How to establish credit when you're just starting out
Getting credit in the form of a credit card or loan can be difficult when you don’t have an established credit history. At times, it may even feel like having bad credit is better than no credit at all. But don’t fall for that. Working to establish a positive credit history early on will serve you better in the long term — if you develop a plan and stick to it.
Why is it important to establish credit early?
The most important reason to start establishing credit early is that a long history of credit has a positive effect on your credit score. Creditors like to see accounts that are years, even decades, old. A history like that indicates stable relationships with creditors, a commitment to repaying your debts, and many other qualities lenders appreciate.
Establishing credit in college, for instance, can be a great first step toward financial health as long as you protect your credit score from day one. If you keep your credit score high throughout college, once you graduate and begin looking for an apartment or need to buy a car, your good credit history will help you secure an auto loan or qualify for an apartment in that trendy neighborhood you’ve had your eye on.
Later, when you’re ready to make a down payment on your first home purchase, you’ll have several years of solid credit payments and reporting. This will provide comfort and peace of mind to creditors who are about to engage in a 30-year relationship with you.
The bottom line is this: The earlier you establish credit and the harder you work to maintain your good credit, the better it will serve you over time.
Key credit terms you need to know
One of the greatest laments of modern society is that high schools don’t require graduating seniors to complete at least a fundamental financial literacy course. Before you dive into establishing credit, there are a few key terms you should become familiar with:
- Credit: money loaned to you from a financial institution, such as a bank or a credit card company
- Creditor: an entity that extends credit through a loan or line of credit
- Credit report: a report that details credit accounts, payment histories and current balances of your past and present credit situation
- Credit score: an assigned score based on your borrowing and repayment history that signals to creditors your capacity to manage your debt
- Credit utilization: the amount of credit you’ve used compared to the amount of credit available to you
- Debt-to-income (DTI) ratio: the amount of debt you owe each month compared to the amount of income you earn each month
- Revolving credit: credit accounts that are open-ended and don’t have specific start and end dates, such as credit cards
- Installment credit: a credit account involving a specific amount of borrowed money to be repaid in periodic installments, like a loan, with a specific start and end date
- Fair Credit Reporting Act (FCRA): an act passed by Congress requiring credit reporting agencies to verify the accuracy of the information they include in your credit report
Understanding these basic terms can help you make wiser borrowing and repayment decisions as you work to build credit.
Getting started: Your path to building credit
For most people, getting started with establishing credit is the hardest part. It’s like getting a job. It’s easier to get a job if you have verifiable experience in the field in which you’re applying. Hiring managers prefer a candidate who has demonstrated at least a basic understanding of what the job requires — although some companies offer entry-level employment that allows you to get your foot in the door.
The same concept applies to credit. Lenders want to see signs that you understand how credit works and how to use it responsibly. That’s what a favorable credit history indicates to lenders. Without this history of experience behind you, you should consider “entry-level” credit-establishing options such as these:
Start a checking account.
Although this doesn’t provide a credit history, per se, having a checking account helps familiarize you with certain concepts, such as reconciling statements, balancing your account and managing your money so that you don’t overdraft your account. It’s a level of responsibility that will help you with the next step. In fact, many lenders require you to have a bank account before they’ll extend you any type of credit.
Obtain a secured credit card.
You can think of a secured credit card as a prepaid credit card. A cash deposit, usually in the amount of your credit limit, is required to secure the card. With a secured credit card, you reduce the risk for the credit card company, increasing the likelihood that the company will later extend you credit.
Most of these types of credit cards work by offering a dollar-for-dollar match of available credit to the amount of money you deposit into the security account. If you deposit $300, for instance, you’ll have $300 of available credit.
If you continue making payments on time, the company may return your initial deposit and transition you to an unsecured account — one that doesn’t require a cash deposit — or extend your available credit beyond the amount of your initial deposit.
Get a credit-builder loan.
Credit-builder loans work differently than secured credit cards. The point of this loan is to establish a positive mark on your credit report. To do that, you make monthly payments to the lender, which deposits the paid funds into an account. These funds are no longer available to you until you complete the loan terms. When that happens, the lender will return your money to you, minus the interest rate for the service.
For this loan to work to truly build your credit, you must make payments on time, every time.
Add alternative data to your credit profile.
You make monthly payments all the time. From your mobile phone to rent and utilities, you likely have a positive history of making timely payments. That’s why it's a good idea to link these accounts to your credit report whenever possible.
Experian Boost and eCredable are notable services that allow you to do this. Linking nontraditional accounts to your credit profile can boost your credit standing with certain lenders when you’re starting to establish credit.
Upgrade to a traditional credit card.
Once you’ve had a secured credit card for six months to one year, ask about upgrading to a traditional credit card with the same company — or apply for a different unsecured credit card. It’s a good idea to leave your existing secured-credit account open so that you have a longer history of credit reporting.
Become an authorized user.
Ask someone you trust who has excellent credit to list you as an authorized user on his or her credit account. Without doing anything, you’ll get to share the benefits of their responsible spending habits. However, this is a risky proposition for you as well as the person who agrees to list you, so this option should not be considered lightly.
Ask someone to be your co-signer.
Another option is to ask someone you know who has a positive credit history to co-sign a loan with you. This means if you fail to repay the loan, that person is financially responsible for doing so (and may take a hit on his or her credit report). In other words, it’s not a favor to ask of just anyone. However, if you can get someone you trust to agree to this, it can be instrumental in helping you establish credit in your name.
Building a better credit score
It’s not enough to simply open the right accounts. What really matters is what you do once the accounts are open. Not only do you need to have the right mixture of accounts and positive spending and repayment habits, but you also need to make sure you’re not overburdened by any debt you accrue. It’s a delicate balancing act that will either help you get the high credit score you desire or leave you drowning in a frustrating pile of debt.
The first, and perhaps most important, thing to remember is to start small. It may be tempting to apply for credit on every front, but that can backfire on you in a big way. Establishing credit takes time if you’re doing it right. Here are some ways to make your credit history work in your favor rather than against you:
Choose diversity in credit accounts.
Don’t open multiple credit card accounts, not even secured credit cards, when you’re just starting out. Instead, consider starting with one credit card, adding a credit-builder loan after five or six months, and then perhaps an auto loan once you’ve repaid the builder loan in full. It’s a process that will take a couple of years, but one that can help you avoid becoming overwhelmed by debt.
Keep credit utilization low.
Don’t max out your credit cards. In fact, you want your credit utilization (the amount of credit you’ve used compared to what’s available to you) to be less than 30%. For instance, if you have a $300 credit limit on your credit card, you don’t want a balance that’s more than $90 at the end of the billing cycle.
The lower you keep this number each month (by paying your balance in full, when possible), the better your utilization number and your peace of mind.
Pay your bills on time.
This is non-negotiable. If you want to build good credit, you must pay your bills on time. Every time.
Lenders don’t want to feel like they have to chase you down or work hard to get their money from you. They want to see that you have a history of paying early or, at the very least, on time every month for the duration of your relationships with various creditors.
If you’re using alternative data reporting, bills for things such as utility payments, rent payments and even mobile phone payments that are paid on time have a positive effect on your score.
Maintain a low debt-to-income ratio.
Your debt-to-income ratio carries more weight with some lenders than others. However, it’s an integral part of the information many lenders use when making credit decisions. If you have a low income, you don’t want so much debt that lenders believe you won’t be able to comfortably repay additional debt.
Apply for credit sparingly.
Applying for large amounts of credit at one time can be a red flag to lenders. It’s different if you apply at multiple agencies for an auto loan within a short period of time. That can be viewed as “rate shopping,” where you explore your options for the best possible interest rate.
However, if you apply for multiple credit cards, various short-term loans and an auto loan within a short amount of time, it will make lenders nervous that you may be getting in over your head. Even if your credit score is good, this action can make lenders reluctant to extend credit to you.
Check your credit reports regularly.
Just as you have to revisit your checking account frequently to make sure everything balances, all checks have cleared and no one else is writing checks on your account, you need to check your credit reports frequently to ensure they display accurate information.
The three major credit reporting agencies — Experian, TransUnion and Equifax — each allow you to obtain one free credit report per calendar year. Additionally, you may request one any time you’re turned down for credit, and it’s a good idea to do so. Despite the best efforts of credit reporting agencies to verify information appearing on your credit report, some things fall through the cracks and mistakes happen.
Avoid closing old accounts.
The longer you have open credit accounts, the happier potential lenders are with the idea of lending you money. Even though it may be tempting to close high-interest accounts, or even secured credit accounts, they can do more for your credit (in a positive way) if you leave them open and use them on a limited basis.
It’s not always easy to establish credit when you’re just starting out, but making an effort to build your credit the responsible way will serve you well in the future and make it easier to achieve your financial dreams along the way.