Understanding credit scores & their impact
In America, credit scores determine how good or bad your credit is. Therefore, building a good credit score can be considered the key to opening the door to a successful financial future.
However, the key to building credit starts with clearly understanding how credit works and knowing what you should be working toward.
So, before we jump into our tips for building good credit, let’s take a look at what a credit score is, why it matters, and how your credit score is calculated.
What is a credit score?
A credit score is a type of number that is assigned to you by a credit union. It represents your overall credit health on a numerical scale. Your credit score can indicate how trustworthy you are to lenders which makes it a valuable asset to have and protect.
The FICO credit score and the VantageScore are the most commonly used types of credit scores in America.
However, the FICO score is the most popular of the two and is used by 90% of top lenders in America. For this reason, many people focus on tracking and building this score over the VantageScore.
When it comes to FICO credit scores, the number you are assigned will fall between 300 and 850 with higher numbers representing better credit health. The following FICO score ranges also show approximately where you stand and how lenders might view your score if you apply for a loan.
FICO credit score ranges:
According to myFICO.com, FICO scores over 800 are well above the national average and show lenders you have proven your creditworthiness.
Very Good (740 to 799):
This range of scores is higher than the average score in the U.S., and it shows lenders you are creditworthy and dependable.
Good (670 to 739):
This range of scores is about average among U.S. consumers, and it is typically considered good or acceptable by lenders.
Fair (580 to 669):
This range of scores is below average, although you may still be able to get approved for credit cards and loans.
Poor (579 and below):
This range of scores is well below the U.S. average, and it shows lenders you present a significant amount of risk.
If you’re building credit for the very first time, there’s a good chance your credit score will start at the low end of this scale. It’s even possible to not have a credit score at all if you’re new to credit, new to the U.S., or if you simply don’t have any credit history to speak of.
Why does building a good credit score matter?
Building a good credit score matters because it shows lenders that you are a trustworthy (or untrustworthy) borrower, depending on your score.
You will use your credit score if you ever need to take out a loan, get a new credit card, or apply for your own apartment. In each of these examples, a business conducts a hard inquiry on your credit report to verify your credit score and credit history. If they don’t like what they see, you may not be approved.
Likewise, if you don’t have a credit score you may find many tasks that require credit checks nearly impossible later on in life.
Here are some examples of common scenarios that require a good credit score:
- Taking out a mortgage to purchase a home
- Borrowing money for a car
- Qualifying for financial products and loans with fair and reasonable interest rates
- Taking out a business loan to fund a business venture
- Getting most apartments without a cosigner
- Becoming eligible for a rewards credit card
- Qualifying for the lowest car insurance rates
- Getting a credit card with a decent credit limit
As you can see, there are many important reasons to start building credit as soon as possible. While a good credit score can make all of these financial moves considerably easier to accomplish, poor credit can stand in the way of nearly every financial goal you have.
How credit scores work
Your three-digit credit score is assigned by each of the credit bureaus — Experian, Equifax, and TransUnion — using information reported to them.
This information can include the balances you owe, your payment history, accounts you have in default, and more. It can help you build credit or make it worse depending on how good you are at managing your finances.
When it comes to FICO credit scores, five major factors are used to determine where your score falls:
Payment history (35%):
This factor is determined based on whether you pay your bills on time.
Amounts owed (30%):
This factor, also known as your credit utilization, represents how much debt you have in relation to your available credit.
Length of credit history (15%):
This factor represents the average length of all your credit accounts.
New credit (10%):
This factor is determined based on how many new credit accounts you have opened in the recent past.
This factor is determined based on the types of credit you have, whether you have personal loans, student loans, mortgage debt, revolving credit accounts, and other types of credit.
Once you look at the factors that make up your credit score, it’s fairly easy to see how to build credit and different paths you can take to improve it.
With that in mind, let’s take a look at our tips for building a credit score from scratch.
Ways to build credit from scratch
Starting to build credit from zero is almost a right of passage in America. Everyone has to start somewhere, and most people start with no credit history at all.
That said, there are ways to build credit that can capitalize on other people’s existing credit history to help you get a boost when starting to build your credit. There are also tools and strategies designed specifically for people who are starting their credit journey.
Here are some ways to build credit quickly from scratch:
- Get a secured credit card
- Become an authorized user on someone else’s card
- Get a credit-builder loan
- Find a co-signer
- Pay on time, every time
- Use credit-building apps
- Start with a student credit card
- Dispute any errors in your report
Following any of these tips should help you start to build credit from scratch, but they can also improve your existing credit score.
Let’s break each point down for a closer look.
How to build credit: the best practices
As we have mentioned, there are many ways to build credit quickly, and some are easier than others. That said, here is our list of important habits and goals to master for building good credit.
Pay your bills on time, every time:
Being late on your payments will hurt your credit score and will generate high interest that can leave you in more debt. High debt on your card that rolls from month to month will also damage your credit score. For this reason, the best tip is to pay your bills on time and in full, each month.
Keep your credit card balances low:
Similar to how spending more than 30% of your credit line acts as a bad signal to lenders, high balances can indicate you don’t have enough money to pay your bills. This is a sign to lenders that you may not be a trustworthy borrower. As a result, your credit score will drop.
Diversify your credit profile:
Consider applying for a mix of credit cards, loans, and mortgages. If you make on-time payments, applying for different types of credit can help you build credit faster and improve your overall credit score. That’s because a diverse mix of credit types shows banks that you are successful at managing your debts and paying off multiple credit lines at a time.
Limit new credit applications:
Although we recommend applying for different types of credit, you should be careful when and how often you do it. Each time you apply for a new line of credit, it shows up as a hard inquiry on your credit report. Hard inquiries will lower your score in the short run, but on the flip side, gaining a new type of credit will improve your score in the long run.
Check your credit report regularly:
Even credit bureaus make mistakes. For this reason, it’s important to make sure your reports are accurate and dispute any errors that you see to get them rectified as soon as possible. By reading your credit report you can also learn from mistakes you make and avoid them in the future.
How to build credit without a credit card
Building credit can be more difficult when you don’t have a credit card, but plenty of the steps above can still help you get started.
For example, you can always apply for a credit-builder loan from a company like Self. With a Large Builder Loan from this company, you could pay $48 per month for 12 months and get $539 back at the end of the year. During that time, your payments would be reported to the credit bureaus, and you would only fork over $46 in interest and fees.
Apps like Experian Boost can also help you build credit using regular bills, and becoming a co-signer on another person’s credit card can also help.
Most importantly, you need to be responsible and careful with any credit you are granted. This means paying bills on time, keeping your debt-to-income ratio at a reasonable level, and avoiding situations where you get in over your head.
How to establish credit with no credit history
If you don’t have any credit history at all, many of the same strategies apply. However, a secured credit card could be the best financial product for your needs.
This type of credit card can approve anyone — even people who have no credit history at all. This is based on the fact you secure your own credit line with a cash deposit. If you were to default and stop paying your credit card bill, your own security deposit will be used to pay it off.
In the meantime, a secured card will report all your credit movements to Experian, Equifax, and TransUnion. This means that on-time payments to your secured card issuer can help boost your credit score in a short amount of time.
On the flip side, it’s worth noting that late payments on a secured card can make your credit score worse than it is. Finally, the low available credit you get with a secured credit card can make it difficult to keep your credit utilization on the low end. For that reason, we suggest only using a secured card for purchases you can afford to pay off each month.
Credit mistakes to avoid
To avoid some of the biggest credit mishaps out there, you first need to know where you stand. With that in mind, we suggest checking your score using any number of tools, including Capital One CreditWise, Credit Karma, or CreditSesame.
Each of these tools will let you see at least one version of your score for free, and they can also help you identify problems within your credit reports.
Once you know how you’re doing in terms of good credit, you should follow these rules:
- Don’t pay any of your bills late.
- Make sure you’re only borrowing money if you can afford to pay it back.
- If you tend to rack up debt with credit cards, stick to debit cards for most of your spending and bills.
- Use the best rewards credit cards, but only if you can avoid paying credit card interest.
- Check your credit report from each of the credit bureaus at least once every few months.
- Keep your credit utilization at or below 30% of your credit limit on any given credit card.
Whatever you do, make sure to take your credit seriously, and focus on borrowing responsibly for the long haul. While good credit can make your life easier, a bad credit score almost always does the opposite.