If you have applied for a loan, want to buy a home, or simply want a credit card, then you’ve probably heard about credit.
You may already know that having a high credit score is better than a low one and that you can work to build your credit if your credit score is low.
However, it can be difficult to figure out how to build credit and boost your credit score.
This article outlines everything that you need to know, from what credit is to how to ensure your credit score is high enough to help you qualify for the financial assistance you need.
What is Credit?
Your credit score is a three-digit number calculated based on your historical ability to manage debt and other regular payments. Credit is your ability to borrow money with the agreement that you will repay it.
What Makes Up a Credit Score?
Before we dive into how to build your credit, it’s essential to understand what factors your credit score is based on. There are three major credit reporting bureaus. They are called Equifax, Experian, and TransUnion, and they use a complicated algorithm to determine your credit score. However, you should know the major factors they use to evaluate your credit score. They are:
- Payment history – Your payment history is the most important factor in the algorithm that determines your credit score. It considers how long you’ve had certain debts and if you’ve made regular on-time payments.
- Credit utilization – Your debt to credit ratio, or credit utilization, also plays a large part in your credit score. You should try to use less than 30% of the total credit extended to you. For example, if you have a $1000 credit limit, you should try to carry less than a $300 balance.
- Credit mix – The credit bureaus look to see how many types of credit you have. For example, it might be wise to balance a credit card, make regular utility payments, and maintain your lines of credit for a long time.
- Hard credit inquiries – A hard credit inquiry is when a company officially requests your credit score to evaluate if you are a viable candidate to borrow from them. You should avoid hard inquiries except when necessary. A soft inquiry does not damage your credit score and includes when you check your credit score online.
- Negative or incorrect information – If you have negative information on your lines of credit, it can deeply affect your credit score. Examples include missed payments, collection accounts, or bankruptcy. Be sure to monitor your credit report closely to see if you have any negative marks. If you see something that you did not do, like open a new credit account, you could be the victim of identity fraud, which can seriously damage your credit score.
How to Build Credit and Boost Your Score
Now that you understand what makes up your credit score, you can use this information to make decisions that help you improve your credit score.
Pay Your Bills on Time
One of the most important things you can do to build your credit is always to pay your bills on-time. Because your credit history is the most crucial factor in determining your credit score, you should make sure that both your debt payments and other bills are always paid-in-full and on-time.
To help you pay your bills on time, you may want to schedule automated payments. This will help to ensure that your minimum payments are taken care of each month. The consistency created by automatic payments will help to build your credit score.
If you notice that your credit report has a missed payment on it, you may want to see if you can make the payment now and erase it from your report. This is often possible if you are less than 90 days past due on the bill and can pay the balance in full. Backdating payments is more difficult with outstanding payments.
Keep Your Debt to Income Ratio Low
You can improve your credit utilization by keeping your debt to income ratio as low as possible. You can do this in two ways:
- Pay off as much debt as possible. You could strive to use less than 1/3 or about 30% of your credit limit. This means that if you have a credit card with a $1,000 limit and you’ve maxed it out by using all $1,000 available to you, then you have a 0% debt to credit ratio. However, if you were to pay off $700 of your balance, you’d be using about 30% of your available credit. Decreasing the amount of available credit that you are using will help you improve your debt to credit ratio and increase your credit score.
- Increase your credit limit. If you can’t pay off your credit cards but want to decrease your credit utilization, you can try to increase your credit limit. The important thing to note when increasing your credit limit is that you should not continue to increase your credit card balance. For example, if you have a credit card with a $1,000 limit and you’ve maxed it out, you might want to call your credit card company to see if they will increase your credit limit to $3,000. This way, you’ll be using less than 1/3 of your available credit.
Apply for Credit Only as Needed
When you apply for credit, you will receive a hard inquiry on your credit report. This means that when you apply for a home loan, auto loan, student loan, and apply for credit cards, your credit score could take a small hit. You should only apply for credit when you need it to avoid taking small hits to your credit score.
If you are applying for credit often, it can signal to companies that you do not have the capital to make regular payments on your debt. This will make you a less viable candidate to receive money from lenders.
Keep Existing Credit Cards Open
Your credit history includes how long you have had some lines of credit available. If you have unused credit cards that do not have annual fees, you should keep them open. This will help to keep your available credit high and will positively impact your credit utilization ratio.
Keep an Eye on Your Credit Reports
While simply knowing what is on your credit report will not help you increase your credit score, it is wise to know what your credit report looks like. When you are aware of what has contributed to your credit score, you will have a better idea of what is correct on your credit report and will be able to catch any inaccuracies more quickly. Additionally, you will know what actions you can take to increase your credit score when needed.
You can typically check your credit score for free and without penalty at creditkarma.com and through your banking app. Do not simply search your social security number online, and do not give away your social security number to a source that is not secure.
Why is Good Credit Important?
Having good credit is vital for several reasons. It can help you save money on interest when you borrow large sums, and it can help you get access to favorable financial products. Here are a few ways that having good credit can help you:
- Access to the best credit cards – High credit scores will provide you access to some of the best credit cards on the market. This means that you will be able to earn points and other perks that come with having a good credit card. You will also be eligible for higher credit limits and lower interest rates.
- Better housing options – When you apply for a lease, you will likely be subject to a credit check and background check. If you have a low credit score, you might not be deemed trustworthy in making your rent payments. A good credit score can help you secure better housing for you and your family.
- Lower interest rates – When you take out a large loan such as a mortgage, student loan, personal loan, or auto loan, you will likely try to shop around for the best interest rate. If your interest rate is even one percent lower on a loan, it can mean saving thousands of dollars over the life of the loan.
- Better terms on loans – Not only can you receive better interest rates on loans, but you can also get better terms on loans when you have a higher credit score. When you have a high credit score, you will have access to the most loan and credit card products and will be able to negotiate the best possible terms.
The Bottom Line
Having a high credit score means that you will have access to the best financial products and terms available. When you understand what makes up a credit score, you can take action to improve it and keep it high over time. The best ways to improve your credit score are to be consistent with your money and to keep your credit utilization low.
Michael launched Wealth of Geeks to make personal finance fun. He has worked in personal finance for over 20 years, helping families reduce taxes, increase their income, and save for retirement. Michael is passionate about personal finance, side hustles, and all things geeky.