Why You Need Credit — and How to Build It From Scratch

by Miranda Marquit on 10 December 2013 (2 comments)

This post is brought to you by Discover it.

One of the most important aspects of your finances is your credit score — it’s basically your financial reputation. Before you are approved for a car loan, home loan, or even a private student loan, your credit will be checked.

In some cases, your credit score can even influence decisions about your cell phone service plan, Internet access, whether you are approved for the apartment you want to rent, and your insurance premiums.

As you become financially independent, building your credit is one of the most important things you can do. What you do with your credit now will influence your finances for years to come.

That’s why it’s vital that you start building your credit today, since there are times when having no credit history is actually worse than having poor credit. Here’s how you can get a good start in your financial life by building your credit from scratch.

Open a Credit Card Account

One of the fastest and most effective ways to build your credit history and achieve a good credit score is to open a credit card account. Credit cards are among the easiest forms of credit to get when you have a limited (or even no) credit history.

There are three credit bureaus that monitor consumer credit, and most credit card issuers report your payment habits to these credit bureaus each month, so it makes it easy for you to quickly build a credit history. Simply use your credit card for a few purchases each month, and make your payments on time when your statement comes. This is a good way to show you can be responsible with your money.

When using credit cards, though, it’s important to use them in conjunction with your regular spending plan. Credit cards are best used when you already have the money in your checking account — you don’t want to become overwhelmed by debt. Pay off the balance each month, and you will avoid financial problems later.

Many credit card issuers offer student versions of their cards. These student versions are specifically designed for those who have little to no credit history. You can even find student rewards cards, which provide benefits like cash back when you make purchases. Use a student credit card to begin building your credit, and after you have established yourself, you can apply for the “regular” versions of rewards cards.

A heads-up about applying for your first credit card — according to the Credit CARD Act of 2009, if you are under 21, you might need a co-signer if you can’t prove that you have adequate income to borrow on your own. If you have a job, you might be able to get around the requirement for a co-signer.

Get a Small Installment Loan

A credit card is an example of rotating credit. You apply for the credit once, and you are given a credit limit. As long as you have “room” on your credit card, it’s possible for you to keep borrowing. As you pay down your balance, you create more room to borrow the next month.

Good credit, though, requires that you have different types of loans. A credit card is a good start, but you also need an installment loan to appear on your credit report and contribute to your credit score. An installment loan is one that offers you a set amount and a regular payment schedule until you pay off the loan. Unlike the rotating credit line, it isn’t possible to borrow more as you pay down your balance.

If you plan to buy a car, consider taking a small loan for the purchase. You can also usually apply for a small personal loan from your bank. In some cases, you might need the help of a co-signer to qualify for the loan. However, if you can show that you have enough income to afford the loan payments, and if you have built a solid credit foundation with the help of a credit card, you might be able to qualify without help.

Try to keep your installment loan small and fairly short-term. An installment loan that lasts between 12 and 36 months is usually a good start. And you don’t have to spread your payments out over that entire period — it’s possible to make extra payments to repay your installment loan faster.

The important thing is to show that you can handle different types of loans responsibly. If you have a mix of rotating and installment credit and you pay on time, it will be easy to build your credit from scratch.

Important Things to Keep in Mind

Since the goal is to create a good financial reputation, you need to be mindful of how use credit; the whole plan can backfire if you aren't responsible. As you build your credit from scratch, here are a few quick tips to remember:

  • Never borrow more than you can afford to pay off fairly quickly.
  • Always make your payments on time and in full.
  • Use credit as part of your overall financial plan.
  • Pay off credit cards each month so you don't end up paying interest.
  • Make extra payments on installment loans to pay them off faster.

With the right approach, you can build your credit from scratch, and position yourself to get the things you need later in life.

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I didn't know credit card companies offered student versions of their cards. I'll have to check that out.

Guest's picture

Thanks, Miranda, for this post. This is one of the most common questions I get from those coming to my classes. I'll agree on the student version of the credit cards, as far as ease of getting approved, though getting and using credit in college tends to be, for the not-so-financially-disciplined-quite-yet average student, a losing proposition (something like $3,000 to $5,000 of credit card debt upon graduation, with a significant percentage having their cards maxed out plus late payments on their reports).

I'll add a few other credit-building ideas, many of which I've gleaned from the students in these presentations:

1. If you have a utility or cell phone contract in your name and have a history of on-time payments, contact the company and ask them to report your payments to the credit bureaus. They don't do this automatically but usually can upon request. It is not weighted as heavily as a history of credit card payments, but it can still help.
2. Ask a family member (particularly a parent) with good credit if they'd put you on their credit card as an "authorized user." As an authorized user, you are not responsible for the payment of the account but can inherit some of the account owner's good credit... even if you never use or even see the card issued to your name.
3. One of the easiest places to get credit can be a tire store, although their interest rates are usually in the low- to upper-20% range. However, if you're going to purchase tires for your car anyway, consider getting an account with the tire company, then either paying it all off with the first statement or paying all but $20 or $30 off so you can make another two or three monthly payments. Either way, you're minimizing the interest you're paying on this account.
4. Retail cards are relatively easy to get approved for. These include accounts at stores such as Target, Dillard’s, JC Penney, etc. Again, they carry higher interest rates typically than major bank credit cards, but that's because they're taking more of a risk by lending to someone with little or no credit. As with the tire store card, I suggest you pay off the account almost immediately (at JC Penney, you can even pay off the new account at the same register where you opened it). And never buy something just to build credit.
5. Using credit builder loans or secured loans can also help the credit newbie or the credit-challenged, but they definitely come with additional fees (monthly, annual, even per transaction) and higher interest rates. Plus, some secured credit cards don't even report to the credit bureaus.

Here are my DON'Ts for building credit that I've seen others suggest:
*Do NOT go to a payday or title loan. They don't generally report to the credit bureaus, and, worse, they charge astronomical fees (annualized at 400% to 800%+ for payday loans and about 100% for title loans).
*Do NOT use Rent-to-own as an option. They generally don't report to credit bureaus either, but even if they do, you end up paying usually 100% to 500% or more for a piece of furniture or an entertainment system component than you would if you purchased it new at a department store.
*Do NOT carry a balance on a credit card because someone (who often should know better) suggests that you need monthly payments to build credit. Yes, monthly payments help, but the size of those monthly purchases can just as easily be for a $15 Netflix account payment that you pay off in full every month.
*Do NOT apply for more than 1 or 2 new accounts in a 12 month period. Each account application typically shaves about 1% off your credit score. 1% to 2% usually won't matter, but 10% or 20% in a year will drop your score significantly.

All the best, Miranda, in your continued blogging and publications. And the same to anyone trying to build credit from scratch (or rebuild it... this typically works as well).

Todd
Author of "Everyday Money for Everyday People"