It’s no secret, you need good credit to make it in this world. Many employers require good credit to even be considered for a job. Buying a home requires good credit, but did you know you may not be able to rent an apartment without good credit? Buying a car, being approved for a credit card, and even how much you pay for car insurance can be affected by your credit score.
So how can you build credit from scratch? Credit appears to be the classic Catch-22 situation; to receive credit you need a credit score, and to get a credit score you need to receive credit. Fortunately, building credit is much less daunting than it appears.
Knowing how a credit score is calculated, what tools are available for you to build credit, and how to manage those tools will help you in your journey to build credit.
How a Credit Score is Calculated
Your credit score, also known as FICO, was devised by a company named Fair, Isaac and Company in the 1950s. They developed a formula that determines the likelihood of a borrower paying back their debt. The score ranges from 300-850, and the higher the score the better. An average score is around 680, and in 2017, only 20% of Americans had an 800 or higher FICO.
The exact calculation that determines the credit score is only known by the FICO Company, but we have a good idea of what is important. Paying on time determines 35% of your score, and 30% of your score is based on how you use credit. The length of your credit history accounts for 15%, and the types of credit you use affect your score by 10%. There are other factors as well, such as how often you apply for credit. Pretty much anything that looks like you are using credit irresponsibly or that you can’t pay your bills will affect your score negatively.
Tools for Building Credit
This leads to the question, “How do you get credit to show you can be responsible and pay on time?” Getting a secured loan and secured credit card are two great answers.
This type of product uses money held in your savings account to secure a loan from your financial institution. For example, $500 in your savings account is put on hold as collateral, and in exchange, the $500 is loaned to you by the financial institution and deposited into your checking account to use as you wish. You make monthly payments on the $500 borrowed until the loan is paid off. Once the loan is paid off, the hold on your savings account is removed. This type of loan builds your installment loan history.
Secured Credit Cards
These accounts allow you to use a credit card that is secured by the funds in your savings. If $500 is held in your savings, the credit limit on your card is $500. By paying the balance in full each month, you won’t pay interest and will build your revolving credit history. As your credit strengthens, you will have the option to apply for an unsecured credit card, and if approved you can close your secured card to free up the $500 that was held in your savings to secure it.
Establishing Good Credit
Typically your credit score will generate six months after you open one of the accounts referenced above. To establish good credit, make your payments on time and use less than 50% of your available credit card line. Over usage can cause a drop in your credit score. You can also use various loans to show you can handle multiple types of credit. As time goes on, your score should climb. Because so many financial institutions lend based on credit score, an improved credit score should give you opportunities to apply for other forms of credit, such as auto loans, personal loans, and unsecured credit cards.
If you haven’t established credit yet, now is the time to get started. Many mortgage lenders like to see at least two years of credit history before approving a home loan. Borrowing to start a business is also heavily based on personal credit, especially before a business generates its own credit. By combining these borrowing techniques, saving to make purchases, and not overextending yourself, you can build great credit and increase your chances for financial success.