Building a Credit History

By Philip Brewer. Last updated 24 May 2011. 5 comments
Photo: Philip Brewer

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Books on personal finance used to have a chapter on building a credit history, because it used to be harder to do. Young people used to find themselves in a classic chicken-and-egg situation, unable to borrow money without a credit history, but unable to build a credit history without borrowing.

Things changed about twenty years ago, when the credit card industry started giving anyone who could scrawl their name a credit card. That's become a little less true since the financial crisis, but only a little.

So, it's pretty easy nowadays to build a credit history. Even so, it's worth giving the topic some careful attention, because building a good credit history can save you a lot of money over the course of your life. (See also: How Debt Fools People)

How to Build Your Credit History

The procedure is easy. There are three steps:

  1. Borrow money
  2. Make payments on time
  3. Make the last payment a little early

As I say, that first step used to be tricky, back when lenders insisted that their borrowers be credit worthy. Nowadays, it's not so tough.

Don't just skip to the last step, though. You might imagine that you could just borrow some money, then pay it back, and you'd be done. But that's not the sort of credit history that borrowers want. What they really care about (and they care about it more deeply than you might imagine) is that you can make payments on time.

They care for two reasons.

First, because a proven ability to make the payments turns out to be a very good indicator of your ability to eventually pay the money back, even if you run into problems. (That is, they're not interested in your ability to borrow money, stash it in a bank account for a month, and then pay it back.) They care about your demonstrated ability to be organized enough to get the payments made. They care about your demonstrated willingness to make the little sacrifices needed to make the payments even when there's some glitch in your income or an unexpected expense.

Second, that's how they make money. A borrower who pays the money right back is of no particular interest to a lender, because he or she pays much less interest.

What type of credit card are you interested in?
How much do you spend per month?
Do you carry a balance?

Making the last payment a little early is no longer as important as it used to be, but it can't hurt. (It was important back in the days when the records were kept on paper — when an actual person had to look down a row of entries in a ledger to see if your payments had been made on time. Lazy people would just check that you made all the payments, and then check that the loan was paid in full by the due date.)

Building Your Credit Score

Be aware that your credit history is only one piece of minimizing your borrowing costs; you also want a great credit score.

Happily, if your credit history shows you can make monthly payments on time, you're most of the way there.

The other important factors for your credit score are:

A Longstanding Credit History

If all your debts are new, it hurts your credit score. Solution: Keep your oldest credit card active.

Plenty of Available Credit

If your cards are maxed out, it hurts your credit score. Solution: Don't approach the limits on your cards.

Few Credit Checks

If your credit history is checked by multiple potential lenders, there's no way for the lenders to tell if you're just shopping around, trying to get the best deal on a loan (fine), or desperately trying to arrange more credit because you're overextended (not fine). Solution: When shopping for additional credit, apply to a small number of lenders, and apply to them all at once.

A good credit history and a good credit score can save you a huge amount of money on a mortgage and a modest amount of money on a car loan. But remember — you're just "saving" money compared to what it would cost to borrow if you had a crappy credit history. In actual fact, borrowing costs you money, no matter how good your credit history is. The real way to save money is not to borrow in the first place. That's not to say that credit can't be a reasonable choice at certain times — it's just never the cheapest choice.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any card issuer.

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Guest's picture
Ann

Interesting points-- you are so right that it used to be much more difficult to borrow. Both my children were bombarded with credit card offers once they were ready to head off to college.

Guest's picture

Oh man, have I been there! I was advised by my older sister and parents to not get a credit card too soon. Before I knew it, I was graduating college and getting denied for credit cards because I had no credit history. The catch-22 from yesteryear had reared its ugly head in my face. I work for a blog and made a video (http://blog.mangomoney.com/trends/improving-your-credit-score-2) about this same subject, but advice for building credit is like advice to floss my teeth. I know what the proper behavior is, but a gentle (and often) reminder never hurts :)

Guest's picture

I just wanted to comment on this statement as some people may be wondering what the actual limit should be: "Plenty of Available Credit
If your cards are maxed out, it hurts your credit score. Solution: Don't approach the limits on your cards."

Banks like to see you keeping your credit card debt under 40% of the actual card limit. Of course you can go over that and you won't be penalized, but the point is, try to keep that percentage as low as possible and do it as rarely as possible.

Philip Brewer's picture

Right.

One exception would be when you want your credit limit raised. If that's your goal, getting your credit used up near 50% of your available credit (and then paying it off) will make the bank think you need a higher limit. I describe the procedure here:

http://www.wisebread.com/getting-your-credit-limit-raised

Guest's picture

Building a solid credit score takes time! A lot of people get impatient and end up signing up for multiple credit cards at once with the idea that having a lot of credit extended to themselves will raise their score, but in actuality, applying for multiple cars at once will bring your score down from too many hard pulls! Be careful with your credit score because past inequities can come back to haunt you for up to seven years!!