Establishing Credit When You Don't Have It
To get a mortgage and buy a home, you need to have good credit. But if you're a young person just starting out, how do you establish credit in the first place if you don't already have it?
The fact that you need to have a credit history to qualify for credit cards and other loans that will allow you to build a credit history is perhaps the greatest Catch-22 in personal finance. How can you establish a credit history if you can't get credit in the first place?
Fortunately, there are a number of fairly easy ways to get the credit ball rolling. And once you've taken that first step, things get considerably easier from there on - provided you make your payments on time.
It isn't a fast process - it may take a few years to establish a credit history that will enable you to qualify for a mortgage. But the sooner you get started, the sooner you'll reach that point - and in the meantime, you can also put yourself in a position to obtain lesser types of financing, such as for credit cards or an auto loan.
Here's what you can do:
Secured credit card
One of the quickest ways to start building credit is with a secured credit card. Basically, you deposit a certain amount of money in an account, say $200-$500, and you're issued a credit card that allows you to charge up to that much.
It may seem rather silly, since you could simply pay cash using the money you deposited. But the important thing is that it allows you to establish a history of using the card and making payments on time. After about 12 months of regular use and on-time payments, you should be able to obtain a regular credit card, either from a bank or a retailer - the latter are often easier to get as one's first unsecured card.
Depending on your credit profile, you may also be able to get a secured card that allows you to charge more than you have on deposit - for example, depositing $50-$100 for a $200 credit line.
Secured credit cards will usually charge an annual fee. When shopping for one, look for the smallest fee possible - try not to pay more than $30 a year.
Co-signer on a credit card
Another way to develop a credit history is to become an authorized co-signer on someone else's card - often a parent. All it requires is the permission of the cardholder - you don't need to qualify yourself.
When you're an authorized user, the card's payment history is reported on both your credit history and that of the authorized user. So it helps you establish a record that should enable you to obtain your own card in about a year, similar to using a secured card.
Of course, this requires a strong measure of trust on the part of the cardholder and a close relationship with them. But parents often allow such uses.
Co-signing a loan
One of the most common ways for young people to begin to establish credit is to obtain a loan with the aid of a co-signer. In this situation the co-signer, typically a parent or other relative with an established credit history, accepts equal responsibility for the loan and for making the payments. It's often used to buy a car or make some other major purchase.
The downside of this type of arrangement is that if the primary borrower fails to keep up with the payments, the delinquency damages the co-signer's good credit as well. While the co-signer is required to step in and cover the payments in that situation, it could be several months before they realize the debt is in arrears, because the billing statements are sent to the person who will be making the payments.
Get a secured loan
A secured loan is a great way to begin establishing credit and one that is often overlooked. It's a way that parents can help their adult children make a necessary major expenditure while establishing an initial credit history. It also protects the parent's credit in a way that co-signing a loan does not.
The way it works is that the parent or other second party puts up some type of collateral to secure the loan. These are often in the form of stocks or certificates of deposit that are pledged as a guarantee the loan will be paid - if the borrower defaults, the collateral is used to pay off the loan.
There are several advantages to this approach. First, the borrower is the only one on the loan - the payments are reported on his or her credit history alone, and not on that of the person putting up the collateral. Second, the person posting the stocks or CDs still enjoys the benefits of any dividends, interest or profits they generate while they're being used as collateral - they simply can't sell or cash them out until the loan is paid. Third, as a fully secured loan, the interest rates are some of the lowest available.
The downside of this approach is that if the borrower defaults, the person who posted the collateral could lose whatever assets they pledged.
Student loans are another way of building one's credit. They're generally easier to qualify for than other types of loans. However, they won't start building your credit until after you've graduated and have begun making payments on the debt. But once you've been doing that for a year or so, you should find other types of credit easier to obtain.
Rent and utility payments
Traditionally, rent and utility payments have not been reported to credit bureaus to help build a credit history (although failure to make such payments can count against you). However, that has begun to change in recent years.
Experian was the first of the major credit bureaus to being accepting reports of rent payments as part of a FICO credit history. However, not all landlords report rent payment histories to credit bureaus - you may be more likely to have your history reported if you're renting from a large property management company.
Several new credit scoring systems have been developed in recent years as alternatives to FICO, which long had the credit scoring market to itself. Some of these newer systems do take into account rent and utility payments in assessing your creditworthiness. However, this won't help you if the lender you're applying to doesn't use those scores in approving credit applications - most still rely on FICO.
Some things to watch out for
- When establishing your credit, your credit score will be based not only on your payment history but also on how much debt you're carrying. With credit cards or other types of revolving debt, you don't want to use more than 30 percent of your available credit at any one time. Running a balance higher than that will hurt your credit score, rather than helping improve it.
Paying off your credit cards in full every month won't hurt your credit score - it'll help it. There's no need to carry an ongoing balance to prove your credit worthiness. The key thing is showing you can manage the debts you incur.
- Having and using multiple lines of credit will help build your credit faster than a single loan will. Making responsible, regular use of three credit cards will build your credit faster than a single credit card will. Using different types of credit helps as well - having an auto loan, student loan and a credit card will build your credit faster than if you just had five credit cards.
At the same time, seeking too many new lines of credit too quickly will hurt your credit. When building your credit history, it's a good idea to add new lines of credit no faster than every six months - more than that makes it look like you may be taking on debt too quickly.
- Once you have them, don't cancel any credit cards or other revolving lines of credit you may have. It's not true that having too many credit cards hurts your credit. Rather, canceling them can wipe out whatever good credit history you have with those lenders.
The exception would be any accounts that have annual fees, which you want to covert to no-fee accounts if possible. Otherwise, you can go ahead and cancel those to save money. No need to keep paying the annual fee on that original secured card once you've been able to get other loans or lines of credit.
- While recurring debts such as utility payments, medical bills, cell phone charges, etc. generally won't help you build a credit profile, they can hurt you if you don't make your payments. So don't think you can skate on your cable bill just because your payment history isn't reported to the credit bureaus - a default almost certainly will be.
Building a credit history takes some time but you can establish a fairly solid record within a few years. The important things are to establish several lines of credit, make your payments on time and don't take on more debt than you can easily handle. If you do that, you'll be well on your way to a solid credit score.
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