The Right and Wrong Ways to Build Credit

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There is a lot of credit advice out there on what it takes to build a good credit score. So how do you know what’s true and what’s false? Below are the myths on how NOT to build credit.

How NOT to Build Credit: Debunking Credit Myths

Myth: You need to carry a balance to build credit. One of the most popular credit score myths is that you need to carry a balance in order to build credit. But this is not true! Your credit score is made up of multiple factors with payment history having the most impact, at 35% of your total score.

Creditors don’t care if you carry a balance or not, they just want to see that you pay your bills on time. In fact, credit card companies will report the statement balance each month with no other information. If you’d like to check your credit score, sign up for ReadyForZero and use the PLUS feature to see your score.

You are building credit, based on your payment history and your balance, regardless of whether or not you pay interest to the credit card companies.

Myth: Fewer credit accounts means a higher score. This might come as a surprise, but your credit score will often be higher if you have 6-10 credit accounts than if you have just one or two.

Why? Because the credit bureaus want to see a good mix of different credit types, to round out your credit mix. That doesn’t necessarily mean you should go out and get new loans or credit cards, though! Just remember, all types of accounts – credit card accounts, installment loans, mortgages and even student loans – affect your credit history. And more accounts sometimes means a higher score.

A short credit history is the best. The longer your credit history, the higher your credit score will be. Just think about it; would you give a loan to someone who’s had a responsible history for 5 years or someone with a history of 5 months? Exactly!

Creditors want to see that you have a long history of paying your debts on time. This is why you want to be careful about closing any credit card or loan accounts. If it was the first account you ever opened, it’s better if you leave it open to prove a long credit history.

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The Right Ways to Build Credit: Using Credit Responsibly

In order to build a solid credit history you have to use credit products responsibly. But how do you do that without incurring a ton of debt? Here are the most popular credit products and how you should approach them (with caution) to optimize your credit.

Credit Cards

A credit card, as you probably know, is a piece of plastic you use much like a line of credit. It allows you to make purchases, without using cash, and pay for them at a later date — usually 30 days later.

You receive a credit limit with a specified dollar amount and at the end of the cycle period, you get a bill for your total card activity. If you pay less than the balance due in full each month, interest will be charged on the balance you carry over to next month’s bill. If your balance creeps up and your ratio of debt to available credit is too high, it will affect your credit score negatively. To make a plan to get out of debt (as fast as possible), sign up for ReadyForZero, a free tool for paying off debt.

Secured Cards

A secured credit card is great for establishing or rebuilding credit history. Unlike prepaid cards, secured credit cards give you a credit line based on a small prepaid sum, or collateral.

Your payment activity is reported to the major consumer reporting agencies just like a normal credit card, but without the fear of incurring too much debt. You rebuild your credit history by making on time monthly payments to your creditors and keeping your balances low.

Installment Loans

With an installment loan you apply for a specific amount, like when you’re purchasing a new car. If you’re approved, you are given a lump sum of money to finalize that purchase. You then repay the loan in equal monthly installments for a number of months or years, until the loan is paid off.

An auto loan, or even personal loan, is a different kind of credit product and therefore can be good to have in your credit report mix. Of course you don’t want to go out and get a car loan just to increase your credit score, but it’s a smart account to have versus taking out more credit cards.

Student Loans

Student loan debt is a type of installment loan. This means your credit score is improved by making consistent on-time payments. On the other hand, paying your student loan payments late can hurt your score as much as late payments on any other type of account.

The age of a student loan is factored into credit scores no differently than any other type of credit account, so the longer you’ve had your student loan, the farther back your credit history goes. You can manage all your student loans in one place using ReadyForZero.

For the student loan borrower who also has a credit card or two, the presence of a student loan on the credit report can have a positive impact on their credit by demonstrating the ability to manage different types of credit products.

Mortgages

A mortgage is viewed by some experts as one of the best kinds of debt you can have, since it’s tied to a physical asset that (generally) increases in value over time. It also rounds out your credit score mix since owning real estate is a completely different kind of debt, compared to credit cards, student loans and auto loans.

If you pay your mortgage on time every month, mortgage debt has a positive effect on your finances. Banks and financial institutions are more likely to approve you for new credit if you have a mortgage listed among your debts. To them, it makes you look more responsible.

But before you get a mortgage, you want to follow our rules about the right and wrong ways to build credit, because the higher your credit score is when you’re approved for a mortgage, the lower interest rate you’ll pay. Even a 1% savings on interest can pay off big time when you’re looking at a 20-30 year term.

The Importance of Staying Out of Credit Trouble

One of the fastest ways to land in credit card trouble is by making late payments on your accounts. Yes, we’re all human and sometimes we miss a payment by accident, but making one late payment on your credit card can impact your credit score. You never want to get into a habit of making payments late, and always do your best to pay them on time.

If you do have a payment that’s paid late, often times you can call your credit company and ask them to waive the late payment fee and apply your payment to the due date. This will keep your payment from showing up late on your credit report and save you money in late fees. It never hurts to ask!

Another vital part of using credit is keeping your balances under 30% of your overall credit utilization. For example if you have a credit card with a $10,000 credit limit, you never want to charge more than $3,000 on your card at any time. Of course, 0% is ideal, but staying under 30% is the most important threshold for your score.

It’s far too easy to get into debt problems, and that has a negative effect on your credit report. In order to stay out of credit trouble, make your payments on time and keep your credit usage at an easily manageable amount. If you have more questions about credit, ask us in the comments below.

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  • Solace

    As a young person with about five years of credit history, a couple of credit cards (no balance), and about $10,000 remaining in student loan debt, would it then be better for my credit score if I did *not* try to pay off the student loan as quickly as possible? I’m on track to pay it off in about two and a half more years, but then the only credit I’ll have will be the cards, and I wouldn’t be too thrilled if that hurts my credit score substantially.