator of expansion, economic growth and, consequently, consumerism. Our credit history is now the main factor used by lenders when determining our ability to borrow something of value and pay for it later, an ability in turn defined by our borrowing history and how often we make timely payments on our debts.
How to Build Credit
When determining our creditworthiness, prospective lenders take into account our credit history gathered from sources such as banks, retailers, landlords, utilities, public documents, etc. They then calculate a credit score, a three-digit number intended to predict our likelihood of becoming delinquent on our debts. Besides our payment history, a number of other factors go into the algorithmic calculation that determines our creditworthiness, like how much we owe, the length of our credit history, the variety of credit accounts under our name, and total hard inquiries into our credit.
Credit is not a requirement for financial stability or solvency, in fact, you only need credit if you plan on applying for an auto loan, mortgage, or credit card down the road or want to have the ability to borrow comfortably in the event of an emergency. If you’re among those who would rather have a backup to cover unforeseen expenses, building credit and improving your credit score is essential. You can establish credit by borrowing money in the form of a loan or credit card, yet those options may not be as easily obtainable for someone with no previous credit history.
Five Ways to Start Building Credit
Since nothing is ever free in the finance world, inform yourself about interest rates and fees before committing to a credit card or loan that could negatively impact your borrowing ability in the future. Here are some additional options you may want to consider carefully and read about thoroughly:
1. Get a Credit Card
There are credit cards with terms that are tailored to specific purposes and economic goals, from cards with no interests and additional rewards, to those specially designed for students, frequent travelers, and small businesses. Getting approved for an unsecured credit card or one for which you don’t need to provide a deposit can be difficult for someone with little or no credit history. Thankfully, there are options specifically designed for people like us, just now starting to figure out the ins and out of building credit.
• Prepaid Credit Cards – As the name suggests, these types of credit cards have to preloaded with funds and are primarily used for easy cashless spending. Prepaid cards may come with very high fees, so get all the details and shop around before committing to this option.
• Secured Credit Cards – Secured credit cards are similar to prepaid cards, yet the user is required to make a deposit that will serve as collateral as well as the line of credit for the account. The deposit will be equal to or less than the card limit, usually $300 to $500, and you’ll get it back after closing the account.
• Student Credit Cards – Student credit cards differ from regular unsecured credit cards in that they’re typically marketed towards students and individuals with low credit scores. These types of cards often feature higher interests and lower credit limits as well rewards and benefits like cash back for maintaining good grades.
When choosing between credit card options, consider your priorities and decide whether rewards, benefits or a low APR are your biggest concerns. Before applying for any type of credit card, evaluate your credit situation by obtaining your FICO credit score or a free “educational” VantageScore 3.0 from our partner, Credit Sesame or a similar service. Knowing your credit score can help you narrow down which credit cards you are most likely to get approval for.
2. Become an Authorized User on Someone Else’s Account
Another great way to establish credit is to become an authorized user on someone else’s card, like a parent, family member or significant other. This is a great option if you are unwilling to open your own credit card account, but be aware that your credit could be negatively affected if the account holder fails to make their payments on time or has a high credit utilization rate.
3. Get a Co-signer
If you have insufficient credit to obtain a credit card or loan, you can ask a parent or family member with good credit standing to be your co-signer. Just remember that whoever you choose as co-signer will have to be responsible for the full amount you borrowed if you fail to make payments.
4. Use Your Utilities or Rent Payments as Evidence
Some utility companies and landlords report on-time rent payments to credit reporting agencies and bureaus. Experian, for example, has partnered with several rent payment processing apps and reporting services to gather rent payment history data on consumers and make it easier for them to establish a credit history. Rent reporting services aren’t free, however, so they may not be an option for everyone.
5. Take out a Loan
As a last resort, consider applying for a student loan, secured loan or credit-builder loan. Student loans can be either private, which often feature higher borrowing limits and variable interest rates, or federal, which offer fixed rates but have a maximum annual limit. Credit-builder loans are often personal loans or secured loans typically offered by credit unions and few other banks to those who are able to prove their financial stability yet need help establishing or repairing their credit. Institutions offering loans for the sole purpose of credit building typically place the funds on a locked savings account that cannot be accessed by the borrower until the loan is paid in full, while those offering secured loans require a collateral in the form of a savings account or other assets.
How to Improve Your Credit Score
Establishing credit is a surefire way to improve your credit score, but it’s only the first step in a long journey. In order to maintain good credit and improve your score, you’ll have to make timely payments and pay your bills in full at the end of each month. If your main goal is to build credit, only use your credit cards to purchase what can afford to pay back, like meals, gas, and utility payments. Another good tip is to set up automatic bill payments if you fear you won’t be able to remember to check your credit card accounts regularly. Remember that credit card accounts have to be used at least once every three months to remain active and that closing a credit card account with an outstanding balance can hinder your credit score.
Checking Your Credit Score
Checking your own credit score is known as a soft credit inquiry, meaning your credit history is not being evaluated by a prospective lender. Soft inquiries do not affect your credit score, so you can monitor your credit and keep track of your progress through a credit reporting service. Know that your free annual credit report will not include your FICO score, which is the most commonly used by banks and credit card companies. There are, however, a number of free online services offering free credit report summaries and consumer VantageScores, which can give you an accurate idea of your current credit standing. Building credit can be a slow process, but one with many potential benefits for those who can pay on time, stay within their credit limit, and pay more than the minimum at the end of each month.