Whenever students are told that they need to be responsible once they become adults, everyone talks about building credit. Unfortunately, almost nobody ever explains what exactly that means. Having a good credit score is what allows you to finance cars, eventually buy a house, and generally participate in the financial economy that facilitates consumer purchases. Unfortunately, this goes the other way, with bad credit (or no credit), you might not even qualify, or in your best case get prohibitively expensive options.
Now, there are a lot of things that parents can do for their children to get them to start building credit. An example of this is adding your child as an authorized user so they can somewhat piggy-back off of the card's activity and build credit that way. However, this article will focus instead on what you can do as soon as you turn 18, to start your own financial future, and build credit independently.
1. Payment History to Build Credit
If I was to rate the one thing that would have the greatest impact on your ability to build credit, it would be your Payment History. At the end of the day, Creditors are interested in seeing how you would make your payments, and your history with others is an indicator of if they will make money or not.
How to build credit on your history?
The easiest way to start building credit is by getting a small-money pre-paid credit card with a financial institution. Most issuers will give you the option to start with this card, and after a few months of paying it off, you will most likely qualify for expansion into higher dollar amounts, and cards that aren't pre-paid. This will be the start of your credit history and be a building block for other more substantial financing, which will continue compounding over time into more and more qualifications... as long as you pay!
Once you have a starting point, qualifying for larger personal loans or car loans is an excellent way to get big-ticket items on your credit that encourage lenders. This secondary step after your starting point on small/medium sized credit cards is the most difficult part of your journey and probably also your most expensive. Depending on your actual payment history, length of time with paying back debt along with other factors like your income will determine the difficulty of this step. Once you've paid off a car loan for example, you are likely in the clear in terms of building credit, now it is just a game of maintaining your credit.
How to maintain credit on your history?
Always make your payments on time
The minimum payment should always be made before or on the due date.
If you expect issues in making payments please contact the creditor, since they might be accommodating - especially if you have a good reason
Don't skip a payment even if a bill is in dispute. Creditors will report the information the way they have it. It would be better to pay and then retrieve the money after/if the dispute is won. If you assume you have a point and you don't make a payment, that might result in a negative reporting.
2. Credit Utilization is bad for building credit
Another factor that really affects your ability to build credit would be your Credit Utilization Rate. It is the ratio between your balance and the amount of credit granted to you. The higher this ratio, lower the score. Basically, this ratio shows how much debt you area using. If they provide the ability to borrow $1000, and you borrow it all and don't pay it off at the end of the month, that suggests to lenders that you might be over-leveraged or be purchasing outside of your means.
Also, don’t go over your credit limit. If you have a credit card with a $5,000 limit, try not to go over that limit. Borrowing more than the authorized limit on a credit card can lower your credit worthiness and make it much harder to build credit.
Try to use less than 35% of your available credit. It’s better to have a higher credit limit and use less of it each month.
For example:
a credit card with a $5,000 limit and an average borrowing amount of $1,000 equals a credit usage rate of 20%
a credit card with a $1,000 limit and an average borrowing amount of $500 equals a credit usage rate of 50%
If you use a lot of your available credit, lenders see you as a greater risk. This can be true even if you pay your balance in full by the due date, as the credit reporting agencies take time to update their information.
Understanding Utilization
This utilization calculation is undergone for all the debt that you as a consumer have borrowed.
To figure out the best way to use your available credit, calculate your credit usage rate. You can do this by adding up the credit limits for all your credit products.
This includes:
credit cards
lines of credit
loans
For example, if you have a credit card with a $5,000 limit and a line of credit with a $10,000 limit, your available credit is $15,000.
Once you know how much credit you have available, calculate how much you are using. Try to use less than 35% of your total available credit.
For example, if your available credit is $15,000, try not to borrow more than $5,250 at a time, which is 35% of $15,000.
3. Use different types of credit
If you have only one type of credit, lenders may view you as less trustworthy. This is generally a function of the fact that this lack of variety is usually based around having only credit cards on file (also known as revolving credit, instead of the other major type, instalment).
Think about it this way. Instalment credit requires that the lender pulls money from your account over a long-period of time, for large amounts. Revolving credit requires you to make at least a minimum payment on the due date. A lender wants to see that you can handle all these transactions in a timely manner.
The idea of multiple types of credit also builds into Comparable trades. A lender wants to see that a client has proven themselves with a comparable responsibility. Given that throughout your life, you might want to apply for a lot of different products, showing exposure to both revolving and especially instalment credit types (like cars) can make your life easier.
To illustrate this, let's go through an example: if you request an amount of $10.000 and you have shown that you have handled this amount in the past then any lender would feel more comfortable approving you for similar amounts to the $10.000. This idea of taking on loans you can handle for larger amounts of money can help you when building credit as you move up the $ amount chain (going from 10k to 20k for example is definitely possible, since if you paid 10, you can also probably pay 20, or it is at least a defensible risk).
4. Think about timing when you build credit
Time in credit matters. In the credit report there is an item called “Date File Opened”. That reflects the time you first entered the credit sphere, and. it represents the first time a lender pulled your credit.
The longer you have a credit account open and in use, the better it is for your score, since it suggests you have been credit-worthy for longer. Your credit score may be lower if you have credit accounts that are relatively new.
If you transfer an older account to a new account, the new account is considered new credit.
This can also work in your favour. For example, some credit card offers come with a low introductory interest rate for balance transfers. This allows you to transfer your current balance to this new product. Keep in mind, the new product is considered new credit, but your previous account doesn't close.
You should consider keeping an older account open even if you don't need it. Use it from time to time to keep it active. Make sure there is no fee if the account is open but you don't use it. It is easy to check if there is a fee, since it all needs to be disclosed in the credit agreement. Of course, it is probably not worth it if there is a fee, but if not, having an older account open on your credit report can help you build credit as it appears to show more trade lines.
5. Limit your number of credit applications or credit checks
It’s normal and expected that you'll apply for credit from time to time. When lenders and others ask a credit bureau for your credit report, it’s recorded as an inquiry. These inquiries are also known as credit checks.
If there are too many credit checks in your credit report, lenders may think that you’re:
urgently seeking credit
trying to live beyond your means
How to control the number of credit checks when you build credit?
To control the number of credit checks in your report:
limit the number of times you apply for credit, and potentially the number of lenders you apply to (since different lenders will pull credit again).
If you do choose to apply to multiple lenders, it might be a good idea to only do so if necessary. For example, if you get a decline or a rate that you think is unfair.
“Hard hits” versus “soft hits”
“Hard Hits” are sometimes referred to as “Regular Hits”. They represent credit checks that appear in your credit report and count toward your credit score. Anyone who views your credit report will see these inquiries and as mentioned before, they can be detrimental to credit building efforts.
Examples of hard hits include:
an application for a credit card
some rental applications
some employment applications
“Soft hits” are credit checks that appear in your credit report but only you can see them. These credit checks don't affect your credit score in any way.
Examples of soft hits include:
requesting your own credit report
businesses asking for your credit report to update their records about an existing account you have with them
You might also hear “Soft Hits” from the finance company you do your banking with. TD Canada Trust, for example, has an internal score that sometimes they use in order to make some internal decisions.
Although, there is a lot more associated with what you can do to help improve your credit, this serves as a rough guide with some useful tips for when you do start getting involved in that world. It can be overwhelming, but by taking it one step at a time, and moving carefully, you can definitely build a sustainable financial future for yourself!
By: Mateo Gjinali
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