With so many myths and misconceptions regarding the credit building process, it's no surprise that many young consumers are turned off by the process entirely. The general misconception is that credit cards are mostly bad, and by avoiding credit cards (and credit card debt) you're regarded as a trustworthy consumer.
Unfortunately, this is simply not the case; having no credit won't get you anywhere if you need to apply for a home or auto loan in the future, and the longer you wait to build credit the harder it can be to do so.
Simply put, you have to earn your credit score; staying debt-free with zero credit card usage isn't the way to do so. Before you learn how to build credit, it's important to understand how your credit score is calculated (according to FICO score inventors Fair Isaac):
1.) Your Payment History: The most important factor that determines your credit score is your payment history. Never miss a payment, make multiple payments each month ALWAYS pay in time to build your payment history.
2.) Your Credit Utilization Ratio: This refers to the amount you owe relative to your total available credit. The less you owe and the more available credit you have, the better off your credit utilization will be. Ideally, you want to report less than 10% total usage of your available credit; if you have a $1,000 credit line, try not to owe more than $100 to credit card companies.
3.) How Long You've Used Credit: This metric indicates why you should begin building credit early. The longer your credit history, the more lenders and issuers have to work with regarding your credit profile and creditworthiness.
4.) New Credit Accounts and Types of Credit: New credit accounts provide consumers with the opportunity to show lenders yet again that they can use all forms of credit responsibly. New credit can help alleviate past payment issues, while varying types of credit accounts help to “diversify your portfolio” and improve your credit appeal with various lenders.
If you're more of a visual person, check out Creditnet.com's infographic on how to build credit.
Now that you have a basic understanding of how your credit score is calculated, here are some tips for applying for, receiving and using a credit card responsibly to build your credit score and credit profile over time.
The first thing you need to do is apply for a credit card. Before you do this, it's important to know what kind of credit cards you're likely to be approve for. If you have limited or no credit history, you're unlikely to get approved for the most rewarding cards on the market today.
However, you CAN get approved for a credit card that will help you build credit. There are a few ways to go about this, the first (and probably easiest) being a secured credit card. Secured cards require a security deposit upon approval, but the best ones a.) report to the major credit bureaus and b.) include credit monitoring tools so consumers can track their progress.
The security deposit required on these cards guarantee a significant portion of your credit line, and the fact that they actually help build credit is what sets them apart from prepaid or debit cards. Generally, their ongoing interest rates are low (though if you're paying in full each month, this will never be an issue) and they can lead to an unsecured application in the future if used correctly.
Speaking of unsecured cards (credit cards that don't require a security deposit), unsecured cards for no credit are also available, albeit at a bit of a cost to the consumer. Unsecured cards for limited or no credit that do not fall under the “student” umbrella (more on those in a moment) often carry high interest rates, steep annual or monthly fees and low credit lines. If you can front the security deposit for a secured card, we generally recommend secured cards for building credit compared to their unsecured counterparts.
Finally, if you're a student you actually have some solid credit card options available to you despite your limited credit. The only catch is that if you're under 21, under the CARD Act of 2009 you need to provide a co-signer or prove that you have sufficient income. ‘Sufficient' is not a term with a definitive answer, so it's hard to say if you're part-time job at the university bookstore will get you approved for such a card. (Our best guess is that it's unlikely, but possible.) Your best bet is to convince Mom or Dad to co-sign on your credit card; remember to tell them that it's important to your financial future, and will help to boost their own credit score in the process.
Once you've applied for and finally received your credit card, building your credit is simple; use your card semi-frequently, make on-time payments each month (and multiple payments if you can) and show lenders that you're a responsible, trustworthy consumer capable of using credit.
As time goes on, your improved credit score and credit history will open up a whole new world of credit cards to you, like those fancy cards you see advertised on TV constantly with the cash back bonuses and miles. The more established your credit profile, the more likely you'll be approved for auto loans, home loans and the big-ticket items you're working up to.
In the meantime, start small, pay on time, stay debt-free and watch your credit score flourish.
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