How to start, what to avoid and tips for making the most of your financial decisions.
Just as a good employment reference can help further your career, a solid credit history can help you move forward economically. "Even though it is possible to live on cash [alone], most [people] will need a thick and positive credit file to purchase big-ticket items such as a house or a vehicle," says Gail Cunningham, vice president of membership and public relations at the National Foundation for Credit Counseling. "It's important that consumers recognize the impact that a positive credit file can have on [your] financial well-being."
While there are many ways to establish a solid credit history, the following tips will help get you started:
Check your credit report
First, learn about your current financial situation before diving into building credit. The best way to do this is by checking your credit report, which can be obtained for free once a year from each of the three major credit bureaus: Experian, Equifax and TransUnion. "As you build that history, we collect it from your creditors, store it and keep it updated so it is instantly available the moment you need it," says Maxine Sweet, vice president of public education at Experian.
Upon a credit lender or bureau's request, credit reports are fed through a mathematical formula created by Fair Isaac Company to create your FICO credit score, which is used by financial institutions across the world to make consumer credit decisions. FICO scores have become the standard for measuring an individual's credit risk and range from 350 to 850, with a higher number representing better credit.
"For someone just starting out, it's important that they look at their credit report, verify that there are no mistakes and make sure all the information on that report is accurate because it is that information that is run through the algorithm to generate the score," FICO spokesman Anthony Sprauve says. "If there are mistakes on the credit report, that will impact your credit score."
Where to start
When you are ready to start building credit, experts suggest focusing your attention on one line of credit. Credit cards in particular may be a good starting point. "A credit card is self-managed, and only you can decide how much you are going to charge on it each month and how much you are going to pay on it each month," Sweet says. "It is a strong and predictive indicator of your credit management abilities."
Because unsecured credit cards have spending limits determined by your credit history and income, it may be hard to acquire one at first. Secured credit cards require a security deposit that becomes collateral as well as the credit limit for your card and may be an easier place to start, according to an Equifax finance blog. Every card issuer has different standards so research your options to find a card that has a lending profile that fits you best, according to the NFCC.
Co-signed cards or loans can be another opportunity for credit beginners to start building a history, but they come with risk. "Whatever happens with that card is going to affect both [parties]," Sweet says. "Just make sure every month you check, and make sure that the agreed payment was made or that the balance isn't getting out of control." If managed closely, co-signed credit can benefit everyone involved, Sweet says.
Regardless of how you start, it won't take long for your actions to affect your credit. "The joy of credit scoring is the minute you start doing a couple of really positive behaviors, you will start to see improvement in your score," Sprauve says.
What to avoid
"Equally as important as establishing credit is treating it responsibly," Cunningham says. Credit payment history is the most important factor in calculating your credit score, especially in the beginning when every move matters.
Paying your bills on time, every time is a great way to help your credit, but it's also important to make sure the balance you are working to pay off doesn't get too high. "Keep the balance at 50 percent or less of your total credit limit for the card," says Trey Loughran, president of Equifax Personal Solutions, a division of the Equifax credit bureau. "But if possible, it's best to pay off the total balance each month, or pay more than the minimum monthly payment required."
FICO scores reflect more positively on someone using less of his or her available credit because "if someone is using most of their available credit, that can be an indicator of someone that potentially could have trouble repaying their debt," Sprauve says.
Having credit makes it easier to get more credit, but having lots of credit isn't always ideal. "It's a red flag in the FICO algorithm if someone opens a lot of credit at the same time," Sprauve says. "There is a myth out there that 'the more credit I apply for and the more credit I have, the better that is for me,' but it's not true. What can happen is you can look like a bigger risk if you open a lot of credit at once."
While FICO scores are factored into 90 percent of credit decisions in the United States, scores are not the only thing lenders take into account, Sprauve says. Keep up with your personal bills to put yourself in the best light for potential lenders. "Things like rental and utility payments are not consistently reported to the credit bureaus, so the FICO score doesn't take those things into account," Sprauve says. "But when applying for a line of credit, each lender will look at different things, and they may take those things into account."
After some time with your first line of credit, you can consider getting additional credit based on your needs. There's no difference between the type of credit and its impact on your FICO score, but experts say it helps your score over time to have a variety of credit. "The very best credit reports have a mix of credit, so that means it's good to have revolving credit, plus an installment loan, like a car or boat loan," Sweet says.
If you miss a payment or two, the best way to rebuild your credit is to pick right back up with the monthly payments. Additionally, the longer ago something happened, the less impact it has on your score. "The point there is that we have all made mistakes," Sprauve says. "As soon as your start those good habits and maintain those good habits going forward, any bad habits or mistakes in the past become less critical."
Lastly, once you have a credit-building regime in place, don't forget to check both your credit report and FICO score at least once a year. "Some people believe this type of inquiry can have a negative impact on your credit score, but this is not true," Loughran says. "We actually encourage monitoring of your credit regularly so you clearly understand where your credit stands and also detect any potential signs of identity theft."