Good credit helps you save money and improve your finances in other ways, even if you never borrow a dime.
Find out why maintaining high credit scores improves your financial life, how your scores stack up against the average, and nine tips for building excellent credit.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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You've probably heard that you need good credit scores to qualify for the best terms on credit accounts like mortgages, personal loans, and credit cards. Plus, good credit helps you save money and improve your finances in other ways, even if you never borrow a dime.
Today's show will highlight nine savvy tips for building credit. You’ll learn why maintaining high credit scores improves your financial life and how your scores stack up against the average.
Hey, everyone, and welcome back to Money Girl—I'm glad you're spending time with me! If you're a new listener, my name is Laura Adams. I'm an award-winning author and finance expert who's been bringing money tips and advice weekly on this podcast since 2008, with over 40 million downloads.
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OK, let's talk about savvy credit-building strategies that help you save money and boost your finances. But first, I want to review why having great credit is so vital in the first place.
One of the best reasons you should strive for excellent credit is that it qualifies you for lower interest rates on credit accounts, like credit cards and loans, which saves a bundle. For instance, getting a mortgage that charges 1% less interest saves $80,000 on a 30-year, $350,000 loan!
In addition, having great credit helps your finances in the following ways:
If you’re ready to get your credit in excellent shape, here’s what you need to know and do.
1. You must understand how credit scores work.
You must know how the credit system works to improve your credit scores. Many credit scoring models use data from your credit reports to calculate various scores. The information in your credit files gets reported by your creditors, such as credit card issuers and lenders.
Three leading nationwide credit agencies maintain your data and resulting credit reports: Equifax, Experian, and TransUnion. Your creditors can report your information, such as payment dates and account balances, to one or all credit agencies.
While creditors don't have to report your data and must pay for it, they get access to consumer data in return. Government agencies that maintain public records, such as bankruptcy and lien filings, don't report data to credit agencies; however, agencies usually get public data on their own.
Credit report information gets used to create credit scores, such as the well-known FICO score. However, hundreds of different scoring products, including VantageScore, TransUnion, and Equifax, have their own algorithms and score ranges.
Credit scoring models use factors such as your payment history, debt balances, account types, age, and new credit inquiries. Note that when calculating your scores, credit models don't use demographic information, such as your race, marital status, gender, or income.
LEARN MORE: Build Better Credit–The Ultimate Credit Score Repair Guide
2. You can’t have credit scores without credit accounts.
It's a common misconception that being debt-free gives you excellent credit. If your credit reports have too little or no data, they can be too "thin" to generate scores. Unfortunately, having no credit score is the same as having poor credit.
The bottom line is that you must have credit accounts and use them responsibly to build excellent credit. So, don't hesitate to apply for credit accounts you genuinely need and can manage wisely.
3. You must prioritize timely payments.
Since your payment history is typically the most significant factor in credit scoring calculations, paying your bills on time is critical. Even if you can only send your credit card's monthly minimum, paying on time builds a history of positive data in your credit reports. Likewise, making even one late payment can significantly hurt your scores.
Timely payments are critical if you have federal student loans that will no longer get suspended beginning September 1, 2023. The interest-free loan forbearance that started during the pandemic financially relieved millions of student loan borrowers.
But Congress' debt ceiling negotiations put an end to future extensions, so don't neglect making payments this fall. You should receive a notice from your loan servicer with loan payment details at least 21 days before they begin. Failing to pay on time could have significant negative consequences for your credit.
LISTEN ALSO: 6 Ways to Get More Value from Your Credit Cards
4. You should consider the downsides of closing credit accounts.
If you pay off a revolving credit account, such as a credit card or line of credit, keeping it is much better for your credit than canceling it. That's because closing an account shrinks your available credit, causing your credit utilization ratio to skyrocket.
Your utilization ratio is a formula calculated by dividing your outstanding balance by your available credit, and it's a significant factor in your credit scores. Let's say you have two credit cards with $4,000 credit limits and owe $0 on the first and $2,000 on the second. Your credit utilization ratio would be 25% ($2,000 / $8,000 = 0.25)
If you close the first card after paying off the balance, you instantly lose half your available credit, causing your credit utilization to double to 50% ($2,000 / $4,000 = 0.50). Such a significant increase in your ratio causes your scores to drop.
More available credit relative to your debt balances is best because it shows you use credit responsibly. And cutting your available credit makes you appear less creditworthy, even when you aren't.
LISTEN ALSO: What to Know Before You Cancel a Credit Card
5. You don’t need to carry debt to build credit.
It's a common myth that you must take on debt to improve your credit scores. When you need a credit account, the upside is building credit when you manage it responsibly.
However, an excellent credit-building strategy is making credit card charges that you pay off each month. That allows you to avoid interest charges, get card benefits, and maintain a low credit utilization ratio that boosts your credit scores.
RELATED: 7 Credit Mistakes That Could Cost You
6. You can build credit from scratch.
Credit can often feel like a catch-22 where you can't get approved for credit cards and loans without having good scores, but you can't build good scores without having credit accounts. The savvy way to build credit from scratch is by applying for a secured credit card.
Secured cards work like standard cards but require you to pay an upfront refundable deposit that becomes your credit limit. After you make on-time payments for a period, you typically qualify for a regular, unsecured card.
Just be sure a secured card reports payment data to nationwide credit agencies. Otherwise, your payment history won't get recorded in your credit files, and you won't have the opportunity to build your credit scores.
7. You may benefit from being an authorized user.
A credit card holder can add an authorized user to their account who isn’t financially or legally responsible for repaying it. For instance, a parent might add a child as an authorized user so they can have a card in their name without having to apply for their own card.
A common question is whether becoming an authorized user helps you build credit. The answer depends on the card owner’s financial behavior and whether the issuer reports their payment data to the authorized user's credit reports. Check a card’s website or call them for clarity about whether they report data to authorized users’ credit reports.
When positive, on-time payment information shows up on an authorized user's credit history, it's a great way to boost credit. However, if the card owner doesn't manage their card responsibly and makes late payments, it could hurt an authorized user's credit. However, some credit agencies protect authorized users by not posting negative information on their credit reports.
8. You need a mix of credit accounts.
Your credit mix, or the types of accounts you have, contributes to your credit scores. While it's not as significant as your payment history, it's part of the calculation in most scoring models. For instance, having revolving accounts (such as credit cards) and installment loans (like auto, student, and home loans) shows you can successfully manage different types of credit.
As I previously mentioned, having multiple credit cards increases your total available credit, reducing your utilization ratio and boosting your scores. In addition, every account you own adds to your credit history, another scoring factor. However, I don't recommend opening new credit accounts you don't need or would have difficulty managing responsibly just to improve your credit mix.
READ ALSO: How Many Credit Cards Should You Have for Good Credit?
9. You must be patient to build credit.
So how long does it take to build credit? Improving your credit scores never happens quickly, nor is there a magic fix for poor credit. If you're starting from scratch or rebuilding after a financial hardship, you can see significant increases in your credit scores after six months or a year. It may take longer if you have had accounts in collections or bankruptcy. However, scores typically give more weight to your recent account activity.
How often your credit scores update depends on when creditors report information to credit agencies. Generally, your account data gets updated monthly, and scores can change monthly.
If you're wondering how your credit stacks up where you live, looking at state averages can be helpful. The VantageScore model ranges from 300 to 850, and Equifax data shows that the U.S. average in early 2021 was 698.
The five states with the highest average scores were:
And the bottom five were:
Don’t be shy about reviewing or downloading your credit reports for free, which never hurts your scores. Regularly checking your reports and scores at sites like Credit Karma and Finder is the best way to catch errors or fraudulent activity that could be dragging down your credit scores.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.