How to Build Credit Without Falling into Debt
When I was beginning my journey into adulthood, I did not understand the importance of building credit. A lack of credit made it difficult to buy a vehicle. Not having a vehicle meant not being able to get to work or school.
The vehicle replacement options were:
- pay cash,
- get a co-signer,
- or take out a loan with a high interest rate.
Since, I did not have any wealth family members to give me money, an auto loan was the only real choice at the time.
I am passionate about living a debt free lifestyle. At 36 years old, I am currently debt free except for my mortgage, but if something were to happen to my vehicle, I would need to take out a loan. I am currently working on saving up for a replacement vehicle, but I am not ready to make that purchase, yet. Life does not always work on our timeline, so I work to continuously improve my credit. I like to have the option to finance, pay cash, or a mixture of the two options.
What is building credit?
Building credit refers to the process of creating a financial history and improving your credit score over time. Building credit creates one’s credit score and allows one to qualify for loans, credit cards, and other types of credit.
Your credit score is your resume for your finances. Your credit score can affect your vehicle insurance rates, rent, interest rates, and if you qualify for a loan or credit card. Building your credit is a critical step that most young adults do not think about until your credit score affects your financial decisions like when you need to buy a vehicle or house.
Credit Score is your financial resume
How do finance institutions know when to lend money or determine interest rates? They use your credit score. If you have never used credit (credit card or loan), you do not have a credit score which is just as bad as if you have misused credit.
Lenders and credit card companies use credit scores to evaluate risk. A credit score will help lenders decided how likely this person will pay back the money they borrow. A high credit score means a person uses credit wisely, will pay the loan back, and make payments on time. A low credit score means a person may or may not pay back the loan, could be late on payments, or inconsistent on payments.
Credit score ranges from 300 to 850. The higher the score, the better credit offers you will qualify for. The breakdown of the ranges is below:
- 300-579: Poor – Difficult to qualify for loans or credit cards
- 580-669: Fair – May qualify for credit, but could get really high interest rates
- 670 – 739: Good – Will qualify for credit with reasonable interest rates
- 740 – 799: Very good – Will qualify for low interest rates
- 800 – 850: Excellent – Considered very low-risk borrower and qualified for the best/lowest interest rates.
The difference between a good credit score (670 – 850) from a bad credit score (below 659) can be very costly. It can be the difference between 5% versus 15% interest rate. That can be an enormous difference on a $40,000 vehicle purchase. A monthly payment of $750 at 5% interest is better than a $950 monthly payment at 15% interest. I do not know about you, but I can think of better ways to spend $200 a month than on interest.
How to start building credit
The only way you can build credit is by using credit. One needs to build a history of on-time payments and credit use. Credit cards are great for this. If you use credit cards responsibly, you can build credit without going into debt.
How to Use Credit Cards To Build Credit
My recommendation to building credit is to get a credit card as soon as you feel you are responsible enough to mange one. This assumes, you have a job earning at least a few hundred dollars a month. Your very first credit card limit is likely to be around $500 and that is ok. After all, you are building a credit history from nothing. Even a $500 credit card limit can help you improve a credit score by showing a on-time payment history and responsible credit use.
To keep a credit card active, you need to have at least one transaction per month. My recommendation is to have a reoccurring monthly charge auto charged to your credit card. I have used streaming services and/or bills. I also make sure to pay my credit card balance off each month. Having a credit card balance will affect your credit use or credit utilization ratio.
Credit utilization ratio is the percentage of credit used versus available credit. For example, if I have a credit card with a $50 balance and a total credit line of $500, my credit utilization is 10%. This can negatively affect your credit score; however, once you pay the balance your utilization ratio will increase. As your income increases, you will have an opportunity to increase your credit limits on your cards.
A Word of Caution! Do not spend more on a credit card than you can pay off in the same month!
Many people have fallen into the trap of using credit cards to supplement their income. Credit card companies charge interest rate on the balance that is carried over each month. This is one way credit card companies make money. Interest rates on credit cards are typically between 15% to 33%. On a $50 balance, the interest could be a $12.50 (at 25%) for a total of $62.50 payment to pay off the credit card. If you make a minimum payment of $25, it leaves a remaining balance around $37.50. The following month, an addition $9.38 of interest is billed to your account for a remaining balance of $46.88 assuming you do not make any new charges.
By only paying the minimum monthly payment, it could take years, depending on the credit card balance, to pay off the card even if you do not make any new charges to the card.
Do Not Fall into This Trap! Many people have spent hundreds of dollars in just interest. We work too hard to just spend our money on interest!
I made this mistake when I was a young adult. I was able to transfer the credit card balance to an other loan with a lower interest rate before incurring the 33% interest on a few thousand dollars; however, I still had to pay off the debt. The lesson I learned, it is better to delay gratification than to use credit cards to enjoy a moment.
Credit cards can be a great tool for building credit, but you really need to pay the balance off every month, or you could fall into credit debt. Credit card debt can negatively impact your credit score which is the opposite of building credit.
Loans
There are many types of loans including school loans, personal loans, mortgage loans, and auto loans. In addition to credit cards, adding a loan to your credit history can improve your credit score.
Taking out a loan will cause debt. Loan amounts can vary from a few hundred dollars to several thousand dollars. Interest rates on loans are typically lower than credit cards and must be pay back on a payment schedule.
For a person to qualify for a loan, they must show proof that they can repay the loan in addition to a decent credit score. Loan companies will typically ask for income tax records and paycheck statements for proof of income.
Tracking Your Credit
Congrats! You have just opened your first credit card and have started building your credit. There are a couple of things still left to do:
- Review your credit report regularly – There are three major credit bureaus. They are Equifax, Experian, and TransUnion. Most financial institutions offer credit monitoring benefits. Check your credit report for accuracy and that there are no errors on your credit report.
- Repair credit – Work to resolve any missed payments or collection accounts. You can sometime negotiate with creditors to remove negative items once the mistakes are fixed.
My credit card company allows me to check my TransUnion credit report and gives me tips to improve my credit score and provide tools to help see how taking out loans or increasing my credit use impacts my credit score. More and more credit cards and financial institutions are offering this service, so check out what options you may already have.
Use Credit Sparingly
To build credit you must use it, but use credit sparingly. I have listed three reasons below:
- Opening too many new accounts can negatively affect your credit score. It is best not to open more than one or two accounts (credit cards or loans) in a single year.
- Best way to use credit is to pay off the balance each month. If you are keeping a balance on your credit card, you could be falling into the credit card trap of debt. Take a step back and reevaluation your money goals. If you can not pay off the credit card balance each month, you need to adjust your budget or you need to look for ways to increase your income.
- It is easy to damage your credit, but can take time to fix credit mistakes. You were late on a payment or you were unprepared for an emergency and now have $3,000 credit card balance. These are typical credit report items that impact your credit score but can be fixed. A history of on-time payments will make up for that late payment. Paying off that $3,000 credit card balance will improve your credit utilization but it will take some time to earn the money.
I currently have three credit cards. My oldest account is 14+ years. This was my very first card. To be honest, I only have it because it is my oldest account on my credit report. It also has the highest interest rate of 33%. My newest account is a year old (Amazon). Yep, got this one to save $$ on a large purchase. My other card is 7+ years old and was open for international travel (no foreign transaction fees).
I would be lying if I told you that I have never been tempted to take out credit cards while shopping. We hear “save an extra 20%”, “get 0% interest for 6 months”, or “no payment required for 3 months”. As I mentioned above, this is how I got my Amazon card but have turned 99% of these offers down. Why? Because they do not meet my long term financial goals. Keeping your goals in mind will help you make the decision to say “no” much easier.
I have periodically increased the credit lines as my credit history grew and my income increased. Increasing my credit lines have help me build my available credit without taking out new credit card accounts. If you use your credit cards responsibly by paying the balance off each month, you will not need lot of credit card accounts to build your available credit limit.
Summary
Building credit is important especially when you are starting your financial journey.
One way to building credit is by getting a credit card and learn to use it wisely by paying the balance off each month.
Loans can build credit by diversifying the type of credit in your credit history.
There are many ways to build credit; however, if you misuse credit by maxing out your credit card, not making on-time payments, or missing payments, these actions can negatively affect your credit score.
Review your credit report at least once a year to check for mistakes or negative items.
I encourage you to join me on my financial journey to living a prosperous life. I will share ideas and tips that have worked for me. Our passion for Her Prosperous Path is to help and inspire the community of readers to reach your prosperous life.
Disclaimer
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