Even if you have a love-hate relationship with it, credit plays an important role in our lives and economy. It allows us to reach financial, personal, and professional milestones that we might not otherwise be able to achieve.
Here’s why you need to take your personal credit seriously, and a complete guide to establishing, building, and improving it throughout your life.
Why You Need Credit
Like it or not, there’s a definite need to establish credit responsibly in order to achieve your dreams and purchase things you want. You need credit so you can:
- Buy a dream home. This means getting approved for a mortgage (unless you plan to save up hundreds of thousands of dollars). Until that day, you’ll still need good credit to be approved to rent a decent apartment.
- Get better insurance rates. Insurance companies consider your credit rating in determining your premiums.
- Receive an upgraded education, which usually means applying for student loans or financial aid that will need to be paid off after you graduate.
- Invest in your future so you’ll have a better chance of success. If you want to invest in real estate as part of your retirement income later, or start a business so you don’t have to work for someone else your whole life, you need to establish a good history of using credit.
Popular Reporting Agencies and Types of Credit
So what is credit and what types are available? The three major national credit bureaus, which monitor your credit score and report, are Experian, TransUnion, and Equifax.
When you borrow money to pay for goods, services, or big purchases, credit is used in an agreement to pay back the funds you borrowed. In addition to paying back the principal balance, you may also have to pay finance charges and interest.
One or all of these credit reporting agencies will track how often you pay back the money, whether you’re on time, what your total payments are, and anything else related to the debt account.
There are three types of credit that you may need throughout your life. They include:
- Revolving credit. This includes credit cards and lines of credit because it’s limited to a certain amount of credit you can use each month. You then continue to pay off the balance you carry forward, or that revolves, every month.
- Service credit. Any arrangement with a service provider — for electricity, cellphone, water, heat, or even a gym membership — is considered service credit.
- Installment credit. With this type, a creditor will approve you for a specific amount of money that you agree to pay back in regular installments over a set period of time. Examples are a mortgage or a car loan. Charge cards are sometimes viewed as installment credit, but are often singled out as another form since they differ from traditional installment credit.
Establishing Your Personal Credit
The best way to establish credit, especially if you don’t have any to begin with, is to start small and slow. Getting your first loan or line of credit can be challenging. But with the right method and credit habits, you can establish a solid foundation for your personal credit.
Often the best personal credit options for first-timers include talking to a local department store, credit union, or community bank. They have options with low credit-line limits that will help you establish a history of responsible credit use.
They also have lower barriers to what’s required for you as a consumer to apply for any credit.
Don’t Take Out Too Much
It may be exciting to think of building credit for the first time, but don’t start applying at every store or bank. Taking out too much credit is a red flag to other financial institutions that you hope to receive a loan from in the future.
In addition, each time you apply for a credit card or loan, there’s a “hard pull” on your credit report. Too many of these could cause your credit score to go down. So start out slowly and only choose specific places to apply for credit.
Keep Your Balances Low
Nothing will be more devastating to your personal finances or your credit history than maxing out credit card balances. You want to establish smart spending habits, and prove to creditors that you’re a trustworthy borrower.
The perfect formula is to keep your entire credit usage less than 30% of your entire credit limit. So for instance, if you have a $1,000 credit limit, you want to keep your balance under $300. This will show how you manage credit efficiently and that you’re ready for more responsibility.
Continuing to Build Your Credit History
Once the initial foundation has been built and you’re starting to get a feel for using credit, here are the next steps to building upon it.
Check Your Credit Report Regularly
Sometimes a creditor will apply a payment to your account late, thus putting a ding in your payment history. Or someone might apply for credit in your name, or steal your identity. There are a host of mistakes and errors that can occur with your credit report, so always check it regularly.
Call one of the three credit reporting agencies if you see any erroneous information on your report. Ask that they update or remove any incorrect names, accounts, or addresses.
Close Accounts With Caution
As you move into this next phase of being responsible with your credit history, there may be some accounts you no longer use.
For example, your first credit card may have a $500 credit limit, which you’ve outgrown and are using other credit cards with higher spending limits. Even if you don’t use this account, it may not be a good idea to close it.
The time you’ve spent establishing your credit history is one of the main factors that proves your credit worthiness over time. So having older accounts can display your history — and the longer it is, the better.
Have a Good Mixture of Credit Accounts
As your professional and personal needs increase, consider taking on different types of credit to create a solid mixture of accounts. An ideal credit history includes accounts like a mortgage (installment loan), credit cards (revolving credit), and utility bills in your name (service credit).
You don’t want to take on extra debt if you don’t need it. Just beware how often you’re applying for accounts and what category they fall into. Your goal is to create a smart and diversified mix of credit.
Improving Your Credit Profile
This last phase of handling credit successfully is improving upon the foundation you’ve built. It’s not quite as exciting as the previous steps, but an important part nonetheless.
The longer history of credit you have, the better interest rates you’ll be able to get, and the more likely you’ll be approved for loans. In other words, don’t undo all the work you’ve done to reach this point, and be smart about your credit decisions going forward.
Always Pay Bills on Time
Late payments should be avoided because they will negatively affect your credit report. This could put you in a bad light with a financial institution if you’re trying to apply for a loan. They may view late payments as an ongoing pattern and reject your application based on a spotty payment history.
Do whatever you can to pay your debts and bills on time. In the event you fall behind, call your lender and work out something. It’s better to come to an agreement about the payments than to ignore the situation.
Many lenders will work with you to set up a different payment schedule or lower the interest rate and other terms to accommodate your needs. You simply need to ask.
Ask a Friend to Co-Sign a Loan
If you find your credit profile slipping, you may want to ask a friend or family member to help get you back on top by co-signing a loan with you, or adding you as an authorized user on their account.
This is a good way to improve your credit profile by using them as an accountability partner with your spending. You might also learn a few tips for credit usage from them.
Demonstrate Consistent Responsibility
A few other factors that may impact your overall credit history include how long you’ve been employed, how long you’ve lived at your current residence, and whether you own or rent your home.
As your financial situation changes in life, always aim to display a consistent level of responsibility in all areas — both with your job and current living situations. Constantly moving around, quitting and finding new jobs, can take a toll on your family as well as your credit profile.
Think of your credit as an investment that needs to be tracked, thoughtfully considered, and carefully monitored. In doing so, you’ll be able build an excellent history of credit and increase your credit score, so you can fulfill your financial dreams.