Building a strong credit score is an essential step towards financial health. It can open doors to better interest rates for loans and credit cards, increase your credit limit, and even make it easier to rent an apartment or secure a job.
Understanding Credit Scores
Before you build your credit, it's important to understand what a credit score is and the factors that are used in determining your score. A credit score is a three-digit number that creditors use to determine how likely you are to repay your debts. The higher your credit score, the less risk you present to lenders and the more confident they are about your ability to repay your loan.
There are companies that use data analytics to create your score. One of the more popular company’s lenders like to use is FICO (Fair Isaac Corporation). A FICO® score refers the score that was calculated by FICO. Scores range from 300-850. Anything below 670 is considered fair to poor. A good credit score is 670-739 and anything higher is just more evidence you are a creditworthy borrower. Your score is reported to the credit bureaus by companies like FICO.
Factors that are used when calculating your credit score include: your credit history (history of on-time payments), credit utilization ratio (amount of credit used as compared to what is available to you), number of new credit card accounts you have recently opened, how much you currently owe and your mix of credit (i.e. loans, credit cards, etc.). Your payment history and amount you owe are the most important factors and account for over 60% of your credit score.
If you are new to using credit, you won’t have much, if any, of a credit history and likely not owe anything, not allowing for much of a credit score. You will want to build up your credit so you can have the option to borrow money, if needed, for a big purchase such as a car or home or simply just getting and using a credit card.
Credit Building Strategies
Whether you are looking to build or maybe rebuild your credit, these strategies should work to help you in that effort. Increasing your credit score will not happen overnight, but with diligence and time you will begin to see it grow. Typically, you need about 12-months history of on time payments to impact positively affect your score. The sooner you start, the quicker you will arrive at your goal.
Step 1: Check Your Credit Reports
To improve your credit score, you should first know where you stand. You can get a free credit report from AnnualCreditReport.com once a year. You can also retrieve a report from each of the three major credit bureaus - Experian, TransUnion, and Equifax however there may be a cost involved. Review these reports for errors and dispute any inaccuracies you find.
In the report you will find:
- Accounts opened and the type of each account
- The date each account was opened
- Credit limits or loan amounts
- Current balances on open accounts
- History of payments
What you won’t see, your credit score. The credit history on your credit report helps determine your credit score, but this isn’t typically offered as part of your free credit report. Many banks, credit cards, and other financial services may offer you an opportunity to review your credit score at no cost. If you don’t have a free option, you may have to pay to see your credit score.
Make sure to look at each item carefully to ensure it’s accuracy. If you see something isn’t right, it might take some time to dispute the report and get it corrected.
Step 2: Pay Your Bills on Time
One of the most influential factors of your credit score is your payment history. Consistently paying your bills on time can drastically improve your score. If you have trouble remembering when to pay, set up automatic payments or calendar reminders.
Lenders need assurance you will repay the money they loan and when you have established a history of responsible borrowing by making your payments on time each month, they are more likely to approve you for a loan or credit card.
Step 3: Reduce Your Debt
The percentage of your available credit that you're using, known as your credit utilization ratio, also affects your credit score. Try to lower this ratio by paying off debt rather than moving it around. The ideal ratio is about 30%. That means if you have $1,000 in available credit and you are only using about $350 or less.
Likewise, if you have $1,000 in available credit and you are consistently using most or all each month, lenders may question your ability to manage your finances. They might hesitate to loan to you wondering if you will have the means and/or the discipline to repay them.
Keeping your debt as low as possible will not only keep your credit utilization ratio in a good place, but it will also afford you the freedom to use your money as you wish, as opposed to sending it off to your creditors each month. Debt can be necessary, just be sure to manage it responsibly.
Step 4: Don't Close Old Credit Cards
Length of credit history is another important aspect of your credit score. If you close old, unused credit cards, you could shorten your credit history on your credit report and lower your score. Lenders want to see that you have been responsible for some time, and this assures them you will likely be responsible now, should they lend to you.
Additionally, by keeping older cards open that you no longer use, you will lower your credit utilization ratio. Whatever amount those cards accounted for in available credit, even if you don’t use the cards, will be counted towards calculating your ratio and potentially boost your credit score.
If an account is dormant for a certain period of time, typically the lender or bank may contact you to let you know the account may be closed due to inactivity. They will give you a date they will close the account if it remains inactive. Once you receive that notification you can determine if you would like to use the account to keep it open or allow them to close it.
Step 5: Diversify Your Credit
Mixing different types of credit can also improve your score. For instance, having both revolving credit (like credit cards) and installment loans (like a car loan or a mortgage) can show lenders that you can handle different types of credit responsibly.
An installment loan is the most basic type of loan. You borrow $1,000 and make payments (with interest) each month, for a specified period of time until the loan is paid off. Revolving credit allows you to use up to certain amount (your credit limit) and when you repay that money, it becomes available for use again. Your available credit will always be your credit limit less whatever money still needs to be paid back.
Step 6: Limit New Credit Applications
Every time you apply for new credit, a hard inquiry is made, which can lower your score. So, limit the number of credit applications you make and only apply for new credit when necessary. There are two types of credit inquiries soft and hard. A soft inquiry is more of an exploratory inquiry that could be made by a credit card company, even without your knowledge, looking to see if you could you be approved. If so, they might send you an application in the mail to offer you to apply for the credit card. There also soft inquiries you would be aware of such as a background check or a loan prequalification check.
A hard inquiry is when you apply to borrow money and a more thorough look of your credit is taken. If you have a strong credit history and score, the chances are you will be approved. However, if you apply to Lender A and are denied and then go to Lender B and then C, your credit score will reflect this.
Additionally, if you apply to Lender A and are approved and then do the same at Lender B and C, your credit score can also go down as well due to your increasing the number of new accounts open.
Hard credit checks don’t impact your credit with any significance when they are only done occasionally. It’s when there are a series of hard inquiries in a short period of time that your credit could be negatively impacted. So, if you are tying to build your credit by applying for a lot of credit, be careful that you aren’t doing more harm than good.
Step 7: Options for Those Without Credit
If you don't have a credit history or have a low credit score, consider getting a secured credit card or credit builder loan. This can help you start building your credit while being backed by a cash deposit that you provide.
Sometimes to demonstrate your financial responsibility you need to put your money where your credit is. Secured credit cards for example require you make a deposit (in the amount that would be your credit limit) to the credit card issuer as an insurance that the money used on the credit card can and will be repaid. After using the card responsibly for some time, with all your timely payments being reported to the credit bureaus on your behalf, you might be able to convert the card to an unsecured card (no deposit required).
Another alternative to a secured credit card is to be added as an authorized user on a family members account. By being an authorized user this will allow you to establish yourself while still under the guidance of a more experienced credit user.
A newer option rising in popularity for those looking to build their credit are third-party companies that will work with you to build your credit by reporting regular rent and/or utility payments made on time each month to the credit bureaus to demonstrate your ability to make payments responsibly and timely.
By using these steps you will be able to build your credit. Building credit requires a combination of good credit habits, such as paying bills on time and keeping balances low, and strategic credit management. With some patience and diligence, you can improve your credit and open the door to new financial opportunities. Remember, your credit score will continually change over time to reflect your current state of financial discipline —consistent and responsible behavior over time will get your score up and keep it in a good place.