Credit is one of the most essential, and for many, the most confusing, aspects of having a healthy life financially. Your credit is a huge factor that determines if you’re able to take out a loan for a car, buy a house with a mortgage, or get approved for a small business loan.
For all of that, many people, especially college students and young professionals, don’t understand credit, how it can impact their life, and the role they play in shaping their own credit.
This guide will serve as a crash course to help you understand credit, how your credit score is calculated, and what you can do to start building credit now.
What is Credit?
In its simplest terms, your credit is an extension of trust by one or more agencies to loan you money when you need it, and how much they’re willing to loan. When people think of loans, they tend to think of a mortgage or a car loan, but your credit card provider is also a lender giving you a loan: when you swipe your card at Kroger or wherever you shop, you’re declaring that your card provider will pay for your items now, and you’ll pay them back later.
The way that banks, lenders, and credit card companies determine if they’re willing to extend you credit, and how much, is by referencing your credit score. While there are several different agencies that generate scores, by far the most dominant score referenced is generated by software from the Fair Isaac Corporation, known as a FICO score. Your FICO score ranges anywhere from around 300 to 820. Higher scores will improve your chances to get better interest rates and credit limits.
How is it Calculated?
While there are many factors that determine your credit, these are the main categories that agencies assess to determine your credit score:
- Your Payment History – How long you’ve been paying various bills and lines of credit, and how often you missed or were late with any payments.
- How Much Debt You Have – Your total amount of financial obligations. This ties into your Debt to Income ratio, or DTI, which lenders factor heavily when determining whether or not to extend you a loan.
- How Long You’ve Had Credit – The amount of time that you’ve had an account open. There’s a saying in finance circles, “Old credit is the best credit.” Accounts that you’ve kept in good standing with over longer periods of time will count for more.
- How Much New Credit You Have – New lines of credit that you’ve secured in the past six months to a year.
- What Types of Credit You Have – The various types of credit you’ve been approved for. Examples include car loans, mortgages and student loans.
There are three major agencies, Experian, Equifax and Transunion, that generate your credit score. Each agency will allow you to check your credit score once per year for free.
What Can I Do Now to Build Credit?
There are a host of options when it comes to building or improving your credit score. Most of them are straightforward and accessible for everyone, but building credit requires conscious effort on your part, and careful monitoring over time.
Start Early
You need to start establishing credit as soon as possible, no matter your goals or circumstances. This is important because the sooner you start building a credit history, the more time you have to improve it, ensuring that you won’t be stuck without a good score when the time comes to buy a car or explore options for loans you may need. As nerve-wracking as it can be for parents, if you’re a high schooler, or the parent of one, you need to consider getting a credit card, with a reasonable credit limit to begin establishing credit as soon as possible. This will allow you to buy the things you’ll be spending money on regardless, while building your credit history at the same time.
Always Make Your Minimums on Time
This is the simplest thing you can do to build credit and improve your score, because it’s something you have to do anyway. No matter what type of bill you’re dealing with, be it your rent, utilities, credit cards, etc., every agency you owe money to will have a set amount you must pay with a recurring deadline.
Being late with your payments, or worse, missing one, will severely impact your credit score. While you should always try to pay off the full amount of all your accounts, especially credit cards, at the least, you must always pay your minimums on time.
Live Well Within Your Means
As we discussed above, your level of debt plays a huge part in determining your final credit score. In order to ensure that you gain the trust of creditors and lenders when you need it most, do your best to spend far less than what you make, based on your DTI. A good range to shoot for is no more than 35%, but absolutely do not exceed 43% if at all possible. Just because you can afford it, doesn’t mean you shouldn’t go for something cheaper, or live without, if you can.
Stay Well Below Your Credit Limit
Whenever you’re given a line of credit, be it a home loan or a credit card, it will come with a credit limit, or the total amount of money you can borrow at a time. While it’s tempting to max out those credit cards to get that brand new car or get the perfect dress for your anniversary, it’s financial fratricide to use up your lines of credit.
Lenders and creditors grow concerned when you’re reaching the upper limits of your credit, because it indicates that you’re relying on credit to afford things you might not be able to with your own income. The best range to stay in is at 30% of your credit limit per or less per account, and unless it’s an absolute emergency, never go above 50%.
Work Now to Diversify Your Credit
When we say diversify your lines of credit, what we mean is that you should try to open
different types of credit from different lenders, as much as is feasible. When calculating your score, having a portfolio of different creditors, that you’ve successfully paid back over time, helps to improve your credit history, and shows that you can manage different types of credit with different limits, interest rates, minimums and payment deadlines.
While diversifying credit is a key component of a good score, it can also get you in trouble. Creditors will be just as wary of you if you try to open too many new lines of credit, all at once, as if you don’t have enough. A good option is to open no more than two or three different credit cards that you can use to pay instead of the cash or savings you normally would.
For example, getting a credit card from your bank (bank card), where you buy most of your clothes (retail), and where you pump your gas (gas credit) is more than sufficient to start, without appearing desperate for credit. This will diversify your credit, increase your limit, and help you to build a track record of responsibility that appeals to creditors and lenders.
Don’t Close Your Credit Accounts, Even If You’re Not Using Them
While it may sound contradictory to being responsible with your accounts, don’t automatically close any lines of credit you have just because you’re not actively using them. As we discussed, both your total amount of available credit and your credit history play a big role in determining your FICO score. By keeping an account open, you’re increasing the total amount of credit available as you open new accounts, building a history, and, most importantly, staying well below your credit limits. Just because you’re not shopping at Forever 21 anymore, doesn’t mean their credit can’t help improve your own score.
It Takes Time
This may seem obvious, but building a solid credit record and improving your score takes time. If you’re a young professional who’s just out of college and starting your first job, you may find that having a low credit score is hurting your ability to get the apartment you want or buy a new car.
The most important thing for you to do is start with the options we’ve discussed above, looking at your own unique situation, what you want your credit to do for you, and formulating a plan to get there. Take advantage of your free annual credit checks to gauge how you’re progressing. While credit can seem confusing at first, once you starting implementing these suggestions, you’re well on your well to establishing a solid line of credit that works for you.