Building credit is essential, yet for young adults starting out, the process can feel overwhelming.
Credit scores are calculated based on a variety of factors, and understanding these can help you manage and improve your credit. Here's an overview:
Payment History (35%): This is the most significant factor. It includes your track record of on-time payments on credit accounts such as credit cards, mortgages, student loans, and other financial obligations. Late payments, defaults, and bankruptcies can negatively impact your score.
Credit Utilization (30%): This ratio measures how much of your available credit you're using. It’s calculated by dividing your total credit card balances by your total credit limits. Keeping this ratio below 30% is generally recommended to maintain a good score.
Length of Credit History (15%): This factor looks at how long your credit accounts have been active. A longer credit history tends to be favorable because it gives lenders more data about your borrowing habits.
Types of Credit in Use (10%): Having a mix of credit (credit cards, retail accounts, installment loans, finance company accounts, and mortgage loans) is usually positive. It shows lenders you can manage different types of credit.
New Credit (10%): This includes the number of recently opened accounts and the number of hard inquiries lenders make when you apply for new credit. Too many new accounts or inquiries in a short period can be a red flag to lenders.
Public Records: Items such as bankruptcies, tax liens, and civil judgments can also appear on your credit report and impact your score, although these are less common.
Each factor plays a role in building your credit score, and focusing on them can help you improve or maintain it.
Establish Credit Accounts Thoughtfully
Now that you understand the components of a credit score, let's discuss how to begin building credit. A key step is establishing credit accounts, but it's important to be strategic.
One of the easiest ways to obtain a credit score from scratch is becoming an authorized user on someone else's credit card account, preferably a parent or relative with a long history of responsible credit use. As an authorized user, you'll gain the benefit of their positive payment history. However, be aware that if they miss payments or accumulate debt, it could negatively impact your score too.
Yet another avenue is to take out a credit-builder loan or secured installment loan from a credit union or community bank. As you repay the loan, the lender reports your payments to the credit bureaus, helping to establish your credit history. Make sure the lender reports to all three major credit bureaus (Experian, TransUnion, and Equifax) for maximum benefit.
Whichever method you choose, remember to keep your credit utilization low. Using less than 30% of your available credit is generally recommended. For instance, if you have a secured credit card with a $500 limit, aim to keep your balance below $150. This practice demonstrates responsible credit use and can boost your score over time.
Monitor Your Progress
Regularly checking your credit reports and scores is crucial in building credit. It allows you to identify errors that could be hurting your score, track your progress, and ensure you're on the right path.
You can request a free copy of your credit report once a year from each of the three major credit bureaus at annualcreditreport.com. Additionally, some credit card issuers and personal finance websites offer free credit score monitoring. Take advantage of these resources to stay informed about your credit status.
When reviewing your credit report, look for any inaccuracies, such as late payments that you've made on time, incorrect credit limits, or accounts that don't belong to you. If you find any errors, contact the credit bureau and the creditor to dispute the information. Provide any supporting documentation you have to help resolve the issue.
Building credit is a journey, and staying committed to good financial habits is key. By understanding how credit scores work, establishing credit accounts thoughtfully, and monitoring your progress, you'll be well on your way to a solid credit foundation that will serve you for years to come.
