How to Build Credit

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What if I told you that you could build up your credit score by investing about 30 minutes of your time each year?

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It may sound too easy, but you don't need a wallet full of credit cards or a history of paying on five different loans to get the best credit scores. You certainly don't need to pay for a credit building service, either. Just one account, managed well, puts you on the fast track to building credit.

What you need to know about building credit

Your credit score is based on a number of factors, some of which you can control, and some of which you can't. Your effort is best spent focusing on the things you can control, as well as the things that make a real difference to your score.

That means you should spend your time worrying about just three things:

  1. Paying your bills on time.
  2. Carrying low balances.
  3. Building experience over time as a credit user.

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That's about it. Seriously.

We're going to focus on these three things, because it's how you get to an 800 credit score, a score so high that it puts in the top 21% of Americans and will qualify you for the best rates and terms on any loan you could ever need or want.

1. Laying the groundwork for good credit

The first thing you should do to build credit is establish an account that will serve as a reference point for how long you have used credit. Think of it as a "mile marker" on your credit report.

Credit bureaus primarily measure your experience by the age of your oldest account. Thus, the first account that appeared on your credit report is the most important one as it establishes when your credit record started. Unfortunately, not all types of credit accounts or loans are a good fit here.

The best practice is to establish an account that will stick around on your credit report forever. For this purpose, nothing works better than a no-annual-fee credit card. You can open a no-annual-fee credit card account and keep it on your credit report for 50 years, if you want to. In contrast, a car loan typically comes to a close after just three to seven years and eventually disappears from your report all together.

This is a simple step, but it lays the groundwork for every other step that follows. Some people might want a travel rewards card to get miles on every swipe, while others who have bad credit may have to open a secured card. Regardless of where you're starting from, there really is a no-annual-fee credit card that will approve you. (Notice the emphasis on no-annual-fee cards. You will be keeping this account for a very long time, so it's best to avoid an annual charge just for having it.)

In the next step, we'll talk about ways to ensure that this new "forever card" account lives on -- and reports to the three major credit bureaus -- for as long as you want to keep it. 

2. Making friends to build credit

As a general rule, card companies close accounts that haven't been used in the past six or 12 months. Your goal should be to do at least the bare minimum so that your "forever card" doesn't become the victim of a bank's cost-cutting program. Remember, the purpose of this credit card is to keep it open, active, and reporting, so that it can stand as a mile marker for your credit history.

One stupid-simple way to keep the account open is by using the card once per month, more than satisfying the minimum requirements. There are two ways to do just that.

Method

What It Entails

1. Personal plastic

Use the card for daily purchases, and pay it off in full every month. Never let the balance grow to more than 30% of your credit limit.

2. Netflix and chill

Use the card to pay one recurring bill (like a Netflix subscription) and pay it in full every month with automatic payments from a checking account. Never let the balance grow to more than 30% of your credit limit.

As far as building credit without paying any fees or interest, the important part of the equation is keeping the account open, paying the balance in full each month, and keeping the balance lower than 30% of the credit limit at all times. Both methods accomplish just that. 

The first method is nice if you open a cash back or travel rewards card as your new "forever card," since you will earn rewards on all of your daily spending. Of course, some find that having a credit card for daily use is a dangerous temptation and would prefer to use their credit cards for only the bare minimum to build credit, and thus prefer the second option. That's fine, too. 

You know yourself better than anyone else, so only you can decide which route is best for you. No matter which direction you go, you're halfway there to building a better credit score. 

3. Playing defense to avoid bad credit

You probably have several bills you have to pay that aren't reported to the credit bureaus. For example, most of us have to pay utility bills, but these bills aren't regularly reported on our credit reports.

That said, if you decide to stop paying your electric bill, you'd quickly find that the utility company can deliver a knock-out punch to your credit report by reporting your delinquent account. This can happen in many different ways -- the account can go into collections or find itself in small-claims court -- but rest assured a bad account will find its way on your credit report. A delinquent account can send your score plunging by more than 100 points, erasing years of gains and otherwise perfect credit history.

The key thing here is that virtually every bill, whether it reports regularly to your credit report or not, can be a problem on your credit report if you don't pay it. That's why I've called this part "playing defense," as you need to pay all of your bills on time to avoid any problems on your credit report.

I find it kind of annoying that you can pay a bill on time for 20 years and get no benefit for it, but paying it late one time can trash your score. I don't write the rules, though, so all you and I can do is abide by them.

4. Twiddling your thumbs while your credit score improves

We've gone through the rationale for opening a no-annual-fee credit card to keep for life, how to play offense (keeping a credit card open) as well as defense (staying current on all your other bills). Now it's time to play the waiting game.

This is arguably the hardest part of the whole process, because only time travel can help you here. At this point, you're doing everything right. Making a purchase once a month keeps your account open. Paying on time and in full builds another good month of on-time payments while steering you clear of any interest charges. And keeping your balances to less than 30% of the credit limit ensures your score isn't dinged for high balances.

The following table shows how these behaviors hit the mark on the three most important factors that together make up 80% of the credit scoring algorithm.

Component of Your Credit Score

How We Addressed It

Payment history (35%)

Paying your credit card (and other bills) on time and in full does the job.

Amounts owed (30%)

Keeping your balances under 30% of the credit limit maximizes your score.

Length of credit history (15%)

Establishing a credit card that you will keep open for life builds credit history.

New credit (10%)

You can't do much about this, except by opening accounts only when you need to, or when it is advantageous to do so.

Credit mix (10%)

You can't do much about this, either, since it would be silly to buy a home so that you have a mortgage on your credit report. This is a byproduct of having a good credit score, not a prerequisite.

I'm wary of making guarantees, but if you follow every step from top to bottom, it is certain that you will have a credit score high enough to qualify you for the best possible interest rates and terms on any loan. 

It won't happen overnight -- though people who start this guide with no credit will improve faster than people who have bad credit -- but it will happen faster than you might think. The road to great credit is paved with small single-digit increases in your credit score month after month.

The key is to start sooner rather than later. Because time is a main component that underlies virtually everything that goes into your credit score, the best time to start building credit is when you don't need it, so that it's there for you when you do.

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