Building Credit in the U.S.
Learning about the financial system in the U.S. can be intimidating at first. How does credit work? What is a FICO® score? What type of loan(s) should I get? Can I even get a credit card? How do I start building credit?
Here is an in-depth breakdown of how credit works, and how you can build and take advantage of the benefits of having strong credit.
What is credit?
According to Experian, credit is the ability to borrow money or access goods and services with the understanding that you will pay later.
Simply put, it’s a show of good faith to allow you to buy things you can’t afford at the moment, or defer payment for something you want over a longer period of time so you can get the things you want or need right away without a huge, immediate impact on your finances.
Why is credit important?
Your credit history shows people how trustworthy you are repaying your debts. Having a strong credit history means you can be offered higher credit limits and/or lower interest rates on loans.
So why do you need credit? Couldn’t you just go through life without ever building credit?
Yes, you technically can go through life in the U.S. without ever opening a credit product as long as you have enough money to pay for everything with cash.
One of the main benefits of having credit is a credit score. Credit is usually required for buying a car, as well as renting an apartment or buying a home, and can even be viewed by some employers during the hiring process.
Different types of credit
There are two main types of credit: Revolving credit and Installment credit.
Installment credit products are loans for a set amount that you borrow from a lender to pay for something that you agree to pay back over time.
Some examples of installment loans are auto loans used to pay for a car over time, and personal loans if you need funds for a different type of purchase like furniture or to pay for a wedding. The only catch is that in exchange for the ability to pay for large purchases up front, you will have to pay some interest, or extra money, on top of whatever you borrow.
Revolving credit lines are loans that never close. They are a set amount of credit that a lender provides so you can buy things as you need them and repay, usually in monthly installments with interest.
Some examples of revolving credit are credit cards that can be used for everyday purchases like gas and groceries, and Home Equity Lines of Credit (HELOCs) where the loan is secured by your home.
Now that you understand what credit is and why it’s important, let’s go through building your credit.
FICO® scores and how to build your credit
Building credit is as simple as using credit; get a loan, use it, and pay it back on time. The easiest way to start building credit is to apply for a credit card and use it for regular purchases, such as gas and groceries. The more you use it, and the more you pay it back, the better your credit score.
The FICO® score (more commonly known as a credit score) is a ranking from 300 to 850 that indicates how much of a risk factor you are when it comes to paying back your debts. Generally, the higher your score, the more likely lenders are to grant you credit and charge you lower interest rates.
Your credit score is affected by a number of things, but it’s mainly determined by these five (5) factors:
- Payment History
35% of your overall score on average
Making your payments on time is critical to ensuring that your credit score gets stronger over time, as it’s the main way you interact with your credit outside of spending.
- How much you owe vs how much you have available
30% of your overall score on average
Making sure that you’re not using most of your credit line is a big factor in helping it grow. If you have most of your credit line used up, it’s more likely you won’t be able to pay it back or you’ll go over your total credit limit. The credit bureaus recommend using somewhere between 20%-30% of your credit limit to stay clear of your upper limit.
- How long you’ve had your credit
15% of your overall score on average
This is one of the reasons why building credit at a young age is a good idea. The longer you’ve had your credit lines and the more times you were able to get loans and pay them back, the better it looks and the stronger your credit score.
- Types of credit
10% of your overall score on average
Having a diversified portfolio of credit products is a surefire way to show that you were/are responsible with your payments and managing different types of loans effectively.
- Opening new credit products
10% of your overall score
Make sure you have only what you need, and make sure that you’re not applying for multiple credit products in a short period of time. Applying for loans and credit cards multiple times in a short period of time can hurt your credit score.
So how are you supposed to know if you have a good credit score? Does it hurt to check your credit score regularly? Not necessarily because there are two types of credit checks: hard and soft inquiries.
According to Experian, a soft inquiry is when you or someone you allow (like an employer) checks your credit report. This doesn’t affect your score because it isn’t tied to a credit application.
A hard inquiry, which is an inquiry tied to an actual credit application will affect your score since it is an inquiry for a real loan. There is a temporary decrease in your score, and in the case of looking for a home or auto loan, multiple inquiries of the same type within a certain period (14-30 days) are counted as a single inquiry.
You are also entitled by law to a free hard inquiry annually for yourself through annualcreditreport.com. Stanford FCU provides each member with their free credit score quarterly in Online Banking and the mobile app (App Store | Google Play)! Visit Services > MORE OPTIONS > View your credit score.