When it comes to building credit, there is no shortage of companies claiming miracle credit building hacks. The problem with a lot of these programs is that credit isn’t something that is a quick fix.
A bit of background…
The 3 main credit reporting agencies are TransUnion, Experian, and Equifax. These three credit reporting agencies calculate the likelihood that borrowers are likely to repay their debts based off of financial behavior. Different lenders will use data from the agencies differently, but one company that has tried to make the data easier is FICO. FICO takes the data from the three agencies and provides a FICO score that ranges from 300 to 850, with a higher score meaning somebody is most likely to repay their debts. This score has become all but synonymous with what people consider their “credit”.
Fun fact: The average FICO score is 695.
Your FICO score is made up of the following components:
35% Payment History – Lenders don’t want their loans to default (aka failure to pay). The biggest chunk of your score is whether or not you’re actually paying your debts. It surprisingly isn’t as big of a chunk as one might expect being only 35%, but it nonetheless has the biggest impact on your score.
30% Amounts Owed – If you’ve heard the term utilization, this is the category that it falls into. Basically, lenders want to see the balances that you already owe to see the likelihood of you being able to meet all of your obligations. The term utilization just refers to the percentage of your available credit. If I have a credit card that has a $1,000 limit and my balance on the card (what I owe) is $300, I have 30% utilization.
15% Length of Credit History – Lenders like to see a history of payments. The larger their sample of your positive payment history, the more likely they would lend you money. This category considers the age of your oldest credit account, your newest credit account, and all the accounts between.
10% Credit Mix – This category looks at the different types of credit you’ve had. Revolving credit (like credit cards that you can use the balance, pay it off, use it again) and installment loans (like car payments that have the same amount every month) show that you’re capable of handling different types of payments. Having experience in different types of accounts can positively impact your FICO score.
10% New Credit – This category looks at recent inquiries (hard checks) on your credit. These inquiries stay on your credit reports for 2 years and show that you’ve recently borrowed or tried to. Lenders have realized that people who tend to open a lot of accounts in a small time period pose a greater risk than other borrowers.
In order to have a higher score, it’s going to take some discipline and planning on your part. Use your budget to make sure you’re keeping your debts in check each month. Going down the list, it’s quite simple.
- Make your payments on time.
- Keep your balances low.
- Don’t close accounts unless they are costing you money.
- Prove you’re capable of different types of credit (card, auto payment, etc.)
- Don’t go on a spending splurge.
While this is extremely oversimplified, it’s a good place to start. One of the biggest problems I struggled with early on was how do I get credit if I don’t have any credit?
If you’ve asked yourself this question, you’re not alone. It’s a very frustrating problem that many young borrowers come to, but fortunately there are ways to break into the credit world. It is very possible that you can be declined on your first credit card for a lack of credit history. If this is the case, look for a ‘secured’ card, meaning one that you put some money into an account that the lender can use as collateral while the account is open. Sometimes, the lender will pay you a small amount of interest on the secured amount and after a given time, you may even get the money back. I was fortunate to find a student credit card that was sponsored by a local bank in my college town, but the interest rate was astronomical. If you are able to find a credit card, it will likely have an extremely high interest rate as well until you can prove that you’re a reliable borrower.
If you’re just getting started with credit and not completely confident, try doing just a tank of gas each month on your card and paying it off in full.
Whatever you do… if you’re unable to pay the balance in full, at least pay the minimum balance! There’s a myth that you can’t have a high FICO score unless you actually carry a balance, however I can tell you from personal experience that I have never paid a penny in credit card interest and have an 830ish score. As you become more comfortable with using a credit card and paying each month, find a credit card that rewards you for your purchases. I personally have two credit cards that I rotate between depending on the type of purchase. However you plan it, maximize your benefits if you can!
I hope this introduction to credit is helpful. We will continue to discuss various credit tips and tricks in the future, but we figured that having a basic foundation of credit is a great place to start.