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Advice and articles on how to build credit are fairly common. But in this post, we’re going to look specifically at ways to build credit more effectively. What do I mean by “effectively”? We’re going to focus on the types of credit building strategies that are likely to give you a strong credit score from the very beginning.
Simply building credit by any means necessary won’t necessarily accomplish that. In compiling your credit score, the credit bureaus use a variety of factors that are not well understood by the general public. The strategies suggested in this article will help you to work within those parameters.
Hopefully, you’ll not only build credit, but you’ll build good credit – fast!
Try these strategies:
Build Your Credit Gradually
In trying to build credit, some consumers try to do it by applying for credit anywhere they can. This is absolutely the wrong approach. Part of the problem is that too many credit applications in a short space of time will actually hurt your credit score. Having no credit score at all is better than having a bad one. That’s why you want to build credit gradually.
Start with a single loan. It can be a credit card, an auto loan, or an installment purchase. The idea is to get that first loan in place.
This is a difficult task if you have no credit at all. You may need to consider getting a cosigner for a loan. Alternatively, you can go with a secured credit card, or what’s known as a credit builder loan.
In either case, you’ll have to put up a savings account balance, generally $500 to $1,000. The lender will give you a credit line or a loan for the amount of your balance. Your credit score, or the absence of one, won’t even be a factor since the loan or line is completely secured. But as you make payments, the lender will report them to the credit bureaus. It can enable you to begin building a decent credit score in six months to a year.
You don’t want to load up with too many of these. Start out with a secured credit card or credit-builder loan (they’re common with banks and credit unions). Wait six months, then add another. Wait another six months, then apply for an unsecured credit card. As you’re making payments on all three, your credit scores will build and improve. Eventually, you’ll be in a position to get an auto loan.
Create a Balanced Credit Mix
Most consumers aren’t aware that the type of loans you have affects your credit score. For example, if you have five loans, and all five are credit cards, it can limit your credit score. But if you have five loans, of which three are credit cards, one is an auto loan, and one is an installment loan, it will reflect more favorably your credit score.
The mix of loans you have does affect your credit score. It may be worth it to you to make a fairly large purchase using an installment loan, rather than swiping a credit card. Having different types of loans shows that you can handle a variety of debts.
There’s even something of a hierarchy with loans, at least regarding credit scores. For example, a mortgage probably has the biggest effect on your credit score. That makes sense because it’s a major obligation. If you can handle it, you’re demonstrating the ability to responsibly manage a very large debt. Auto loans and student loans are generally more significant than credit cards.
As you’re building your credit – slowly – don’t forget to add some variety to the types of loans you get.
Open Credit Lines – And Don’t Use Them
While you’re working on ways to build credit, you’ll want to actually use your loans. That will give you a regular repayment schedule, which is what your credit score will be based on. But once you have a few (hopefully) small debts, you should begin adding credit lines but not using them.
What you’re trying to do is create a low credit utilization ratio. Your credit utilization ratio represents 30% of your credit score and is second only to your payment history. The credit bureaus prefer this ratio to be below 30%. For example, if you have $10,000 in credit card spending limits, you should owe no more than $3,000.
If you have $2,000 in credit card spending limits, and you owe $1,400, your credit utilization ratio is 70%. That will have a negative impact on your credit score. But if you open an additional credit card with a $3,000 credit limit, and you don’t use it, you’ll raise your total credit limits to $5,000. Once you do, your credit utilization ratio will fall to 28% ($1,400 divided by $5,000). That will have a positive effect on your credit score since it’s below 30%.
Never Borrow More than You Can Comfortably Afford
This should be obvious, but it’s worth repeating, especially if you’re in the credit building phase. It’s often when people are first trying to build credit that they’re most at risk of getting in over their heads. Be aware of this reality, and build your credit accordingly.
Never take on a debt obligation you can’t comfortably afford. If you’re new to credit, and you don’t have much of it, a single 30-day late payment to have a devastating effect on your credit scores. Make sure you have both the income and the liquid reserves to meet any debt obligation you sign on for.
Credit building is only effective if you’re able to consistently make your payments on time. If you think you’ll have any difficulty at all meeting a payment, don’t take on the debt in the first place.
Payoff Some Debts Early
Few entries on a credit report will do more for your credit score than a paid loan. That means not only have you made your payments on time, but you’ve done so through the completion of the loan. Lenders also like to see paid loans. It indicates a very high level of responsibility and makes it more likely you’ll be approved for new credit.
This can be done either by taking a small installment loan and paying it off, or borrowing money on a credit card, then paying off the balance. As time goes on, and the number of paid loans you have increased, so will your credit score.
So if you’re looking for ways to build credit, remember it’s not just about building up your credit. It’s more about building your credit more effectively. And that’s the only way you should go about it.
Our advise is based on experience in the mortgage industry and we are dedicated to helping you achieve your goal of owning a home. We may receive compensation from partner banks when you view mortgage rates listed on our website.