Building a Good Credit History and Credit Score

Building a good credit history and credit score does not need to be complicated.

How do you build your credit history? How do you improve your credit score? What affects your credit score? 

Credit is a very misunderstood part of personal finance. 

When I talk with people about credit, I often hear stories of how they received wrong advice. 

Don’t use credit cards.

Close credit cards you don’t use. 

Stay away from debt. 

I disagree.

Establishing a solid credit history and working to improve your credit score is important. It can lead to lower interest rates on debt, such as a mortgage, which could save you a significant amount of money over your life. 

Why is Building a Good Credit History and Credit Score Important?

Let’s say two people, Monica and Sam, are the same age, but Monica took steps to build her credit from a young age. On the other hand, Sam had a slow start and only recently started building his credit.

They are both looking to purchase a home in the next few months. Let’s say they both want to buy a $400,000 home in the same neighborhood, have the same income, same 20% down payment, and everything else is identical, except their credit score. 

In this example, Monica has a credit score of 802 and Sam has a credit score of 685. Monica falls into the exceptional category while Sam falls into the good category.

Which rates will they receive? 

As of August 21, 2020, it’s estimated Sam would receive a 2.887% APR on a 30-year fixed loan. It’s estimated Monica would receive a 2.488% APR on that same 30-year fixed loan. You can estimate your own interest rate depending on your FICO Score here.

What are their estimated monthly payments?

Sam will pay $1,330. Monica will pay $1,262. Monica is paying $68 a month less because she has a better credit score. 

Over a year, Monica will spend $816 less than Sam for her mortgage. 

Although it’s low odds they remain in the house over 30 years, how much would their total payments and interest be?

Over 30 years, Sam pays $478,695.37 in total payments and $158,695.37 in total interest. Monica pays $454,460.86 in total payments and $134,460.86 in total interest. 

Monica paid $24,234.51 less in interest over the life of the loan. 

If you want to run your own calculation, you can do it here.  

While I used a mortgage as an example, this applies to auto loans, credit cards, and other loans. 

But, it’s not just loans. 

Landlords, employers, cell phone companies, utility companies, and insurance companies may review your credit history.

As you can see, your credit history touches many areas of your life. You want a credit history that will help, not hurt, you. 

What is a Credit History? 

A credit history reports your past and present credit and loan accounts. It shows your name, addresses, credit accounts, debt amount, how long they have been open, amount of credit available to you, and whether the debt is paid on time.

In a way, it is like a report card of your credit history. 

The only difference is that there is no letter grade or score to go with it. It merely reports what has happened. It tells others how good you are at repaying debts and whether you are using credit responsibly. Although it only reports what has happened, it influences your financial life. 

Your credit history impacts your credit score. It can be used by employers or landlords when renting an apartment. In some states, even car insurance companies use your credit scores to help determine insurance rates. 

Do you see the importance of your credit history? 

Given the weight it carries in your financial life, you should review your credit report regularly. 

You can review it at www.annualcreditreport.com. Normally, you can obtain a free credit report once per year from each of the three major credit bureaus (Equifax, Experian, and Transunion). Since you only receive one free one per year, I generally recommend staggering them throughout the year. For example, you might request one from Equifax in January, Experian in May, and Transunion in September. This way you can review your credit history and if there is a mistake or someone opened a fraudulent account, you can catch it sooner.

If you were making a huge purchase, such as home, you might want to get all three at once because if there is a mistake, you want to correct it. 

During COVID-19, they are offering free weekly online reports through April 2021, so there is no need to stagger the requests now. 

To obtain your free credit report, follow the steps below. 

Go to www.annualcreditreport.com. Click on “Request your free credit reports.” 

Click on “request your credit reports.”

Complete your personal information and scroll to the bottom to continue. 

Select which credit reports you want. You can select one, two, or all three. 

I selected Experian in this example and confirmed my identity by answering a few questions. 

Now I can view and print my report. 

Now that you know more about credit history, you should learn more about credit scores. 

What is a Credit Score?

While a credit history reports what happened, a credit score takes that information and reports one number that summarizes credit risk. 

There are many credit scores available, but the most popular and widely used is the FICO Score, which is created by Fair Isaac Corporation. 

The scores range between 300 and 850. A score above 700 is generally considered good. You can see the percentage of people in each range for 2019 below. 

You can also see the breakdown of average FICO scores by age below. 

Now that you have seen the scores, you may be wondering how your score is calculated. 

It’s simple – and complicated. 

Simply speaking, your credit score is based on the following five factors:

1. Payment History
2. Amounts Owed
3. Length of Credit History
4. New Credit
5. Credit Mix

Each factor does not impact the score equally. Payment history is 35% of your score, amounts owed 30%, length of credit history 15%, new credit 10%, and credit mix 10%. 

Let’s explore each factor in more detail. 

Payment history: Did you pay your credit accounts on time? How many loans are past due? Do you have bankruptcies? 

Amounts Owed: How much do you owe on all accounts? How many accounts have balances? What is your credit utilization ratio? For example, if you have $10,000 of credit available to you, and you use $9,000, your credit utilization ratio is 90%. This is seen as risky. Generally, you want your credit utilization ratio to be 30% or less. 

Length of Credit History: How long have accounts been opened? How old is your oldest account? What is the age of the newest account? What is the average age of all your accounts? 

Credit Mix: What types of loans do you have? Do you have revolving accounts and installment accounts? Revolving accounts are credit cards or Home Equity Lines of Credit. Installment accounts are mortgages, auto loans, or student loans. Generally, your score is higher when you have a different mix of loans. For example, just having credit cards would not be as positive as having credit cards and a mortgage loan. 

Should you apply for a different type of loan to increase your credit mix? Not necessarily. 

You don’t want to take on debt for the sake of taking on debt. Plus, to apply for a new loan, the creditor will check your credit, which typically lowers your score and remains on your credit report for two years. 

New Credit: Have you opened several credit accounts in a short amount of time? If so, that is seen as riskier. If applying for new credit, inquiries will impact your score for 12 months, though they will stay on your credit history for two years. Generally, a credit inquiry will reduce your credit score by less than five points. 

Checking your own credit history directly through www.annualcreditreport.com will not impact your score. 

Applying for new credit can lower or increase your FICO Score. More on that here.

Simple enough, right? 

Why did I say it was complicated? 

Sometimes taking action you think would help your credit situation can hurt it. For example, some people close old credit cards thinking it will improve their score. It can actually hurt their credit score because length of credit history is one of the factors. 

For example, If you had a credit card that was opened in 2010 and another opened last month, your average length of credit history would be about five years. If you closed the credit card opened in 2010, your average length of credit history would be a month. 

Now, your length of credit history is short and negatively impacts your credit score. 

If you want more information about how your score is calculated, click here.

How to Build Good Credit

Now that you have a better understanding of credit history and credit scores, let’s talk about how to build good credit. 

Below are easy steps to build good credit:

• Use credit responsibly – don’t ignore it! 
• Pay all your loans on time
• Don’t use more than 30% of your available credit
• Be cautious about co-signing loans
• Don’t apply for many loans in a short amount of time
• Don’t close your oldest credit cards
• Use different types of credit if it makes sense for your circumstances

If you follow those steps consistently, you should have no problem building a good credit history and credit score. 

Use credit responsibly – don’t ignore it! 

I hate the advice “don’t use debt” or “don’t use credit cards.” If you have a legitimate problem with spending, perhaps this is good advice, but as blanket advice for most people, it’s terrible. If you never use credit, you never build your credit history.

If you never build your credit history, it’s going to be very difficult for you to apply for a car loan or mortgage. Even if you are accepted, you could pay thousands of dollars more because you might only be eligible for a higher interest rate. Lower interest rates are normally offered to people with good credit histories. I’ll talk about this more later. 

Don’t use more than 30% of your available credit

I find many people get confused about not using more than 30% of your available credit. Let’s say you have a $10,000 limit on a credit card and you spend $5,000 in a month, you are using 50% of your available credit. Instead of waiting until the end of the month to pay it off, pay all or a portion of it off prior to the end of your billing cycle.

For example, if you pay $3,000, it would report as using 20% of your available credit. The benefit is that your balance as reported to your credit report will be $2,000 instead of $5,000. 

I do this consistently for my credit cards. I normally pay my credit card off multiple times per month. Most months, I have a $0-$500 balance reported to my credit history, but I spent more. The other benefit is that I know how much money I have remaining for the month because I pay it off throughout the month – not just at the end of the month. I use it almost as if it were a debit card, but I receive better rewards. 

Here are my thoughts on how to understand your cash flow and budget better.

Be cautious about co-signing loans

I say be cautious about co-signing loans because if you co-sign, that loan will appear on your credit report. You become legally responsible for that loan, and it will impact your credit mix, length of credit history, amounts owed, etc. 

At the same time, if you are in a fortunate financial situation, co-signing someone’s loan can be helpful for them to build credit. For example, parents can co-sign for a child’s credit card or even add them to an old credit card. This can help them start building credit, which can put them on a drastically different financial trajectory. 

For example, if you open a credit card for someone who is age 18, and they keep the credit card until they are age 25, their length of credit history, which accounts for 15% of a FICO Score, would be seven years. It also helps payment history, which accounts for 35% of a FICO Score, because there would be seven years worth of payments. 

If you are unable to qualify for a loan or credit card and need to build a credit history, but do not have anybody to co-sign, consider a secured credit card. A secured credit card is where you place a cash security deposit and that cash deposit normally equals your credit line. If you don’t pay, the credit card issuer keeps the deposit. As you use it, the card issuer normally reports to the credit bureaus, which helps establish your credit history. 

What is a Credit Freeze and Should You Do It?

I don’t normally make blanket statements, but I strongly believe most people should freeze their credit. 

A credit freeze allows you to restrict access to your credit report.

Why is it important? 

When applying for credit, most creditors will run your credit history. If an identity thief tried to fraudulently open an account in your name, most creditors will run your credit history. If it is frozen, the creditor is unlikely to approve a loan without seeing your report. Hopefully the identity thief is frozen in their tracks. (Pun intended). 

It is a bit of a hassle to set up and unfreeze when you apply for credit?

Yes. 

Is it worth it? 

Yes, I believe it is. 

Once you initially set it up, it normally takes less than five minutes to unfreeze your credit. Plus, you can temporarily lift your credit freeze. For example, when I was refinancing my house, I did not know exactly when they would pull my credit report, so I temporarily lifted it for two weeks. 

By doing this, I spent less than five minutes and my credit would be frozen automatically at the end of two weeks. 

Please keep in mind you need to freeze your credit with each of the three major credit bureaus. If you apply for credit in the future, you can normally ask them which credit bureaus they will use to pull your credit history and only unfreeze that one. 

While it’s generally a good practice to freeze your credit, the fact that Equifax (yes, one of the three major credit bureaus) experienced a data breach in 2017 that exposed the personal information of 147 million people, is another good reason. After that data breach, I operate from the assumption that my personal data is out there for anybody to see forever.

The Federal Trade Commission has a good FAQ on credit freezes and links to freeze your credit.

What Actions Can You Take?

Hopefully you can use this information to take one small step towards building a good credit history and credit score. Below are a few ideas:

• Establish a credit freeze: https://www.consumer.ftc.gov/articles/0497-credit-freeze-faqs
• Review your credit history at www.annualcreditreport.com 
• Make a plan for how to improve it, such as paying down your balances before they are reported to the credit bureaus 

Good luck! If you know someone, particularly younger, who could benefit from this information, I hope you’ll share this with them. Good habits at a young age result in compounded benefits.