Credit is an essential part of financial stability. I discussed some of the reasons why it's so important in this article, but the main idea is that most large purchases require utilizing credit. Important aspects of life, like renting a home or purchasing a car, also require credit history. The question is, how do you build your credit?
There is no easy or quick way to build your credit. The two main factors in building credit are time and discipline. The first step to begin building credit is to get a line of credit. Applying for a credit card from your bank or credit union is the easiest way to get a line of credit in your name. Most people will begin with a low limit credit card, meaning you’ll only be able to spend a certain (usually low) amount of money on that credit card.
Once you’ve acquired a line of credit, start using it. Make small, regular purchases using your credit card. By making regular purchases, you show that you will actually use credit. Remember, only spend as much as you can pay back. Never think of your credit card as “free money”. A good rule of thumb is to only use credit to buy something if you have the same amount in cash.
Another important factor to know when using your credit card is to use at most 1/3 of your credit limit. If you have a credit limit of $300 per month, keep your purchases using that credit card below $100 a month. Why? Well, one of the factors used in calculating your credit score is your credit utilization rate. This is the amount of credit you are using compared to the amount of credit you have available to you. So, if you are spending $300 on a credit card with a maximum of $300, you have a credit utilization of 100%.
The credit bureaus (the companies that determine your credit score) provide you with a more favorable credit score if you have a lower utilization rate. Credit utilization makes up 30% of your FICO score (one kind of credit score). This means that nearly 1/3 of your credit score is based on how much credit you’re using.
Why do credit bureaus favor lower credit utilization rates? Well, the higher your utilization rate, the more relative debt you have. So, if you have a utilization rate of 100%, you have the maximum possible amount of debt you are “allowed”.
The more debt you have, the higher the risk you are. Because your credit score measures how risky of a borrower you are, it is lowered when you have a large amount of debt. So, it is best to keep your utilization rate low. The average utilization rate varies from 18-20%, and people with a credit score of 800 have an average utilization rate of 7%. In simpler terms, those with higher scores tend to use less credit. People with “exceptional” credit scores tend to use only $7 for every $100 of credit they have available.
You can easily calculate your credit utilization by dividing the amount you’ve “utilized” or used by the total amount available to you, and multiplying that by 100.
For example, if you have $500 in available credit and you’ve used $200, simply divide $200 by $500 (200/500 = 0.4) and multiply by 100 (0.4 x 100 = 40%). So, your credit utilization rate is 40%.
Another crucial factor in building credit is paying off your credit card balance every month on time!!!! It is extremely important that you do not miss a payment or make a late payment. This will harm your credit score. This is another reason it's best to use a small amount of credit. By using only a few dollars of credit every month, you ensure that you can easily pay it back on time. Making on-time payments shows you are responsible and can handle credit efficiently, further building your credit.
Make small yet regular purchases on a credit card, use 30% of your available credit at most, and always pay back any debt on time. By combining these steps, you can begin building your credit history, increase your credit score, and strengthen your overall credit.