Once, building credit meant taking on debt — sometimes expensive debt like a car loan or a credit card with a high rate.
Today, it’s possible to build a good credit score in a year without a big chunk of cash upfront or a large debt at the end. You can make yourself look better to lenders while keeping more money in your pocket. Here’s how to do it right.
You don’t need debt to build credit
- Old advice: Take whatever credit you can get, even at double-digit interest rates.
- New advice: Start with a credit builder loan, then add a credit card to the mix.
With a credit-builder loan, you build credit and savings at the same time. The money you borrow is placed in a certificate of deposit or savings account that you can claim once you’ve made all the payments, which are reported to credit bureaus.
Many credit unions offer these loans. If yours doesn’t, check to see if there’s a community development financial institution near you that does, or investigate Self Lender, an online lender that makes one-year credit-builder loans of $550, $1,100 and $2,200. Someone who borrows $550, for example, would claim a $550 CD after making 12 payments of $48.50, plus a $12 administration fee.
These loans can help people build credit scores in the high 600s or even low 700s, says credit expert Barry Paperno, who blogs at Speaking of Credit.
“Regardless of the loan amount, one year of on-time-payment installment loan history with no other credit on the report should deliver a decent score,” says Paperno, who previously worked for credit-scoring company FICO and credit bureau Experian.
Once your scores are in the mid-600s, you can qualify for a regular credit card. Using the card for a few small purchases each month and paying the balance in full will continue to build your scores.
You can get plastic even earlier if you have some cash to make a deposit on a secured card. Most require people to put down $200 to $2,000 in exchange for a credit limit equal to that deposit.
“Adding a secured credit card with even the smallest limit and obtained at about the same time as the installment loan would make for an even better score,” Paperno says.
Store cards may improve your mortgage chances
- Old advice: Regular credit cards are better than store cards for building credit.
- New advice: Certain store cards may help you get a mortgage.
Store-branded cards have long been seen as a stepping stone to “real” credit cards. Store cards typically are easier for people who are building credit to get, but regular or general-purpose cards issued by national banks are weighed more favorably by credit-scoring formulas.
However, if you’re building or rebuilding credit with the goal of getting a mortgage, store cards may prove more helpful.
Mortgage buyer Fannie Mae now requires mortgage lenders to look more favorably on people who regularly pay off their credit card balances when that information, known as trended or time series data, is available. Research by Fannie Mae and credit bureau TransUnion has found that people who don’t carry balances are less likely to default on any credit account than those who do.
The problem is that many big credit card issuers don’t report to the credit bureaus how much of their accounts customers pay off each month.
“The percentage of issuers who are reporting this time series data is small, relative to the whole population of issuers that report to the [credit bureaus],” says credit expert John Ulzheimer, who has worked for FICO and Experian.
Some store-branded cards do report actual amounts paid each month, however, including Synchrony Bank’s Amazon card and TD Bank’s Target card. If getting a mortgage is important to you, call the issuer and ask if it will report your actual payment amounts to the credit bureaus before you apply.
Use free credit scores as much as possible
- Old advice: Monitor your FICO scores to track your progress.
- New advice: Keep tabs with free scores and buy the right FICO before you apply for loans.
FICO credit scores are used in far more lending decisions than rival VantageScores, but VantageScores have an edge for people new to credit.
FICO formulas require at least six months of credit history before a score can be generated, and at least one account must have been updated by the issuer in the previous six months. A VantageScore can be calculated as soon as a person’s first account is reported to the credit bureaus, typically within 30 days of approval. VantageScores also can be calculated for anyone with a credit account that’s been updated in the prior two years.
You can get VantageScores for free from sites like NerdWallet. Many credit card issuers also offer free FICOs or VantageScores. The version of the FICO that they typically offer is the FICO 8, the most commonly used score in lending decisions. It’s not the FICO that most mortgage lenders use, however — they typically use older versions of the scores pulled from each of the three credit bureaus:
- The score retrieved from Equifax credit bureau is typically called FICO Score 5 or Beacon 5.
- At Experian, it’s FICO Score 2 or Experian/Fair Isaac Risk Model V2SM.
- At TransUnion, it’s FICO Score 4 or FICO Risk Score, Classic 04.
Similarly, auto lenders use various versions of FICO Auto Scores, which have a 250-to-900 scale. FICO Auto Score 8 is commonly pulled from all three credit bureaus, while version 2 is popular at Experian, version 5 at Equifax and version 4 at TransUnion.
When you’re ready to apply for a major loan such as a mortgage or auto loan, you can get a better idea of how lenders are likely to view you by purchasing your scores from MyFico.com. Currently you can’t buy just an auto or mortgage score; you need to purchase your FICO 8s from each bureau for about $20 each, and the other scores come with the package.
Until then, go for a free score.
This article was written by NerdWallet and was originally published by The Associated Press.