Step by Step Guide to Building Credit
Updated for 2019
Written by Todd R. Christensen
When building credit from scratch (as most young adults must) or rebuilding credit after a run of difficult financial challenges (medical, collections, bankruptcy, job loss, etc.), there are several steps to take to improve credit scores and show potential creditors that you are not a high risk to them (so that they’ll charge a lower interest rate).
Correct and Confirm
First of all, you want to ensure that your credit history is accurate and “clean.” Clean does not mean perfect. It just means that the information listed on the report is accurate. To get a truly free copy of your credit report, start at AnnualCreditReport.com. This site does not require a credit card or debit card number, or to sign up for any trial offers for a ten to twenty dollar per month services that you don’t need (and probably don’t want). This is a federally mandated website where everyone can get a free, no-strings-attached credit report from each of the three major credit bureaus every twelve months. To bust a popular myth, checking your credit doesn’t hurt your credit rating or affect your ability to qualify for a loan.
While not a must, you may also consider monitoring your credit more frequently than this services provides. There are a couple of ways to do this:
Sign up for a fifteen-dollar-per-month credit monitoring service. We recommend avoiding this and looking for free alternatives.
You can sign up for a free weekly credit score at CreditKarma.com to watch for concerning trends on a regular basis.
You may also call to request a free credit report by calling (877) 322-8228 or by mailing a request to Annual Credit Report Request, PO Box 105281, Atlanta, GA 30348-5281.
Ideally, you should use the form provided through the Annual Credit report site at Annual Request Form when mailing for your credit report.
Once you have your credit report in hand (or have access to viewing it online), make sure you recognize the information it contains. Are the names listed on the report yours? Do you recognize the street addresses? Do you recognize the creditors and accounts, including collection agencies, credit card companies, home and auto lenders, and others If any of this information is inaccurate, or if the accounts are not even yours (which accoirding to a 2013 FTC report is the case in about one-in-four consumer’s reports). you can dispute them pretty easily online. While there is no guarantee the information will be corrected quickly, it’s definitely what you want to do.
UTILITIES / Cell Phone
Once you’ve reviewed and disputed any inaccurate information you may have found on your report, the next few steps to building your credit are small ones, but at least they are free. If you have a history of on-time payments to your utilities or cell phone company (not including a prepaid phone services), write them a letter or call them and ask that they report your payment history to the credit bureaus.
They are not required to do this and typically do not do so automatically. However, if they do, it can have a good, albeit rather small, impact on your score.
Next, especially if you’re young or new to credit, consider asking a close family member with good credit (most often a parent) if they would be willing to add you to their credit card account as an authorized user. Authorized users are not ultimately responsible for paying the account, but they are issued a card with their name on it that looks and acts like any other credit card. In some cases, if you have to gently persuade family members, you could explain that they don’t need to give you the card at all. They can request that it be sent to their address, and they can even shred it upon receipt. By the mere fact that you are an authorized user on an account in good standing, you inherit some of the account holder’s good credit vibes.
Did You Know?
In 2019, the average credit score in the United States is 695. The scoring range on the FICO model is between 300 and 850.
Be aware though, that there was enough abuse of this in the mid 2000’s that FICO eliminated this practice as a credit score factor for a while, until public uproar forced their hand into bringing it back. Unfortunately, there had been quite a few “entrepreneurial” spirits out there who were selling their good credit to those in need and requesting authorized user cards in the buyers’ names. Essentially, this became a method of “playing the system” to inaccurately build a credit rating that was better than it should have reflected. Although it was brought back, the impact on the score of being an authorized user is not quite as effective as it used to be.
Applying For and Using Lines of Credit
The remaining steps in building or rebuilding credit involve applying for and using lines of credit. The inclination for many of us is to go right for the big ones, applying for a Visa, MasterCard, American Express, or Discover Card from a national bank. Unfortunately, most of these applications will be denied, due to insufficient credit history. This leads to the common and understandable question, “How am I supposed to build my credit history if I can’t get credit to begin with?”
When building, or rebuilding for that matter, your credit, remember to start small and start local.
Yes, the tire store is a great place to start building credit.
If you own a vehicle and it needs tires anyways, I suggest that you put aside enough money in a savings account until you can afford to purchase the tires in cash. However, instead of paying at the register with cash or a check, apply for a line of credit from the tire store. Many tire stores use in-house financing and are typically more liberal in their approval process. More often than not, though, the interest rates on these lines of credit are high, often in the mid to upper 20 percent range.
After getting approval, I suggest paying the account off quickly, say, in just one or two months. This will minimize the amount of interest you pay (and I’m certainly no fan of paying interest) while also building your credit.
Remember, though, throughout this whole process of building credit, to ask why you even want to build your credit in the first place. It should never simply be for the sake of building your credit.
Credit is meant to help you make major purchases in your life. There can be expenses associated with and then using credit, so even though there are numerous people and organizations looking at your credit outside of lending, it’s better to have no credit than bad credit.
Also, keep in mind that as I make suggestions about applying for lines of credit to build or rebuild your credit history, you should never apply for more than one or two lines of credit per year. That includes store cards, credit cards, bank loans, car loans, home loans, and so forth.
Retail or Gas Card
That said, six to twelve months later, consider applying for a store or gas card. Again, such creditors tend to be more generous with their approvals. Easy credit, though, also tends to mean expensive credit. Most store cards and gas cards have interest rates in the upper teens to upper 20 percent range. Ouch!
I’ll use an example about my own experience. Back when my first-born was about three or four years old, I planned to take him on a six-hour road trip to visit family. That much time in the car with a toddler required a plan of action or it would lead to certain insanity. So, I did some searching and some comparison price shopping and found a TV/VHS (remember those dinosaurs?) at a local Target store for $200.
I arrived at the store fully intending to make the purchase with a check (another dinosaur). However, the cashier asked if I’d like to save an additional 15 percent, I believe, on my purchase by applying for and putting the purchase on a Target card. It had been some time since I had opened a new line of credit, so I took a few moments (probably too many for those in line behind me) to calculate my savings if I were to accept the offer. That was a thirty-dollar savings, and I was at the time a single, self-employed dad to whom thirty dollars was (and still is) a fair amount of money.
A minute or two later, the cashier handed me a small piece of white paper, indicating that it was my temporary card with my new account number on it. Target hoped (as any retailer would) that I would then leave the store with my purchase and with a balance owed to them and promptly forget about paying it off until I got my bill. Most people do this, and when they receive the bill thirty days or so later, find that they’ve spent most of the money intended for the original purpose and are now “trapped” in the cycle of making only minimum payments.
I can’t take credit for making my next move through any intelligent design on my part. I simply followed an impression and walked straight from the cashier, fifteen feet across the aisle to the customer service desk, handed them my temporary card and told them I would be paying off the balance of my account with a check. So, I walked out having paying only $170 plus sales tax. Additionally, I now had a new account on my credit history that, for the next ten years, was listed as open and “paid as agreed.”
The danger of such a strategy involves what one of my students recently shared that regularly happens to her friend. Whenever she is offered a discount for applying for a store card, she take it. Her credit is terrible, but she wants that discount. She gets the discounts, so one might be wondering, “Why not? She’s taking advantage of the stores. What’s the problem?”
The problem is that she, like a third of the population with credit or retail cards in their purses or wallets, ended up making only the minimum payments on those accounts. That leads to a seemingly endless cycle of repayment, since only about 1 percent of most minimum payments actually go toward lowering the principal or balance on an account. The rest goes to interest, or profit, in the stores’ pockets. That’s why stores can afford to offer such discounts to their customers. In fact, nowadays, many retailers (and I’m thinking of electronics and furniture stores) earn about half of their annual revenue not from what they actually sell, but from the finance charges to their customers. Again, that’s why so many will offer seemingly great terms such as “same as cash” for three, six or even twelve months or more. They know that a very large percentage of customers who take advantage of these offers will eventually carry a balance beyond the original term, which, if we read the fine print, not only nullifies the “same as cash, no interest” offer going forward but actually means that the store goes back and tacks on interest to the balance of the loan every month from the beginning of the account as if the “same as cash” offer never existed.
As Exhibit A, having learned the ups and downs of credit through my own mistakes allows me to share an experience with my second line of credit, recalling that my first credit experience was to max out a $2,000 Discover Card at a 19.99% APR in just thirty-six hours. When I was twenty-three years old, I applied for and was approved for a $500 Chevron card. I was at college and happened to live across the street that year from a Chevron station. Not surprisingly, I ended up using that card for much more than gas. I purchased bread, candy bars, soft drinks, chips and other college staples at the card’s 25% APR and had that card maxed out before the end of its first semester in my wallet. In fact, by Christmas break, due to late fees and over-the-limit-fees, my balance exceeded $800. Even my own teenage children would probably respond, “Duh, Dad! What were you thinking?!”
I wasn’t. I was part of the financially undead, wandering from offer to offer seeking to finance my desire to consume. Unfortunately, many of us tend not to use much logic when it comes to using credit. Rather, we react to impulse, and my impulse always seems to carry me towards chocolate and sweets.
In the end, I ended up settling with Chevron to pay it off for less than what was owed, meaning that my credit really suffered for a while.
A secured credit card can be a great credit building product, but it can also be a drain on your wallet. Many, though not all, financial institutions offer them.
Typically, the process involves opening up and depositing a significant amount of cash (usually $300 to $1,000 or so) into a secured savings account at the financial institution. They then issue a credit card (looks and is accepted as payment just like any major credit card) with a limit equal or close to the amount you have deposited into the secured account. By secured, though, you need to understand that you cannot touch the money in the saving account as long as the credit card is open and active. If you miss a payment or incur a penalty fee, it will likely come from your secured savings account, and the card might be deactivated until you pay the fees and return the secured account to the original balance.
Secured cards, as mentioned, act just like any other Visa or MasterCard credit card and can help to build a history of on-time credit card payments. I have two major concerns, though, with secured cards.
First, they always carry fees of some sort. Whether we’re talking about a high annual fee, monthly fees or, in some cases I’ve seen “per transaction” fees, be aware that these “products” are typically much more expensive than standard credit cards. This is why I typically do not suggest to my classes that people use them unless they’re dead-set on buying a home within the next couple of years and really need to build or rebuild their credit rating.
Second, though, is the real kicker. I’ve talked to a number of students in my classes who tell me that after using a secured card for a year or more, paying the additional fees, and ensuring their payments were made on time, they applied for a regular credit card only to find out that their secured card usage wasn’t being reported to the credit bureaus. Consequently, they never received credit for their history of on-time payments.
I suggest, then, that if you’re certain you want to go with a secured credit card, make sure to get in writing that the financial institution will actually report your payments and credit activity to at least one, if not all three, of the major consumer reporting agencies.
Credit Builder Loans
Over the past few years, I’ve heard more and more publicity, advertisements, and word-of-mouth chatter about so-called “credit builder” loans. They are offered by banks and credit unions and appear to be a potentially beneficial product for building credit. They do, as with most of these options, come with their own costs and drawbacks. Here’s how they typically work:
If you’ve filed for bankruptcy or for other reasons have a poor credit rating, you can apply for a credit builder loan of around $500 or $1,000. Let’s use the $1,000 loan example. Say that you apply for a $1,000 credit builder loan and the bank approves you at a fairly reasonable rate (usually in the upper single-digit APR range). They set up a monthly repayment plan, and for the next year, you make those monthly payments to the bank. All the while, the bank is reporting your monthly payments to one or more of the credit bureaus. However, have you noticed anything missing so far? Yes, the money! You don’t actually get the money until you’ve “repaid” the loan. In the meantime, they actually do deposit that $1,000 into an account, much like the secured savings account related to the secured credit cards. You will probably even earn an infinitesimal amount of interest on that $1,000 over the course of the loan. However, this is a loan only in the very loosest of terminology. In practice, it’s a forced savings account with a negative interest rate. Still, I applaud those banks and credit unions who are offering these types of products so that individuals can begin to prove (or in some cases, disprove) that they are ready for the next step in building their credit.
Major Credit Cards
When it comes to building a credit rating, no account, no line of credit, no product is as influential as the major credit card. Even mortgages, car loans, and student loans, although typically much larger than the credit card limit, don’t have as great an impact on credit rating as the major credit card does. Why is that so? Because managing a credit card takes greater self-control and financial “maturity.” Taking care of a monthly installment loan is easy. Making the same payment every month, and you typically can’t add any additional balance to the account. A credit card, on the other hand, requires self-restraint and a determination to pay it off or at least pay it down each month.
For this purpose, getting approved for a major credit card is often more difficult than getting approved for most other forms of credit (exception being a mortgage). Once you’ve spent a year or two responsibly using and building your credit following some of the steps mentioned previously, you may be ready to apply for a major credit card. I generally suggest to first approach your own credit union or bank to ask for a low-limit card of $300 or $500. Of course, if you don’t have a checking account or have not had a positive experience with one, you may want to look elsewhere.
Oddly enough, and although likely disputed by credit union fans, credit cards issues by credit unions do not have as great of an impact on our credit score as do those issued by national banks, which is why you’d want to eventually apply for a credit card from one of the larger national banks.
Regardless of the type of credit, make sure to make at the very least the minimum payment every month, on time. Ideally, you should make the full balance payment. It is a myth that in order to build an excellent credit rating, you must carry a balance on your credit cards.
Make only purchases you would make with cash and pay the balance off by or before the due date. Following those steps will build your credit.
Do’s and Don’ts of Repaying Debt
Don’t carry a balance just to build credit. Our score can be positively affected even if we pay off our balance every month in full.
Don’t close old credit accounts that are in good standing (unless they’re charging fees).
Don’t fall for the minimum payment trap. Making only minimum payments on credit card accounts leads to 15 to 25 years of debt.
Do make at least the minimum payment due on any debt payments.
Do whatever is possible to keep accounts from going to collections. NOTE: Work out payment arrangements with your original creditor AS SOON AS a collections notice is received.
Do pay down debt balances.
Key Takeaways from the Step by Step Guide to Building Credit
7 Steps to Building Credit
Here are seven steps to building your credit history over the next 24 months or so, remembering that no amount of “tricks” and no credit report company can rebuild credit if you’re in the habit of missing payments and maxing out cards. On time payments and paying down your debts can account for 65% of your credit score.
Month 1: Ask your utilities and cell phone companies to report your history of on-time payments to the credit bureaus. Note: They do not do so automatically. If they are able to accommodate your request be sure to allow about a month for this information to show on your credit report.
Month 2: Consider asking a family member (parent) with good credit to ask their credit card company to issue to an authorized user card on their account. Note: This option is particularly meant to help the teens and young adults in our life become established, but it can be helpful for adults as well. Expect at least one month for such an account to begin impacting your credit.
Months 2-12: Apply for no more than one or two new accounts a year, starting with a tire store line of credit, followed by a retail store account and/or a gas station card.
Months 12-18: Look into credit builder loans at a bank or credit union. Essentially, these are forced saving accounts with negative return that report monthly “deposits” as credit payments.
Months 18-24 (if Step 4 is NOT successful): Ask a bank or credit union for a low credit limit card card.
Month 18+ (if Step 5 is NOT successful): Shop around for a secured credit card. Note: These can carry high annual, if not monthly, card fees.
Month 24+: Apply for a Visa or MasterCard from a major national bank.
Written by Todd R. Christensen (content available in Everyday Money for Everyday People, available on Amazon and the Kindle store here)