Credit makes the financial world go 'round. That's true for Fortune 500 companies, first-time homebuyers and aspiring college students alike. Lenders make decisions about the creditworthiness of borrowers based primarily on credit reports and credit scores -- two ways to quickly assess an applicant's credit history.
The strength of your credit history is what determines if you qualify for a credit card, a home mortgage or a car loan and at what interest rate. Have you always paid your credit card balance on time? Have you ever defaulted on a loan? It's all part of your credit history.
For new or young borrowers, however, this poses a serious catch-22: How do you qualify for credit without a credit history, and how do you build a credit history without first qualifying for credit?
More than 50 million American adults have no credit history [source: CNBC]. They've never applied for a loan, a credit card or any line of credit. While it's possible to pay cash for all expenses, it's hard to build enough cash reserves to pay for important milestones like a college education, car or home.
If you're ready to start building a credit history from scratch, you probably have a lot of questions. Where can a new borrower go for his or her first credit account? What do lenders look for in a loan applicant? What are some credit traps to avoid? Keep reading to learn our 10 healthy ways to build credit.
In the United States, credit reports are maintained by three major credit reporting agencies: Experian, Equifax and TransUnion. If you've never applied for any form of credit, then you shouldn't have an open file with any of these agencies.
Before you apply for your first credit card or make an appointment with the loan officer at the bank, check with each of the credit reporting agencies to make sure there isn't a false credit report open in your name. More than 20,000 children and teenagers were victims of identity theft in 2008 [source: Noll]. It's possible that someone has already used your name and stolen Social Security number to apply for credit.
Credit bureaus will open a legitimate credit file in your name when a bank, credit card company or other lender reports that you've had an active credit account for at least six months. All borrowers, not just first-timers, are encouraged to check their credit reports at least once a year and scan them for errors.
Mistakes can damage your credit score for years -- up to seven years for negative information like late loan payments and 10 years for a serious default like bankruptcy [source: FTC). If you find a mistake, contact the credit reporting agencies immediately.
Although credit reports are the best way for lenders to rate your creditworthiness, there are other ways to build a record of trust. Bank accounts are a great way for a young adult to prove a level of financial responsibility before applying for that first loan.
Checking and savings account information isn't included on a credit report, but lenders will request it for most loan and credit card applications. Lenders like to know that you have a few years of experience handling your own money and making regular withdrawals and deposits. They also like knowing that you have a steady income.
Several major U.S. banks offer free checking accounts with no annual fees or minimum deposits. Remember, though, that negative bank account activity will appear on your credit report: [source: Burt]. So if you keep a low balance and end up bouncing a check, future lenders will hear about it.
Since credit reports only track money that you've borrowed, they don't include information about whether you pay your utility bills and monthly rent on time. Likewise, bill payment histories are not used to calculate the most popular credit score -- the three-digit number known as your FICO score.
What most people don't know is that the FICO score isn't the only credit score available to potential borrowers. Some alternative credit scoring models incorporate bill payment histories as one of the main criteria for creditworthiness.
The people behind FICO -- the Fair Isaac Credit Services -- recently introduced the FICO Expansion Score, which culls financial data from "alternative data sources" like rent payments and utility checks to determine creditworthiness [source: Fair Isaac Credit Services].
There's even a company called Payment Reporting Builds Credit (PRBC) that allows you to self-report payments like rent, rent-to-own purchases and utilities. PRBC might not yet have the clout of the big three credit bureaus, but a solid report from PRBC might be enough to get your foot in the door with a lender.
Of course, to earn a good grade from PRBC, you'll have to pay your bills on time religiously. Get into the habit of paying a bill as soon as it shows up in the mail, or consider setting up online accounts to pay all of your bills electronically [source: Burt].
The nice thing about building credit from scratch is that you don't have to do it alone. Most lenders will allow someone with an established credit history -- like your parents, older siblings or a family friend -- to co-sign the credit application with you.
The benefits of co-signing a credit card application or loan application are twofold: The lender no longer has to make a credit decision based solely on your thin credit history and you can "piggyback" on the (hopefully) stellar credit score of your co-signer.
As with any financial transaction, you should be careful when co-signing for credit. First of all, make sure that your co-signer actually has a good credit history. If your older brother tends to exaggerate, don't take his word for it. In the eyes of the lender, you are only as good as your brother's credit score, so ensure that you see it in writing.
Also, stick with co-signers who have a clearly demonstrated relationship with you. Family members with the same surname as yours are always the best bet. A lender might get suspicious if you walk in the door with a seemingly unrelated stranger [source: Steiner].
The most important thing to understand is that co-signing for credit means that both parties are now responsible for its timely repayment. If your dad co-signs your credit card application and you run up hundreds of dollars in late payment fees, both of your credit scores are going to take a hit.
A secured credit card is a wonderful way to get your feet wet in the world of credit. Regular credit cards are called "unsecured," because there's no collateral backing up the line of credit. With an unsecured credit card, the bank allows you to borrow up to your credit limit without any guarantee that the money will be repaid.
A secured credit card, on the other hand, is tied to collateral held in a bank account. In other words, your credit limit equals your checking account balance or another amount required by the card company -- although payments for purchases made with this card won't be drawn from your bank account. If you have $500 in the bank, then your credit limit for the card is $500. If you try to charge more than $500 on the secured card, the transaction simply won't go through.
The cool thing about secured credit cards is that you can use them as training wheels for an unsecured card. Most secured credit lenders -- credit unions are excellent choices -- will let you graduate to an unsecured credit card after 12 to 18 months on a secured account [source: Grant].
Be careful, though: Some secured credit cards carry higher interest rates and fees. Above all, make sure that the secured lender reports to all three major credit bureaus. That's the only way you'll build a healthy credit history.
Another type of "training wheel" credit card is a card issued by a retail store like Macy's or Sears. In general, retail credit cards are easier to obtain than regular unsecured cards. The downside is that they don't carry as much weight on a credit report as a normal credit card [source: Pulliam Weston].
As you should with any secured credit card, make sure that the retail lender reports to all three credit bureaus. Make sure you read the fine print: Some retail cards carry interest rates as high as 30 percent. So if you're going to use one of those cards, you need to be extra diligent about paying your balance on time.
Some credit experts warn against collecting a bunch of retailer credit cards just to cash in on in-store discounts, particularly around the holidays. Every time you apply for a new card, the lender pulls your credit report. Several hits on your credit report in a short period of time will lower your credit score [source: Ulzheimer].
Another type of retailer card is a gas card or oil company card. These cards can typically only be used to purchase gas or other automotive services, while some allow you to get cash advances at station ATMs [source: Taylor]. Once again, make sure that the card reports to all three credit bureaus.
If you've gotten your feet wet with a secured credit card or retailer card and have proven that you can pay your monthly balance on time, it's time to take the plunge. Responsible credit card use is one of the quickest and most effective ways to build a solid credit history.
An unsecured credit card is a "revolving" line of credit. This means that the lender sets a credit limit and allows you to continuously borrow and pay back your balance as long as you stay under that limit. Every month, you're required to make a minimum payment. Any balance that you carry from month to month will be charged interest.
To build healthy credit with a credit card, you must follow one simple rule: Always pay your monthly bill on time [source: Bills.com]. If possible, pay the balance in full every month. If not, at least make the minimum payment.
There are other credit card traps that can affect your credit score. Try not to carry a balance higher than 30 percent of your credit limit [source: Pulliam Weston]. FICO frowns on borrowers who have a high debt-to-credit ratio.
It's also better to stick with one credit card rather than constantly trading in for a card with a lower interest rate. Fifteen percent of your credit score is based on the length of time you've maintained a credit account [source: AuWerter].
Loans are a different kind of credit than credit cards. A loan is what's known as installment credit, since you pay back the loan, with interest, in set monthly installments. A mortgage or a car loan is a good example of installment credit. If you want to make one of these major purchases someday, it's a good idea to show lenders that you have some positive experience with installment credit.
For many young borrowers, a student loan is a great way to begin using installment credit. Student loans carry relatively low interest rates and are reasonably easy to obtain. The best part about a student loan is that you don't have to start repaying the loan until six months after you graduate. The downside is that the loan won't appear on your credit report until you start paying it back.
Student loans are just one type of installment loan. Banks and other lenders allow you to take out small loans for just about anything: a used car, an appliance, a vacation or even a personal loan. Keep in mind that the lender has the right to say no, so come prepared to make your case.
On every credit report, there's a section called "identifying information." In that section is a place to record employment history. One reason for including employment history on a credit report is to give hiring managers an easy way to verify information on a job application. Another reason is to give lenders subtle information about the character of a borrower.
When lenders examine a borrower's employment history, they're looking for stability. If you've been at the same job for years and your salary has continually risen, then you're a good prospect for credit. If you constantly jump from job to job and your salary has been erratic, that puts you in a less desirable position for lenders.
Your employment history is also a good indication of your capacity to repay credit [source: Federal Reserve Board]. A person with a low average annual salary wouldn't have the same capacity to repay a large credit card balance than someone with a higher salary.
If you apply for a mortgage, salary history is one of the most important considerations that lenders will make. Usually, you'll be asked to supply income tax forms for the past two years and current pay stubs as proof of your earnings [source: Federal Reserve Board].
One of the best ways to build good credit over the long term is to avoid the small and large mistakes that can stain your credit report for years.
Pay all of your bills, loan installments and credit card payments on time. Not only will you pay a fortune in late fees -- most credit cards charge over $30 for late payments -- but lenders will raise your interest rates for future credit [source: Willis].
Evictions are doubly nasty. If you're evicted, a collection agency will typically come after you for any back rent. That collection agency will report to the credit bureaus, meaning negative information will now be on your credit report for seven years. Evictions will also show up on tenant screening reports, making it difficult for you to rent future property or secure a mortgage on a future home [source: Sweet].
Avoid bankruptcy at all costs; it's the credit equivalent of poison. Bankruptcies will mar your credit report for 10 years. Above all, do your best not to cross paths with the law. Criminal convictions stay on your credit report forever (yes, forever). Even arrests that don't lead to convictions will appear on your credit report for seven years [source: FTC].
For lots more information on credit, debt and credit reporting agencies, follow the links on the next page.
HowStuffWorks presents seven ways to pay off student loans you may never have thought of, like seeing if your company will help you or using a special app.
Related HowStuffWorks Articles
- AuWerter, Stephanie. "Keeping Score." Smart Money. February 28, 2008 (June 3, 2009)http://www.smartmoney.com/personal-finance/debt/keeping-score-13273/
- Bills.com. "How to build credit." (June 3, 2009)http://www.bills.com/blog/how-to-build-credit/
- Burt, Erin. "Seven Steps to Stellar Credit." Kiplinger.com. June 30, 2005 (June 3, 2009)http://www.kiplinger.com/columns/starting/archive/2005/st0630.htm
- CNBC (via YouTube). "The 'Parallel Universe' of Credit Scores." (June 3, 2009)http://www.youtube.com/watch?v=Jb8FdQDBt-M
- Fair Isaac Credit Services. "FICO Expansion Score: Overview." (June 3, 2009)https://www.ficoexpansionscore.com/Content/About.aspx
- Federal Trade Commission. "Building a Better Credit Report." (June 3, 2009)http://www.ftc.gov/bcp/edu/pubs/consumer/credit/cre03.shtm
- Federal Reserve Board. "Consumer Handbook to Credit Protection Laws: Applying for Credit." (June 3, 2009)http://www.federalreserve.gov/pubs/consumerhdbk/apply.htm
- Federal Reserve Board. "Home Mortgages: The Mortgage Application Process." (June 3, 2009)http://www.federalreserve.gov/Pubs/mortgage/MORBRO_2.HTM
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- Pulliam Weston, Liz. "9 ways to build credit from scratch." MSN Money. May 9, 2008 (June 3, 2009)http://articles.moneycentral.msn.com/CollegeAndFamily/MoneyInYour20s/9waysToBuildAKillerCreditScore.aspx
- Steiner, Sheyna. "How to establish a great credit score." Bankrate.com. (June 3, 2009)http://www.bankrate.com/brm/news/Financial_Literacy/credit_help/build_credit_score_from_scratch_a1.asp?caret=121d
- Sweet, Maxine. "How being evicted can affect your credit report." Experian. July 27, 2005 (June 3, 2009)http://www.experian.com/ask_max/max072705c.html
- Taylor, Don. "Right card can help build credit history." Bankrate.com. (June 3, 2009)http://www.bankrate.com/brm/news/DrDon/20070530_secured_credit_card_a1.asp
- Ulzheimer, John. "Ask John: Retail Credit Cards." Credit.com. (June 3, 2009)http://www.credit.com/rs/vol14.jsp
- Willis, Geri. "Sidestep credit card fees." CNN Money. April 2, 2007 (June 3, 2009)http://money.cnn.com/2007/03/08/pf/saving/toptips/index.htm?postversion=2007040213