Building credit for the first time can be confusing. It’s hard to know where to start or what to do.
There are many myths about building good credit that keep people from getting started. Some of these common misconceptions are holding you back from your financial goals.
We have put together this list of the most common Credit FAQs and Myths to help educate everyone on how building their own credit works and what strategies we can use as consumers to build our scores quickly and easily.
4.1. Tips For Building Credit From Scratch
A common misconception about credit is that if you have no debt, you must have excellent credit.
The truth is that to have good credit, you must have good credit accounts in your name and use them responsibly.
But it can seem like an impossible task when you’re building credit from scratch either because you’re young or a new US resident, or are now in charge of your finances for the first time.
Here are six tips for building credit when starting from ground zero:
- Get a secured credit card – (this was covered in a previous chapter). I want to review it again because it’s such an easy way to prove financial responsibility and prove credit even if you have bad credit right now.
It works just like a regular unsecured credit card that requires you to put down an initial refundable deposit in exchange for a line of credit, the deposit amount varies but could be as little as $50.
Use a secured credit card that reports payment data to at least one of the nationwide credit bureaus so that your transactions are recorded. If you make payment on time, that positive information helps you build credit quickly. But if you miss payments, that negative information is recorded and can result in poor credit scores.
Also, the card company can take your deposit to repay your outstanding balance if you default.
A good strategy for using a secured credit card is to make small purchases that total less than 20% of your credit limit and then pay off in full each month.
Apply for a regular unsecured card as soon as you have some positive credit data in your credit reports. It allows you to build the strongest credit history, and this is the greatest credit financial tool.
- Applying for retail store credit cards – department store cards may not be as difficult to qualify for as a regular credit card. However, they come with some downsides. If the card is not part of the VISA or Mastercard network, it may be exclusive to the retailer, which means you can use it anywhere else.
Also, store cards typically charge higher interest rates and fees than regular ones, so it can become an expensive debt to carry if you don’t pay it off in full.
Retail store clerks can use aggressive sale tactics to try and get you to sign up for cards that typically come with discounts for your sales that day. The salesperson is paid a bonus for signing customers and may try to hide that you’re applying for a credit card.
So before you sign on the dotted line to apply for a retail store credit card, consider all these factors plus the fact that it’s going to come with a hard inquiry on your credit reports.
- Become an authorized credit card user – In addition to having one or more of your secured credit cards, you can build credit by being allowed to use someone else’s credit card.
An authorized user is someone a card owner adds to her account with permission to have a card and make changes but bears no financial responsibility for the account.
For instance, a parent can add a teen to their account, or one spouse can add another spouse to their card.
Unlike being a credit card joint account owner, n authorized user is not responsible for any debt on the account. The owner payment’s history may also appear on the authorized user credit report depending on the card comp.
In some cases, creditors give an authorized user accounts less weight or none because they know the user is not responsible for paying the debt.
Another consideration is whether the card owner makes late payments or maxes out the account. Irresponsible behavior that hurts a card owner’s credit may also hurt an authorized user’s credit.
So keep an eye on your credit reports for any negative information related to the card account. If you see any red flags such as late payments, you can always remove them as an authorized user.
Learn more about adding an authorized user to your card or being an authorized user on someone else’s card.
- Get a cosigner for a credit card – You can become a cosigner for an unsecured credit card with someone who already has good credit as a way to build your credit.
The downside is that you and the cosigner are equally on the hook for the card’s outstanding balance; even if you make few or no charges to the card, you’re 100% responsible for repayment if the cosigner doesn’t pay for any reason.
Both you and your cosigner’s credit scores are at risk if you miss payments or you rack up a high card high balance, so make sure you completely trust anyone who signs a credit card application with you.
- Get a cosigner for a loan – In addition to having a cosigner on a credit card, you can also have one for a personal loan or a car loan.
As you learned in the previous chapter, using a mix of credit types such as opened and lines of credit and closed or installment loans helps you build credit. It shows lenders and merchants that you can manage different kinds of credit accounts responsibly.
- Check your credit regularly – As we’ve discussed in this guide, it’s important to check it regularly as you build credit from scratch.
You can get a free credit report from each of the credit bureaus every 12 months at annualcreditreport.com. Errors on credit reports are common, and they can drag down your credit report without you even knowing it.
Keeping an eye on your credit also allows you to spot any fraudulent activity, such as accounts you didn’t open, which could devastate your credit. If you spot a mistake, always get it corrected by filing a dispute with the credit bureau.
4.2. How Many Credit Cards Should You Have?
Americans have an average of 2 – 4 credit cards, depending on whether you count those with no credit cards. I have six personal cards, and one business card spun across all the major brands:
- Discover and
- American Express.
I get cashback rewards on American Express, but it isn’t accepted at some places if you travel overseas or make purchases for merchants outside of the United States.
You should have a card that doesn’t charge foreign transaction fees. So instead of thinking about an ideal number of credit cards to have, consider how different cards can help you achieve your financial goals, like helping you save money on different types of purchases.
As we’ve discovered, having more available credit is better than less when it comes to building credit.
That may tip the scales in favor of having 3 to 4 credit cards instead of 1 or 2.
There’s no limit to the number of cards you should have. Theoretically, you can have 50 credit cards and still have excellent credit if you manage all of them responsibly.
But my recommendation is to have a minimum of 2, so you have a backup if something goes wrong with one of them. Have as many cards as you feel comfortable managing and will benefit your financial life.
However, if you cannot use credit cards responsibly, you may want to stick with just having a secured credit card. Because it limits the amount of available credit, you could look at other types of installment loans such as car loans to help you build credit.
4.3. Why Credit Scores Can Drop
Here, you’ll learn 5 reasons why credit scores can drop even if you don’t have any late payments or negative information added to your credit files.
Use this information to manage your credit reports wisely so your scores continue to improve and don’t backslide
- You made an expensive credit card purchase – Making a larger than normal credit card charge is one of the most common reasons for an unexpected credit score drop.
As we covered in the previous chapter, the amount of debt you owe on your credit utilization ratio makes up about 1/3 of your score. The ideal ratio is in the range of 20 – 25 %.
If you charge a large purchase and use up more of the available credit, that can cause your utilization ratio to skyrocket, even if you intend to pay off the balance in full.
Your credit card company could report your balance to the credit bureau before your next payment is received. Using more of your available credit is a mathematical signal that you might be in financial trouble and make late payments. In the future, even if you’re not in financial trouble.
To reduce your utilization ratio and boost your score, you have the following options: You could;
- Charge for less each month, account
- Ask for a credit card limit increase,
- Open an additional credit card and spread-out charges on multiple cards,
- Make multiple payments during the months, so a lower balance gets reported to the credit bureaus.
- One of your credit limits was reduced – I mentioned that getting a credit limit increase in a credit card is one way to reduce your utilization ratio and increase your credit score. Likewise, your credit scores can take a hit if your available limits are cut.
Card issuers set your pending limit when you first open an account, but they can increase or decrease it according to the terms of your agreement .
If the issuer sees signs of risk, such as you taking large cash advances on your credit card or exceeding your credit limit, they can take action to protect themselves by reducing your credit limit.
Having less available credit affects your utilization similarly to charging more, your utilization ratio goes up, and your credit score will quickly go down.
If this happens, be sure to review your credit report for any inaccurate info that may be why the card issue cut your limit, then contact the company any mistakes s cleared up and discuss raising your credit limit . Contactdecrease.
- You have zero credit utilization – While having a low credit utilization, revolving accounts is one of the best ways to reduce your credit scores, don’t go overboard by zero utilization rate.
For instance, some credit scoring models ding you if you pay off your credit card and don’t make any additional charges. It’s better to have credit accounts and use them responsibly than to let them become inactive.
In other words, showing some amount of activity such as making a small charge and paying it off in full each month is a smart credit strategy.
- Your average age of credit accounts changed – The age of your credits accounts tells a story about how experienced you are handling credit .
That’s why credit scoring models evaluate the average age of your accounts. It’s typically figured that the total number of months your accounts have been opened is divided by the number of accounts you have.
Having a long credit history helps lenders know if you’re likely to be financially responsible in the future and are good credit risks. The longer you’ve had credit accounts opened in your name, the better.
Once a credit account is closed or paid off, your average age of accounts begins to decrease. If you choose to close an older account, the cancellation negatively affects your credit score than if you close your younger ones.
Also, when you open a new account, you immediately reduce the average age of your accounts. They may cause a sudden credit score drop to make sure your average age of credit accounts will grow. Only open new accounts when it’s necessary, and make sure to keep your oldest accounts open and active.
Many people want to close their credit cards immediately. They pay it off because they think it’s better off their credit. If you can’t use your credit card responsibly, then you should close it.
But another option that’s better for your credit is to pay off your card but leave the account open. That allows you to leverage its positive payment history, longevity, and available credit limit to raise your credit scores.
- Your credit mix has changed – While it’s not the most important factor in calculating your credit scores, having a mix of different types of accounts helps increase your credit scores.
For instance, having revolving accounts such as a credit card or line of credit in addition to installment accounts such as a car loan or mortgage shows lenders that you can handle different types of credit responsibly.
So if you just paid off the only installment loan you had, your credit mix looks less diverse to lenders. There’s not much you can do about that unless you need to finance a purchase like a home or a car. I do not recommend taking a loan just for the sake of maintaining your credit.
If you maintain good habits like paying credit cards and utility bills on time and maintaining low utilization, your credit scores will naturally go up with time.
Another tip is to check your credit reports to ensure there are no errors dragging down your scores.
Inaccurate information can signify, and that a lender fed bad data to your file or you’ve become the victim of identity theft dispute any inaccurate information with the credit bureau so that it won’t hurt your finances.
In the next chapter, you’ll learn key steps to follow to build credit before making one of the biggest credit decisions you might make, buying a home.
4.4. Building Credit Before Buying A Home
Building credit is always important, but it’s critical before buying a home.
Whether you’re a seasoned homeowner or a first-timer, your credit score is the primary factor that mortgage lenders consider when evaluating your application.
Here, you’ll learn 5 steps to build or repair your credit before house hunting, so you get approved for a mortgage that costs as little as possible.
Step1: Check your credit reports – I know I have said this a lot during this chapter, but it is key since lenders put a lot of weight on your credit.
You should be one step ahead of them by checking it first, and if you know, they’re black marks on your credit, such as late payments or accounts in collections.
Start making serious credit repair efforts at least 6 months in advance, and if you can wait a year before applying for a home loan, that’s an even better time frame to whip your credit and finances into shape.
Step 2: Correct any credit errors – if you review your credit reports and find errors such as an account that isn’t your name or bankruptcy that you didn’t file, that’s an urgent error you need to fix quickly.
But even smaller errors need to be addressed, such as incorrect credit limits or late payments you didn’t make. Those are probably going to be pretty easy to clear up by speaking directly with your creditor. It’s also a good idea to submit a formal dispute with the credit bureau showing your error.
If your creditor responds in time but does not agree with you, they won’t adjust your credit report. You can add a statement of explanation to your credit file that allows you to tell your side of your story in up to 100 words.
Future creditors and merchants like a home lender may consider your statement when evaluating you.
Any information you add to your credit history remains there for as long as the disputed account appears in your credit history or until you request to have the statement removed.
Remember that accurate but negative information can’t be removed simply because you don’t like it. As you’ve learned in this guide, late payments and accounts in recollection eventually fall off your report in 7 years, so the earlier you get started cleaning up your reports.
The faster your credit scores can improve before you make a mortgage application.
Step 3: Deal with delinquent accounts – If you have delinquencies such as late payments, accounts in collection, and judgments, they will hurt your ability to get a mortgage.
Your payment history is the most important factor in calculating your credit scores, as you’ve learned. So, if you have poor credit, it’s probably because you haven’t paid credit accounts as agreed.
Before submitting a mortgage application, consider paying off any past due balances or negotiating a settlement with creditors. Unfortunately, making a lump-sum payment or a monthly payment agreement for a delinquent account doesn’t remove it from your report.
However, getting caught up on late payments helps clean up your credit report, and black marks in your credit files can be overshadowed by newer positive information as you make payments on time.
In other words, the older a delinquency gets, the less it factored into your credit scores, and the better you look to a mortgage lender.
If you have a large amount of delinquent debt, always consult with an attorney before communicating with creditors about it.
Step 4: Cut your utilization ratio – In addition to correcting errors and cleaning up delinquencies, use your credit report to manage another key ingredient in your credit scores that you’ve learned about.
This is the percentage of available credit you’re currently using.
Don’t make the mistake of closing any credit accounts before getting a mortgage. Whilesignifyno errors are dragging, it would seem like having fewer accounts will make you appear more attractive to a lender; it can hurt you.
Canceling an account could significantly reduce your available credit, which would cause your credit utilization to skyrocket and your credit score to go down.
So, play it safe and wait until you go into your new home to close any unwanted accounts. Likewise, having more available credit relative to your outstanding balances can reduce your utilization ratios and help your scores.
However, in most cases requesting a higher credit limit comes with an inquiry on your credit which does cause a slight ding. But requesting more available credit might be a good strategy that outweighs the downside.
Suppose you’re struggling to bring down your balances and cut out on your own before making a mortgage application. Also, having a mix of revolving accounts and installment loans helps your credit, as we’ve discussed.
Close all your credit cards that could negatively affect your scores.
Plus, some mortgage lenders require you to have two or three credit accounts already open in your name. To have the best credit, you need to have both installment accounts with positive payment history.
Step 4: Reduce your debt-to-income(DTI) ratio -Another approval factor that mortgage lenders use is the debt-income ratio, its shows how your expenses stack up against what you earn. It’s a good indicator of how comfortably you can take on additional debt.
One formula that’s called the Housing Ratio, also known as the front-end ratio. It also shows what percentage of your income would go to your housing costs, such as mortgage payment, property taxes, association debts, and homeowners’ insurance.
Another ratio lenders look at is the total/back-end ratio which shows what percentage of income would go to all of your debts. So, these ratios are things that mortgage lenders look at carefully
For example, if all your monthly obligations total 25000$ per year and you earn an annual salary of 50000$, your back-end debt-income ratio is 50%, thus calculated by:
$25000(Expenses) / $50000(Income) = 0.5 = 50%
Most housing lenders like to see housing ratios below the range of 25-28% and total debt ratio below 36-40%, so if you exceed these limits, you may need to pay down some debt balances to get approved.
So, crunch the numbers on your debt ratios and see if you can reduce them by paying down debt or consolidating them, so you have lower monthly payments.
Additionally, paying down your outstanding debt balances boosts your credit.
Step 5: Discuss your credit situation with potential lenders – Before applying for a mortgage or taking a house-hunting trip, I recommend that you talk to several potential lenders.
They want to do business with you, and they can evaluate your financial situation for free. Ask how you can qualify for the best rate possible, and then heed their advice.
Each lender evaluates you differently, so you’ll probably hear slightly different guidelines researching possible loans, rates, companies, and brokers exhaustively.
Buying a home is a major commitment, and doing your homework can give you a huge financial reward.
If your finances and credit are as good as the lender needs them to be, you can get pre-approved for a home loan before you begin shopping. It helps you know the price range of homes you can afford, and it tells real estate professionals and sellers that you’re a great prospect.
Pre-approved loan locks in a mortgage offer for a limited period and saves time, allowing you to buy a property much faster than if you were starting from scratch.
It also shows you the down payment you’d need to bring to the closing table. Once you have a mortgage pre-approval, make sure not to open any new credit accounts or make any changes to your financial life.
The pre-approval is conditional on not having any significant modification to your income, expenses, or credit. Keep a low credit profile once you begin the home buying process.
If you applied for a new credit card or a car loan while you’re waiting to close on a home loan, you risk spoiling your mortgage terms or losing the deal.
Remember, every credit score point counts when it comes to getting the best mortgage.
So, use these tips as far before buying a home as possible to avoid getting turned down for a mortgage or paying more than you should.
4.5. Don’t Believe These 12 Credit Myths
We’ve covered a lot about the nuts and bolts of building great credit, but they’re loads of myths and misunderstandings about credit that can trip you up. So, in this chapter, I’ll cover a variety of credit myths and truths you should know.
Myth #1 – Your personal information affects your credit.
Truth: If you’ve heard that credit scoring is discriminatory or uses information from your social media account, it is false. Your credit scores are calculated only using data in your credit reports with the nationwide credit agencies, including Equifax, Experian, and TransUnion. There is personal information in your credit reports. Still, it’s limited to your name, card, previous addresses, social security number, birth date, and public information such as recorded liens and bankruptcy.
Your credit files never include your race, gender, marital status, education level, religion , political parties, or income. Federal law prohibits credit scoring from taking those personal factors into account.
Myth #2 – Your income affects your credit scores.
Truth: There is no connection between how much you earn and your credit scores. Since lenders and credit card companies typically ask about your income on credit applications.
Having a high income can work in your favor, but it’s just one way in which they evaluate you. As I have mentioned before, your credit reports don’t include an income, and credit bureaus don’t have access to your income sources.
You can have excellent credit scores whether you’re employed or unemployed, receive government assistance, or how much or little money you make.
Of course, losing your job or business income could severely affect your ability to pay your bills on time which is a major factor in your credit scores.
Myth #3 – Using a debit card helps build credit
Truth: Debit and credit cards look alike, but that’s where the similarity ends. While debit cards are convenient for making everyday purchases, they don’t help you build credit because your bank activity is not listed on your credit reports.
Myth #4 – You share credit with a spouse
Truth: Your credit history and scores never get merged with someone else’s, even if you’re married. That’s why it’s important to build your credit as an individual.
If you have a spouse with bad credit, that could affect your ability to get a joint loan or credit card, but it cannot taint your credit file. However, if you become an authorized user on someone else’s credit card, the payment history on that account could be reported on your credit file.
Myth #5 – Kids can’t have credit reports
Truth: Kids shouldn’t have a credit report, but if they have a victim of identity theft or have been added to a credit card as an authorized user, they will.
Parents should check by contacting each credit bureaus at least once a year and disputing any fraudulent activities.
Children are an easy target for cyber-crime, so be sure not to give your children social security numbers to any organization or company unless it’s required.
If you must reveal it, ask if you can just share the last 4 digits of the number.
Myth #6 – You must carry credit card debt to build credit.
Truth: Many people mistakenly believe that they have to get into debt to build credit. I hope you know that this is not true because you can use your credit card to improve your credit for free.
Making credit card charges that you pay off in full and on time each month shows that you know how to use credit responsibly, and it doesn’t cost you one penny of interest.
If you cannot get approved for a regular credit card, everyone over 18 can get a secured credit card which we covered in a previous chapter. Using a secure credit card that reports transactions to credit agencies is an to establish a credit history.
The card company may even give you an option to a regular unsecured credit card after demonstrating that you can use a secured credit card responsibly.
Myth #7 – Every bill you pay helps build credit
Truth: Not all bills you pay affect your credit scores. For instance, payments to small companies, individuals, and small services such as rent, pass control, or storage units typically don’t appear on your credit report.
The credit bureaus have strict requirements about who can report consumer information to them, and in many cases, it’s not feasible for small businesses to do it.
If a merchant does not report payment information to the credit bureaus, then your payments history with that company cannot affect your credit scores.
However, if you do not pay them and turn your account to a collection agency, that’s another story. Collection companies typically report information to the credit bureaus on accounts they require.
The best way to find out which companies report information to your credit reports is to get a free copy of it on annualcreditreport.com.
Myth #8 – Closing a credit account erases its history
Truth: Closing a credit card or paying off a loan does not make it fall off from your credit report. I don’t think you can fly under the radar by simply canceling an account with any late payments.
All information related to an account that has negative information stays on your credit reports for 7 years. If an account has only positive information, it stays on for 10 years.
Myth #9 – Credit limits on credit cards don’t matter
Truth: Maxing out your limit or even coming close will send your credit utilization ratio soaring, and as we’ve covered, that’s a bad thing because the ratio has a huge influence on your credit scores.
So,keep balances as low as possible, ideally lower than 20 % of your available balance on any given card even when you pay it off in full each month.
Myth #10 – A repair company can fix your credit quickly
Truth: If you’re feeling the heat of bad credit, it can be incredibly tempting to fall for the promise that someone can “fix ” your credit for a fee.
Don’t believe anyone who tells you that it’s possible to improve or fix bad credit instantly; there’s no way to improve a credit score immediately if it’s based on accurate information. Credit scores can’t be changed overnight because they’re designed to reflect your credit behaviour over time.
The good news is that credit scores typically give more weight to recent activities and information. So if you have negative information on your credit reports like late payments for an account on collection or a bankruptcy, time is on your side.
Those bad marks won’t count against you as they age.
Myth #11 – Rate shopping hurts your credit.
Truth: If you’re shopping for a loan, you can rate shop without getting dinged by too many inquiries. Simply keep the shopping window short by making all your applications within 2-3 weeks and always apply for the same type of loan and amount.
If you do this, the credit agencies batch your credit loan applications so they don’t come up as separate hard inquiries on your credit.
They’ll understand that you’re not trying to get approved for all of these loans, but you’re looking for the best deal and won’t get penalized for that.
Myth #12 – Paying off a balance in collections improves your credit scores
Truth: As we covered in previous chapters, all past due accounts remain on your reports for 7 years from the original delinquency date.
However, you may be able to negotiate with a collections agency to remove your item from a credit report if you pay off your balance in full. The agency is under no obligation to comply with your request, but it never hurts to ask.
Also, paying off an old account or settling for less than you owe shows more financial responsibility than leaving a debt unpaid.
Ok, at this point you have answers to the FAQs and debunked some myths—now it’s time to take action and start building your credit. The next chapter is about Dealing with Old Debt