The Best Ways to Build Credit

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"The most important thing for a young man is to establish credit-a reputation and character."
-- John D. Rockefeller 

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Having a credit record -- and, ideally, a good one -- can make your financial life easier. If you are new to the world of credit and think you'll need a loan one day, you'll want to build a strong credit history. Ways to build solid credit histories include paying bills off promptly many times -- and using secured cards to build credit, too.

Meet the credit score

Let's start with what a credit score is and why you want a credit score -- and a very good one. Credit scores are calculated based on various algorithms to reflect how good you are with credit and how good a risk you are for potential lenders. You might know that there are three main credit reporting agencies -- Equifax, Experian, and TransUnion -- that collect credit-related information about you that's used in credit scores, but you might not realize that there are several companies that offer credit scoring and there are also many different kinds of scores from these companies, too. For example, the FICO score, produced by the Fair Isaac Corporation, is the most widely used score, looked at in more than 90% of lending decisions. The next most used score comes from the folks at Vantage.

The most widely used version of a credit score is the FICO Score 8, but the newer FICO Score 9 is growing in use. How is the FICO Score 9 different? Well, it pays less attention to unpaid medical bills and doesn't count paid collection accounts against you. It also incorporates payment histories on rental housing if such information has been reported.

The power of the credit score

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It's helpful to understand what a good or bad credit score is, and just how powerful your credit score can be when you want to borrow money. Basic (non-industry-specific) FICO scores range from 300 to 850, but when it comes to specifying exactly where to draw the line between, say, a good score and an excellent one, there's little consensus. Here's one take, from the folks at FICO:

FICO Score Range

Rating

800 and higher

Exceptional

740-799

Very Good

670-739

Good

580-669

Fair

579 and lower

Poor

The following table reflects the power of your credit score when it comes time to borrow, showing recent interest rates for someone borrowing $200,000 on a 30-year fixed-rate mortgage:

FICO Score

APR

Monthly Payment

Total Interest Paid

760-850

4.467%

$894

$121,987

700-759

3.689%

$919

$130,956

680-699

3.866%

$939

$138,200

660-679

4.08%

$964

$147,068

640-659

4.51%

$1,015

$165,241

620-639

5.056%

$1,080

$188,980

The difference between the highest and lowest interest rate range in the preceding table is $186 per month (which is $2,232 per year) in mortgage payments -- and about $67,000 in total interest paid! Having a high credit score can save you tens of thousands of dollars.

A Catch-22: You need credit histories to build credit histories

It can be easier said than done, though, to get a high credit score. You can't just sign up for a score and start out with a high one, getting deductions only when you manage money poorly. Instead, your credit history or credit record is quietly started for you at the various agencies as soon as you start making financial moves that show up on their radar, such as paying certain bills off on time (or late!) and opening, closing, or using credit cards.

Credit card usage is a terrific way to build credit, but issuers of great credit cards aren't eager to approve cards for people without respectable credit scores. So what can you do? Well, you might start with a "secured" credit card.

Secured cards build credit

Most credit card holders carry unsecured credit cards. They require no deposit -- their holders just charge various expenses and then repay what they owe. Those who can't get approved for an unsecured card, because of poor credit or no credit, can still get a card -- a secured one, secured by money the user deposits into an account that prevents the credit card company from being left in the lurch.

Secured credit cards are kind of like a mortgage or a car loan -- which is secured by a house or a car, as collateral. If you don't keep up with your payments, the lender can claim that property. When you rent an apartment, you'll likely pay a security deposit -- that's similar to a secured credit card in that the landlord can keep that deposit if you default on your obligation. A personal loan you get from your bank or a friend can be secured or unsecured but is often unsecured. Most credit cards are, likewise, unsecured. There's no collateral protecting the lender.

Getting and using a secured credit card may seem like a pain, but it's a good way to build the credit history and credit score that will get you approved for better, unsecured cards. Some secured cards can be converted into unsecured ones at a later date, which can reduce the hassle factor a bit.

However much you deposit into your secured card account will be, effectively, your credit limit. It will sit in your account, letting you charge that much and then awaiting repayment. If you fail to pay back your debt, the card company can just keep the money. If you close the account or get upgraded to an unsecured card, you'll get your deposit back.

When seeking a secured credit card, look for one with no annual fee, or a fee of no more than $50. Try to avoid being charged an application fee and be wary of other fees that might be present.

Be wary of temptations to get an unsecured card that's advertised as approving people with bad credit -- because many of those will charge astronomical interest rates and/or fees. Think twice before solving your need-a-plastic-card problem with a prepaid debit card, too, as that won't serve to build a credit history and won't help you progress on the path to an unsecured card.

The best secured credit cards will offer some benefits such as a little cash back on your purchases and no annual fee. Once you get a secured card, be sure to use it responsibly, paying off the bills on time. That will help establish you as a trustworthy borrower and will help you build a good credit history and credit score. It will often take about a year of using a secured card responsibly to be ready for an unsecured card.

Other ways to establish a credit history

Using a secured credit card is one of the best ways to establish a credit history, but there are other ways. You might, for example, be designated as an authorized user on someone else's unsecured credit card. Be sure that the card's issuer will be reporting authorized users' activities to the credit bureaus, though, to make this strategy work.

You might also try to get your rent payments entered into the record via services such as RentReporters or RentTrack. Not all credit scores will use a good rent payment history, though, and it might cost you some money to get your rent payments sent to the credit agencies. Another option is a credit-builder loan, typically offered by credit unions or local community banks. Unlike how it works with traditional loans, the sum that you borrow doesn't come to you. Instead, it's held in an account until you pay the loan off. Then you get the money -- and the lender reports your success to the credit agencies, so that it can be used to increase your credit score.

Don't be discouraged if you don't have a credit record or have a poor one. You have the power to improve it.

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Selena Maranjian has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.