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When it comes to establishing credit for the first time or rebuilding damaged credit scores, I like to keep this image in mind: A phoenix rising from the ashes.
To a large extent credit is an equal-opportunity evaluation process. Your credit scores do not reflect your income, age, education, or job title. They indicate how you use credit that’s extended to you. I’ve seen a couple who have two teenage daughters and who work seasonal jobs earning a combined income of less than $30,000 a year with credit scores in the low 800s. And I’ve known a few executives, earning more than $200,000 a year, with credit scores in the subprime 500 range.
With this in mind, here’s the first step you should take to build your credit. Open an account. Any loan qualifies as a line of credit, including car loans and student loans. But don’t just race out and open a bunch of these accounts. All you need is four ongoing lines of credit to produce superior credit scores. For each of these accounts, you also need to remember two critical points:
- Never charge more than 10 percent of the limit on any credit card account. This tells the credit analysis software, which produces your FICO scores, that you are so financially responsible that you only need less than 10 percent of your available limit. Use credit cards every month to purchase items you normally pay cash for, such as groceries and toiletries. If you’re developing new credit habits and you’re concerned that you’ll spend the money before you receive the bill, write the check for the amount you charged and pay it immediately. There’s no rule that says you have to wait for a bill to pay an account.
- Pay all bills on time.
Often, with a poor credit history, the only major credit card you can qualify for will have a limit of $100 or $200 dollars along with huge charges (far greater than 10 percent) to open the account. Using only 10 percent of a $200 limit will mean you can never charge more than $20. This is too difficult. You don’t want a general-purpose credit card with a tiny limit.
If you have no prior credit history and you have a stable job, it’s likely you will be offered a first credit card with a limit of at least $1,000. Remember, you never want to charge more than $100 with a $1,000 limit.
You can build your credit rating without a major credit card. Department stores often have more relaxed lending standards and will extend credit to new borrowers without a fee to open an account. Be careful, however. They also charge outrageously high interest rates so you never want to carry a balance. If there is a store where you shop every month, open an account there. Use it and pay it off each month. The 10 percent rule applies here as well.
Another possibility for building your credit is a secured credit card. With a secured credit card account, you deposit money in a dedicated savings account, which will pay you interest, and then your bank will issue you a VISA or MasterCard. When you purchase a product or service using your card, the bank withdraws the money from your dedicated savings account. These programs vary, but your credit limit is tied to the amount in the dedicated savings account. To maintain your credit limit, you must keep the savings account balance at its original established level after your credit card purchases each month. As with all credit card accounts, you want to stick to using no more than 10 percent of your credit limit.
Financial institutions report your secured account activity to the three major credit reporting agencies every month, just as they would with an unsecured account. Because banks will judge how you handle your secured credit card before issuing you a regular one, this can be an excellent way to build your credit.
How do you find a bank that offers secured credit cards? Look on their Web sites. However, they’re not always advertised so call your local bank and ask. If you search online, you’ll discover nonlocal financial institutions that offer these cards. Avoid these. Stay local. You don’t want the difficult task of evaluating a financial institution you’ve never heard of.
Remember, a few accounts that you use every month for small purchases and pay off immediately will build solid credit ratings. Diligently pay every bill on time, including utilities, rent, cell phones, and student loans. After a year of responsible credit management, you’ll discover your credit scores are up, higher than you probably thought possible.