For every person living in the United States, including children, there are about 2 credit cards, making a total of over 679 million of them active today. Some are used responsibly, and some are not.
The difference between a line of credit used wisely and one that isn’t can have massive effects on your life. Let’s talk about the importance of building credit and how you can get started.
What Is Considered Good Credit?
Whether it’s FICO, Equifax, or Transunion, they more or less offer you the same information in the form of a 3-digit number. That number falls somewhere between 300 and 850 and it will determine a lot about how much your everyday life will cost you.
If you’re not familiar with your score, you can get estimates for free with tools like Credit Karma. They don’t give you FICO scores, they use a different scoring model called Vantage. Vantage scores can differ from your FICO by as much as 50 points.
Reading your score is simple. The higher the score, the better. Your detailed credit history will also help determine a lender’s decisions about offering you new lines of credit, but let’s give some blanket statements just by looking at the score.
Ideally, you want your score to be over 750. If your credit score is between 750 and 850, you won’t have much trouble finding loans in the near future. That’s considered an excellent score.
Between 720 and 750 is a good score. If you fall into this range, you won’t be at any serious risk of being rejected for loans that you need, but your interest rates might be a little higher than someone with a 780 score.
If your score is between 680 and 720, this is pretty fair. You probably won’t have trouble getting a new credit card, but it may not have the same perks that you want. This is the range where many people start early on in their credit history after making a few on-time payments.
If your score is between 600 and 680, there is room for improvement. You may start to find challenges when it comes to getting loans, and you’ll likely be facing higher interest rates on loans that you get.
When a score goes below 600, creditors will be very hesitant to offer loans, especially unsecured loans like most credit cards. Below 550 is considered negligent, which will severely hinder your ability to find loans.
Why Building Credit Is So Important
We all know a thing or two about credit scores. We’ve heard about them from friends and family, from financial institutions, from work, and even from television commercials. Even with all this talk about these 3-digit numbers, you may still be wondering why they’re so important.
Well, it all comes down to leaving your options open in life and not shutting any doors on yourself. Here are a few key examples.
Buying a Home
Your credit can largely determine where you live. You may have the financial capital for a large downpayment on a $400,000 home right next to the school you want your children to attend but be rejected from a loan because of poor credit.
Also, even if you do get accepted for a loan, you will be facing a higher interest rate with a bad credit history. This may not sound too terrible in the context of “an extra 4%”, especially if you’re paying it over 30 years and you’re paying more than that on sales tax, but really think about what that number means.
If you buy that $400,000 home and pay a 7% interest rate instead of 3%, that’s a difference of $16,000 solely on interest. That’s a major difference when you consider your broker fee, inspector, moving costs, and more. Would you want to spend an unnecessary $16,000 on a car? Assuming you answered no, then why would you want to spend it on a house?
This could lead to a significant limit on your purchasing power, even if you have the right income levels. If you’re not ready to downsize, building credit ahead of time is important.
Renting a Home
It isn’t even buying a home that will be affected by your score. In fact, most landlords and property management companies have credit checks in their tenant screening processes. Again, your credit will determine where you live.
You may have a better income and rental history than anybody applying for an apartment that you want, but the credit score may be your nail in the coffin. Property managers typically view a poor credit history as too big of a risk for their units.
Buying a Car
While a car isn’t as important as a home, they still come with a price tag. The cost of automobiles in the US is rising sharply, and new models cost an average of $41,000, which is a record high.
Even if you buy a model from 3 to 4 years ago while they still retain a lot of value, you should expect to pay around $20,000. Again, if the difference in the interest rate between a bad score and a high score is 4% (it can be a lot higher), then you’ll be spending anywhere from an extra $1,000 to $2,000 on a vehicle purchase.
Don’t think of that as being over the course of a 5-year loan, think of it as a purchase that you make once every 5 to 10 years or so. Would you spend an extra $1,500 on Thanksgiving dinner when it’s your turn to host? No, you wouldn’t. Well, $1,500 is $1,500 no matter how long you have to pay it off.
Plus, every $1,000 on a 5-year auto loan is an extra $20 in your monthly payment. Would you subscribe to Netflix 3 times for the same product? Building your credit is just an easy way to save.
Taking Out Loans
There are many reasons that you may need to take out a loan in the future. You may have medical bills, a child attending college, your own student loans, or maybe you want to open a business. Those come with price tags, typically between the price tags of a car or a house.
You don’t want to put these kinds of limits on yourself. What if you find the perfect business opportunity that would help you live out your dream 5 years from now, and you’re held back by your inability to get a loan?
Lastly, we’re going to talk about credit cards. These little pieces of plastic can cause a lot of harm if they aren’t treated carefully. It’s hard to suggest a range of credit card debt as that’s determined by your credit limit.
Credit cards are very handy when used properly. They offer rewards, they give you cash upfront when you need it, and they help build your credit score.
However, they can also destroy you financially, especially if you have low credit. Having low or no credit will make your interest rates a lot higher, and failure to pay on time or only making minimum payments can result in massive issues.
For example, let’s say you take out $10,000 on your credit cards and you only make the minimum payment every month. Assuming that you aren’t spending more on that credit card, you could owe an extra $2,600 at the end of the year with an interest rate over 25%.
That’s only in one year, and interest rates do go higher than that with poor credit. That means that it’s critical to pay down your credit card debt as soon as possible, especially with higher interest rates.
What Factors Determine Your Credit Score?
Before we talk about how you can start building credit, it’s important to know the factors that go into your score. These primary factors are uniform across the big 3 credit reporters with only slight variances between the weight given to each factor. Here are the 5 major factors to your credit score in order of importance.
This is by far the most important part of your credit report and the part that will interest potential creditors the most. Your payment history will be determined by how often you make payments on time.
In most cases, it’s okay to be a few days late. Your creditor will simply determine a fee for you to pay for being late on your payment, which should be in your contract. However, 30 days is the limit that can tank your score, especially early on in your credit history.
If you’ve only had 2 years of credit history and you miss a payment, that means that 1 out of 24 payments on your history will have been late. That will show up on your report as being over 4% of payments, rather than as one missed payment.
That 4% difference can drop your score by over 100 points, possibly even more than 150, depending on a number of factors. If you’ve had your credit for a long time and you miss a payment, it may only drop to 99%, which will still do damage, but you will be able to recover from it.
A missed payment can stay on your report for up to 7 years, so if you plan to buy a house, car, or take out a loan in the next 7 years, you should pay your bills on time.
Credit Card Utilization
In order to even receive a score for this, you have to have a credit card, making this the most unique factor on the list. Not only does it solely rely on one type of credit line, but it is the second most important factor on this list.
Creditors want to see you use your credit card, and they want to see how you manage that debt. If you make a few purchases a year to fill up your gas tank and buy some snacks, this won’t exactly harm or help your score.
However, on the opposite end of the spectrum, creditors also don’t want you to use too much of your credit limit. There is a balance that you want to maintain for the best results.
It’s perfectly okay to leave a small balance on your credit card at the end of the month, but it’s important to make sure that you keep it to a limit. If you keep it under 20%, you won’t notice any major issues. It may drop your score down by a few points but if you continue making regular payments and bring it back down, it won’t last long at all.
If you keep it under 10%, you won’t see any score drop at all. Under 10% is ideally where you want to stick at all times. That doesn’t mean you can’t spend more than 10% of your credit limit, it just means you should try to avoid leaving over 10% as a balance. Under 1% is considered “excellent”, but you don’t have to do that every month.
So, if your credit limit is $5,000 and you buy a $1,200 laptop, you will ideally want to pay off at least $700 of that by the end of the month. If you can pay at least $200, then there will be a virtually non-existent effect on your score.
Overall, that will look good on your credit report, even if you’re paying $200 a month. That shows that you took on over 20% of your limit, brought it below immediately, and managed your debt as the months passed.
Remember to be careful. There’s a reason that there is over $930 billion in credit card debt within the US. Make sure you’re ready to pay for anything that you buy.
Length of Credit
The age of your credit plays a significant role in your credit score, and the only way to improve on it is patience and consistency. Creditors want to know that you’re experienced with managing your debt and different lines of credit.
This will factor in the average age of your credit lines and how long of payment history you have. It definitely pays to keep your credit cards active for a long period of time, as this will only boost the age of your lines of credit.
If you pay off your credit card debt, you may be tempted to cut it up and throw it in the trash. However, there’s a better option. If you don’t trust yourself to use it for regular purchases but you still want to maximize its benefits to your score, add a few of your monthly subscriptions to your unused credit card and pay them off at the end of the month.
These will be recurring payments that maintain your card’s active status, you can keep your card locked away from you, and you won’t have to spend any extra money to keep it in good standing. There are plenty of responsible credit card uses to try out and see what works for you.
How many lines of credit do you have? Creditors like to see a healthy mix of credit lines in your portfolio, as this shows that you can juggle various debts without any issues.
This is of much lesser importance than payment history or credit utilization, but it’s still a great way to add an extra boost to your score. Don’t take on unnecessary debt if you don’t have to, but if you already have student loans, a car loan, and a credit card, opening up another card and just adding some monthly subscriptions or something can provide a small boost.
Hard inquiries are what banks or other creditors use to run a credit check on you and look into all of the details. A soft inquiry will show them your score and payment history, but a hard inquiry shows them all of the details.
These actually have a negative impact on your score, which is why checking hurts your score, but don’t panic. They are important for opening new lines of credit.
We won’t spend too much time on these, as they play such a minuscule role in determining your credit score. However, if you do receive a lot of hard inquiries from different creditors at once, you will notice some temporary damage to your score.
Don’t worry too much about this. The longest they can even last on your credit score is two years, and assuming there were only 3 or fewer of them during one period, their effects will be undetectable within a matter of a couple of months.
However, you should try to avoid receiving too many hard inquiries at once. Try not to apply for too many lines of credit at the same time, and spread them out if you can. If you do that, you can forget all about hard inquiries.
How To Start Building Credit
Whether you’ve never taken out a loan before or if your score was tanked due to payment failures or bankruptcy, you can clearly benefit from trying to build your credit back up.
It may sound hopeless if your score is low or if you’re in debt, but it’s important to remember that those demerits only last for 7 years. In 7 years from now, if you practice good financial habits, you will be so glad that you did.
Apply For A Credit Card
If you don’t have a credit card or if you feel like you can benefit from another (and be safe with it), there are a lot of benefits. Not only does it help you improve your credit utilization score, but it also helps with your average age of accounts over time.
Because of this, the sooner you apply, the better. If you plan to buy a house in 5 years, that boost to your score could save you thousands of dollars when the time comes.
Make Consistent Payments
Making consistent payments should go without saying, but it really is the largest factor in your credit score. If you can avoid it, don’t take out debt that you can’t handle.
At the very least, even if your credit utilization will suffer, make sure that you make the minimum payment every month. Recovering from high credit utilization is a lot easier than a missed payment.
If you’re worried about forgetting, either try to set up automatic payments with your lenders or set reminders on your phone for the due date. This part is too important to neglect.
Use Credit Building Tools
There are several credit-building tools at your disposal that you can add to your strategy. They are great for credit repair or establishing an initial credit history, and they are very easy to use.
Don’t Close Lines
Now, if you pay your car loan off a few months early, that isn’t a big deal. However, you should avoid closing down your credit cards if you can. Keeping them open for as long as possible will be the best way to boost your average age of credit, especially if you don’t have long-term loans like student loans or a mortgage.
Again, you can get creative and put some of your regular monthly expenses on a credit card that you don’t use and set up automatic payments. You won’t even have to think about the card and you’ll still get the benefits of it.
Don’t Give Up!
Building credit simply comes down to patience, consistency, and determination. Put a massive emphasis on “patience”. It does take time to work your way up, but now that you know how to build credit, you just have to put it into practice. Stay consistent with your spending habits, stay up to date with our latest financial news, and feel free to contact us with any questions!