It happens to many people: they're ready to jump into a home mortgage, submit their information for loan prequalification and get denied on account of not having any credit history. Why is that? Why is credit so important?
There's nothing inherently wrong with having no credit, but financial institutions like to see that the people they lend money to have a record of paying back their debts. You need to have a credit history to be able to get a home loan. It's as simple as that.
But there are things you can do to get started on building healthy credit. Here are six simple steps you can take to help establish and build your credit score.
The first thing you can do is piggyback off someone else's credit card. That is, to get yourself added as a joint account holder or as an authorized user. Each method of piggybacking has its pros and cons.
When you add yourself to a credit card as a joint account holder, you take on the legal responsibility for any debts placed on that card. In return, you’ll inherit all the payment history and available credit from the account. This is why it’s important to make sure you’re adding yourself to a card with a strong record of on-time payments and low credit utilization.
It’s also essential to ensure you trust the person who owns the card and who trusts you — a parent, sibling, spouse or close friend. Once you're added as a joint account holder, you can't be taken off the account. If the primary holder runs up the balance or makes a late payment, you're stuck and you will see the consequences with your credit score. Even if there is a break in the relationship, including divorce, death, etc., you are still responsible for the account.
In contrast, getting added to a card as an authorized user allows you to benefit from the payment history and available credit without being legally responsible for the balance. It’s also possible to get yourself removed from the account at any time. This alone makes becoming an authorized user a much safer option when it comes to establishing credit.
The tradeoff is that companies aren’t obligated to report account information to the credit bureaus like when you're a primary or joint account holder. You could see all of the positive payment history from the card added to your credit profile, or you could see no new information reported at all. This is why it’s important to ask each company to confirm their policies on reporting authorized user accounts beforehand to ensure it will boost your scores.
If you’re looking to buy a home soon, becoming a joint account holder is generally the most surefire way to build up your credit score. But, if you simply want to start establishing credit, then being an authorized user might be the more prudent route.
Your next move is to get a secured credit card of your own.
A secured card is one where you put down a deposit with a bank that acts as collateral for the account - a $300 deposit gets you a $300 credit limit. After a year or so, you typically get your deposit back. Once you've established enough credit, you'll be able to get a card without putting money down.
Piggybacking is a great way to get started, but getting a credit card of your own is key to building a strong credit profile. One of the advantages to doing both is that if you piggyback, you should be able to get an unsecured credit card as opposed to a secured card, meaning no deposit required and probably better rates and terms.
Even if you end up not carrying any debt on your card, you'll want to leave it open. One of the primary advantages of credit cards over loans is that you never have to close them. The longer you can leave an account open on your credit report, the more it’s going to help your scores.
However, be aware that banks will close credit cards because of inactivity. Therefore, it’s beneficial to charge something on your card every so often.
Tip: Charge a small balance and pay the card off every month, always keeping the balance lower than 25 to 30 percent of the limit.
Another option is to get a gas station credit card. Most of us always have to buy gas, so why not build scores at the same time?
This is an excellent way to establish credit without creating unnecessary debt. Fuel expenses are already a part of everyone’s budget, so using a credit card for gas isn’t spending in excess of what you’ve already budgeted for. At week's or month's end, just pay off the balance.
When you've established a couple lines of credit through cards, it might be time to take out a small personal loan. It is good to note, though, that it takes time for these loans to boost your credit.
When it comes to personal loans, they can help but need to hit maturity of at least 6 to 12 months. If paid off too early, you won’t see the benefit to your score.
The credit bureaus reward longevity and a reliable ability to make on-time payments. Paying installment loans quickly doesn't show a pattern of consistent monthly budgeting for the long haul.
In short, personal loans can round out your credit report, but they don't do the financial heavy lifting that credit cards can do when it comes to your score.
The most important step in establishing and building up your credit score is making sure that you pay all of your bills on time. Payment history makes up about 35 percent of the score calculation.
Regular on-time bill payments — credit cards, auto, student loans, etc. — normally get reported to the credit bureaus. One missed payment can damage your credit significantly, while consistency in this area is essential to strengthening your scores.
After you've established and begun to build up your credit, it's time to keep an eye on it to make sure there are no errors in the report and to help you keep track of your financial habits.
Once a year, you are entitled to a free credit report from the three reporting agencies. Visit www.AnnualCreditReport.com to begin. This service is absolutely free and doesn't require you to sign up for any sort of monitoring service.
Your free annual report does not include your credit score, but it’s important to remember that lenders use different scoring models depending on the type of loan. While you may see your score on a credit card or loan statement, or even from subscribing to a credit monitoring service, you don’t have a universal credit score.
However, if you keep your credit card balances low and maintain a record of consistent on-time payments, you should find your scores are more than high enough to start your journey toward homeownership once you’re ready.
Need help establishing or improving your credit? Give our VA home loan and credit experts at Veterans United a call at 888-392-7421.