Building credit from scratch can be a little tricky.
Since potential lenders use your credit history to decide whether they want to lend you money, they’ll be reluctant to give you credit unless you already have it.
That makes it seem like building your credit is impossible.
But don’t fret. There are options specifically designed to help you build your credit from zero.
In this article, I’ll explain the importance of good credit, share some credit-building options for people with no previous credit history, and try to break the myth that a good credit score automatically means you’re good at managing your finances.
Building Good Credit Is Important, But It’s Not Everything
Building good credit is important because it affects many of the major financial decisions you’ll make in your life.
A good credit score can help you buy a house, rent an apartment, finance a car, get a better rate on auto insurance, avoid paying deposits for utilities, and even get a job.
A good credit score will also help you get lower interest rates on loans and credit cards. A lower interest rate means you’ll pay less on interest over the repayment period which also means that more of your hard-earned money will stay in your bank account.
For example, let’s say you want to get a mortgage to buy your first house. The bank will look at your credit history and salary to determine whether they want to lend you the money. Based on that information, the bank may decide to give you a $200,000 mortgage at an interest rate of 3.5% if your credit is great, but only at 4.5% if your credit is just OK.
In that example, an interest rate that’s lower by only 1% will save you over $40,000 on a 30-year fixed rate mortgage. That’s $40,000 that you can put towards savings, retirement investments, or other monthly expenses.
Lenders are more willing to give you a better deal when you don’t pose a financial risk to them.
If you’re renting, good credit may allow you to pay a lower security deposit because you’re landlord will trust you’ll make payments on time and won’t break your lease.
All that being said, your credit score is NOT a complete representation of your financial health.
Your credit score is simply a three-digit number that tells creditors how you borrow money and how you pay it back.
It doesn’t tell them the whole story about your money management skills. Credit scores don’t take into account how much you earn, what types of savings and/or investment you have, or whether you make and stick to a monthly budget.
Your credit score is important, but it’s only one part of many when it comes to your personal finances. So in other words, don’t make it your primary focus when you have much larger issues to worry about such as paying your bills on time and getting out of debt.
Review Your Credit Report for Inconsistencies
Before starting to build credit, you should review your credit reports for inconsistencies.
Thanks to the Fair Credit Reporting Act (FCRA), you have the right to receive a free credit report from each of the three main credit bureaus (Equifax, Experian and TransUnion) every 12 months.
Only use annualcreditreport.com to get your free credit report. Imposter sites that claim to give you free credit reports will charge you or make you sign you up for monthly services that cost money. If you have to enter your credit card information, you’ll probably be charged at some point.
If you haven’t looked at your credit reports in more than 12 months, you should order reports from all three of the major credit bureaus. Each bureau has different information and you want to make sure there are no inconsistencies under your name.
What Is in Your Credit Report?
When you receive your credit report, you’ll find a lot of information.
Your report contains your social security number, date of birth, employers, various ways you’ve used your name, and current and past addresses. Make sure your current address is up to date and all other information is correct.
Detailed information about current and past credit accounts are also included in your credit report. You’ll find account balances, credit limits, payment history, important dates, credit inquiries, delinquencies, bankruptcies and much more. Obviously, if you haven’t utilized any credit in the past, no information will show up on your credit report.
Dealing with Identity Theft
If you find any inconsistencies in your credit report, you might be a victim of identity theft.
Identity thieves can use your social security number and name to open new credit accounts. These fraudulent accounts can damage to your credit history and reputation.
Before you try to build your credit, you’ll have to report and deal with your identity theft case. As long as those fraudulent accounts are under your name, they’ll affect your credit and no matter how hard you work, you won’t be able to improve it.
If you suspect your identity has been stolen, you should place a fraud alert and credit freeze on your credit report and contact your current creditors. The link above contains more information about fraud alerts, credit freezes, and dealing with identity theft.
The two most important things you’ll need to do to clean up your record will be filing a police report and creating an Identity Theft Report at identitytheft.gov. You’ll need this paperwork to prove that the debt isn’t yours and prevent creditors from coming after you.
Keep Track of Your Credit Score
There are a few different types of credit score, but the two most popular scores are the VantageScore and the FICO score.
Most creditors (close to 90%) look at your FICO scores to decide whether to lend you money so we’ll focus on that one today.
How to Get Your FICO Score for Free
Many banks and credit card companies give you free credit monitoring when you become a customer. If your bank doesn’t offer it, you can use a free service like Discover’s Credit Scorecard.
Technically, you’ll have a different FICO score at each of the main credit bureaus based on the information that creditors report to them.
You should be aware that these free services may only give you access to one of your FICO scores or to another type of credit score like the VantageScore. For example, Discover’s Credit Scorecard only shows your Experian FICO score.
If you’re making a major purchase (a house or a car) in the next 12 months, you’ll need to get your FICO score to a certain level to ensure you get the best deal available. If you’re striving for a certain credit score, a paid service like myFICO’s Ultimate 3B will give you access to all three of your FICO scores and provide you with tools to help you predict how changes in your credit use may affect your score.
If you’re not making any major purchases, Discover’s free tool will be enough.
How Is Your Credit Score Calculated?
Don’t be frustrated if your credit score isn’t great — you don’t start out with the best credit score and building it up takes time.
To understand how you can improve your credit score, you must first know how it’s calculated.
Credit scores are calculated by looking at the following five criteria:
- Payment History (35%) — whether you make payments on time
- Amounts Owed (30%) — the percentage of total available credit you actually use
- Length of Credit History (15%) — how long you’ve had credit
- Types of Credit (10%) — whether you use different types of credit (mortgage, credit cards, installment loans, etc.)
- New Credit (10%) — credit inquiries and new accounts opened
You can’t change the length of your credit history so don’t worry about it.
Where To Focus Your Efforts
Instead, you should focus on the two major things that affect your credit score — payment history (35%) and the amount you owe (30%).
The longer you make on-time payments, the more your score will improve. Late payments will negatively affect your score. You should set reminders using Google Calendar or your phone’s calendar so you always pay on time.
You also want to decrease your credit use.
I recommend you always keep your credit use under 30%. If you want to improve your score even faster, aim to keep it under 10%.
For example, if you have a credit card with a $1,000 limit, try to keep the balance on that card below $300 or, even better, below $100. This will show creditors that you can be responsible with your money and won’t use all the credit you’re given.
How to Start Building Credit From Nothing
If your credit card application has already been denied and you know your credit isn’t very good (you’ve checked your credit report and credit score as mentioned before), don’t apply for any more credit cards. You’ll continue to be denied and your credit score will take a hit because of multiple credit inquiries.
There are better options specifically designed to help you build your credit from scratch, or to rebuild your credit when it has taken a serious hit.
Apply for Secure Credit Cards
If you have some money saved up, consider using a secure credit card.
With a secure credit card, you’ll make a deposit of cash to the lender and they’ll give you a credit line you’re able to access just like a credit card.
A secure credit card is NOT a prepaid card. The deposit works as an insurance for the lender in case you don’t pay your credit card.
Since it’s just like a regular credit card, you’ll want to only use a small percentage of your available credit and make all your payments on time. Once you’ve built your credit, you can negotiate with the same company to get a regular credit card and get your deposit back.
Ask Someone to Add You to Their Credit Card
Another option is to have someone add you as an authorized user on their credit card. Your parents may be willing to add you to their card.
You don’t need to personally use the card in order for it to build your credit. But make sure that their credit card is clean with a lengthy on-time payment history. If they end up maxing out the card or making late payments, it’ll negatively affect your credit as well. You won’t be responsible for their debt, but the information will be added to your credit history.
NOTE: If you can get a secured credit card or a credit-builder loan, I recommend you go with those options. Things get riskier and more complicated once you link your credit with another person’s credit.
How to Build Credit Without a Credit Card
Use a Credit-Builder Loan
If you don’t have money saved up, you can use a credit-builder loan.
With a credit-builder loan, instead of giving a cash deposit to the lender, the lender will approve you for a small loan but won’t give you the money.
They’ll place the money in an interest-bearing savings account in your name, which will be accessible to you after you repay the loan. This acts as a safety net for the lender since they don’t know if they can trust you yet.
Credit-builder loans are only meant to help you build credit so you won’t be able to buy anything with the loan money (until you pay it back). But the lender will still send information about your payment habits to the credit bureaus. So you should make all your payments on time because negative information will also be reported to the credit bureaus.
You can check your local bank or credit union to see if they offer credit-builder loans. But if they don’t, you can go with online lending services like Self Lender. Self Lender offers loan amounts of $500, $1,100 or $2,200, with repayment terms of one year.
Have Someone Cosign for You
If someone with great credit is willing to allow you to piggyback off their good name, you can take them up on their offer. Get a small installment loan of around $1,000 from the bank and pay it back over a short period of time.
But do NOT spend the loan money. Instead, put the money in a savings account and take money out of the account each month to pay back the loan on time. Remember, your goal is to build your credit, not to get instant spending money.
You should also keep in mind that late payments will affect your cosigner’s credit. If this person agreed to cosign for you, you probably have a good relationship with them. You don’t want to damage their credit and put a strain on your relationship.
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You don’t need to do anything crazy to build your credit.
Building credit will take time. You should focus on developing good spending habits, using only a small part of the credit available to you, and making payments on time.
Credit is an important part of your personal finances and will affect a lot of your financial decisions. You should take good care of it, but don’t focus all your attention on it. You should also learn how to keep a budget, save money, and invest for retirement.
Do you have any more advice on building credit from scratch? Share it in the comments!