You might think credit only matters if you're taking out a mortgage or a car loan. In reality, good credit can help with matters like passing an employment background check, getting an insurance policy and renting an apartment.
Although the average FICO credit score for U.S. consumers is in the good credit range with a solid 704, many consumers have credit that's either less-than-stellar or too scarce to even generate a score.
The traditional credit-building method of opening accounts, then making on-time payments and maintaining reasonably low balances is still essential to a good credit rating. But the credit industry has started incorporating alternative data on credit reports, such as bank account information and utility payments, to supplement traditional accounts like credit cards.
Wherever you are on the credit spectrum, you can use new ways to build credit alongside time-tested strategies. Start with these:
-- Apply for a credit card.
-- Become an authorized user.
-- Take out a credit-builder loan.
-- Consider reporting your rent to the credit bureaus.
-- Make on-time payments on all your bills.
-- Keep revolving account balances low.
-- Keep accounts open to build a lengthy credit history.
-- Apply only for credit you need, since the act of applying for credit can ding your scores.
-- Mix up the types of credit you use.
-- Consider using Experian Boost.
-- Manage your UltraFICO credit score.
[Read: Best Rewards Credit Cards.]
What Is Credit?
Credit is money you borrow with the agreement to pay it back, usually with interest. As you use credit cards and loans, lenders report your payment and account information to the three main credit bureaus: Experian, Equifax and TransUnion. The bureaus create credit reports that describe how you borrow and pay back money. Credit-scoring companies, such as FICO and VantageScore, analyze that information and create numerical scores that measure how well you manage borrowed money. FICO and VantageScore scores range from 300 to 850, with a higher score indicating you're a lower credit risk.
When you hear people talk about building credit, they mean consistently using credit responsibly to get a high credit score. Building good credit can help you qualify for lower interest rates, which helps you save money. On the other hand, "having a low credit score or no credit can have a tremendous financial impact over a lifetime," says Rod Griffin, director of public education at Experian.
For example, on a $250,000, 30-year mortgage, you'll pay $1,212 each month if you qualify for a 4.125 percent interest rate. That same loan at a 5.125 percent interest rate will cost $1,361 monthly. That's a difference of more than $50,000 over the life of the loan.
Proven Ways to Build Credit
Although consumers have new options for building credit, there are several dependable ways to improve your credit in a slow-and-steady style.
Apply for a credit card. These generally come in two types: unsecured and secured. Unsecured credit cards let you buy things without having to put down a deposit, but good credit may be required for approval. Secured credit cards are backed by a cash deposit, which protects the lender in case you miss payments and usually acts as your credit limit.
Aside from the collateral, secured and unsecured cards work in the same way. Once you're approved, the card issuer will grant you a preset revolving line of credit to use on demand. Every month, you can either make the minimum payment, which includes an interest fee, or pay off the entire balance and avoid interest charges. Making on-time payments and keeping the balance low -- usually around 30 percent or less of your limit -- can help you build positive credit. Plus, keeping the account open over the long haul will help boost your credit length, another credit score factor.
Both types of cards typically report your payments to all three credit bureaus, and the payment history from either type of credit card will affect your credit score in the same way. "What's really a plus about (secured) cards is the credit score considers it no differently than a credit card that is unsecured," says Barry Paperno, a credit expert who formerly worked with FICO and Experian. "There are no fewer points for a secured card than for an unsecured card."
If you're new to credit, you may need to start with applying for a secured credit card. Some good news: You could be upgraded. Issuers know secured cards aren't meant to be used forever, so after several months of your showing responsible credit use, the issuer may upgrade the account to unsecured and return your deposit.
Become an authorized user. If you don't qualify for an unsecured card just yet, getting added to someone else's credit card account lets you piggyback on their positive credit. The first step is asking a trusted friend or relative -- ideally, someone with healthy credit who pays bills on time -- to add you as an authorized user.
For example, parents could add teen children as authorized users to help them build credit. Once you're added as an authorized user, the account will appear on your credit report, though the primary user will be responsible for making payments.
"The downside to being an authorized user is you're at the mercy of the primary cardholder," Paperno says. "If they lose their job and can't make the payment, that reflects on your credit." There's also a chance the card issuer won't report the account information on your credit report, which means you won't benefit from becoming an authorized user.
If your friend wants to help but can't spare much of his or her credit limit, that person could add you as an authorized user but not give you use of the card. Even if you're not using it, you'll gain the credit history of the account.
Take out a credit-builder loan. Taking out and paying off loans generally proves to future lenders you can borrow credit responsibly. There are many types of loans that can build credit: car loans, mortgages and student loans, to name a few. But credit-builder loans are dedicated solely to helping people build credit.
"These loans are typically for people who aren't interested in credit cards; maybe they've been burned in the past," Paperno says. "They don't want the temptation to run up a balance again."
Here's how credit-builder loans work: You'll borrow a small amount from a bank or credit union, about $500 to $1,500, though some can be as high as $5,000. But instead of handing you the money, the lender will deposit the funds in a savings account you can't access during the payment period. Every month, you'll make payments on the loan, which helps you establish a positive payment history. Once you finish repaying the loan, you'll get the full balance, sometimes along with any interest earned. Small banks and credit unions typically offer these types of loans with terms around six to 12 months.
If you have the option to become an authorized user, take out a credit-builder loan and use your own credit card, then "I would say do all three, if you possibly can," Paperno says, pointing out that credit score rs look positively on consumers with a healthy mix of credit accounts.
Consider reporting your rent to the credit bureaus. If you're a renter, chances are you're not getting credit for paying rent on time, month after month. Services such as RentTrack and PayYourRent help change that by allowing consumers to report rent payments to the credit bureaus. According to RentTrack, consumers who use the service have seen their scores increase by 29 points or more in two months and 132 points or more in two years. This type of service could be worth exploring if you always pay rent on time and your credit needs a lift. Depending on the company, you may pay a one-time verification fee plus a monthly payment of $7 to $10, or your landlord may sign up for a larger paid subscription.
New Ways to Build Credit
For years, credit bureaus relied on lenders to report information, but two new tools take a more DIY approach. With Experian Boost and UltraFICO, consumers offer information about their bank accounts, which could mean better credit scores. Here's how these methods work.
Experian Boost. With Boost, you'll grant Experian permission to access your online bank accounts. From there, the credit bureau will identify your telecom and utility payment information and add it to your Experian credit report. About 75 percent of consumers who tried Boost and had credit scores below 680 saw an improvement, Experian says, and 10 percent of consumers with thin files became scoreable after using Boost.
There are a few caveats to using this tool. First, Boost is currently in beta, so it's not fully released yet. And second, not every lender checks Experian credit reports or uses a credit score that includes the information provided by Boost. According to Griffin, Boost works with credit scores FICO 8, FICO 9, VantageScore 3 and VantageScore 4.
UltraFICO credit score. FICO's new score, UltraFICO, lets you add balance and activity data from your checking, savings and money market accounts to supplement information already in your credit reports. UltraFICO isn't available to general consumers just yet.
Here's how it works: If you're rejected for a loan, you can ask the lender to recalculate your score using UltraFICO, which is still measured on a scale of 300 to 850. According to FICO, 70 percent of consumers who have positive banking information could see their scores rise. Furthermore, 15 million consumers with thin files could receive an UltraFICO score.
This score may open doors for people who could borrow responsibly but don't have a credit history, says Freddie Huynh, vice president of credit risk analytics at Freedom Financial Network, which owns debt settlement and other financial companies. For example, a person who recently moved to the U.S. with money in the bank and a job lined up may still struggle to build credit. That could be "a key profile of someone who stands to benefit from UltraFICO," Huynh says.
If you're hoping to use UltraFICO, make sure your banking information helps you look like a good candidate to a lender. UltraFICO checks that you:
-- Keep a healthy balance in your savings account
-- Maintain a bank account over time
-- Avoid negative balances
-- Regularly pay bills and make other bank transactions
No matter which credit-building strategy you choose, many of the same rules apply, says Huynh. "At the end of the day, it's about demonstrating responsible payment behavior."
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