How to Build Your Credit
Do you know your credit score? Do you know how your credit score can affect your everyday life? In the journey to building your credit, not only do you need to understand the basics of your credit score, you need to understand how it is affected simply by the kind of loan you might decide to use.
In this series we are going to explore the basics of what a credit score is, reasons why having a good credit score is important, and tips for building a good score and avoiding mistakes that can harm your score.
Build Your Credit: Revolving Loans Transcript
Part 4: Build Your Credit: Revolving LoansVideo
Idaho Assistive Technology Project (IATP)
This is the last presentation in the How to Build Credit series and will discuss revolving loans.
In the last presentation, we talked about installment loans, what they are, how they impact your credit. You learned that installment loans are to make long term purchases on things like cars. You learned that while installment loans can help your credit score, they only help for the duration of the loan and that, in the beginning, certain parts of your credit will be negatively impacted. You learned that installment loans are not a bad thing but that you MUST be sure to make sure your payments are on time.
Now we’re going to talk about revolving loans. Revolving loans are open ended loans. This means that you can borrow any amount of money you choose at any time, as long as you don’t go over the maximum amount possible. If you pay down the balance on these loans, you can go right back out and borrow more. Examples of revolving loans include credit cards, department store cards, and personal lines of credit.
To get your first revolving loan, you can start by applying for a credit card with a low maximum limit. Most national credit card companies are willing to take a small chance on people with no credit by offering high interest cards with low maximum limits.
But, in some cases of no or poor credit, you might not be able to get a traditional credit card. The good news is that there are some other options for people in this situation. For example, using a cosigner can sometimes qualify you for a loan when you cannot qualify on your own. A cosigner is someone who adds their name to your loan, and agrees to become responsible for your debt if you don’t make timely payments. This is a good deal for you, but potentially hazardous for your cosigner because he or she will be responsible for your spending if you don’t make the payments on time. In short, it can often lead to strained friendships and family relationships, so it may be wise to avoid this option.
A third option is to open a “secured credit card.” A secured credit card requires that you give the credit card company a lump sum of money that can be used as collateral against any charges you make on a secured card.
For example, let’s say I open a secured credit card with a $300 limit. First, I would have to have $300 to give to the bank or card company as collateral, then I would go out and use the credit card for purchases. If I failed to make payments on my loan, then the bank would then take the secured money to pay the balance. It’s very similar to using a debit card, only a debit card will not build your credit, while a secured card can.
Even though you have money in your secure account, you never want to be late on a payment because it will still count as a negative payment history on your credit report, and will drop your score instead of build it.
Keep in mind that lots of people get into trouble with credit cards by spending more than they can afford to pay back. The best way to use a credit card is to use it only once every month or two, for small purchases like a tank of gas. That may not sound like enough account activity to build a good credit score, but believe it or not, this is one of the best ways to build your score. Here’s why: since a credit card or other revolving account is considered a good type of credit, it contributes to the “Types of Credit Used Factor."
Just like an installment loan, your brand new credit card will slightly drop your score and reduce your total “Length of Account History”; however, unlike installment loans, you can keep revolving accounts open forever! This does something very positive to your credit. It reduces the need for new loans, and as your new credit card account matures, it begins to add significantly to your “Length of Credit History” factor. A revolving account that is 10 years old or older is considered “golden” which maximizes your benefit from this factor.
Also, "Payment History" is very easy to keep up with since the balance is relatively low, and you may pay it off each month. This makes it easier to build a positive “Payment History” with a revolving account as long you make your payments on time.
"Amounts Owed" is affected by your current balance compared to the maximum potential balance. Some people who get a credit card can’t wait to go out and spend the maximum amount. Not only is this expensive, but it can also harm your credit score. A much better strategy is to always keep your balance low. For instance, if I use my credit card to pay for a single tank of gas every month or so, I will maintain a low balance of about 30 to 60 dollars, which is about 10-20% of the maximum possible balance on a $300 limit card. A consistent low balance like this is the best possible way to get the full benefit of your score from this factor. This essentially shows the credit score agency that you have the ability to borrow a lot of money, but you have the self-restraint to use only a small portion of it.
Keep in mind that you can pay those charges off by the end of the month or the grace period, and you don’t have to pay any interest or finance charges. It’s a common myth that you have to carry a balance from month to month and pay interest on a credit card in order for it to build credit.
Slide 10: (Interactive)
You've learned a few things about revolving loans. Let's take a moment to check what you've learned.
[TRUE or FALSE] Revolving loans can be the most effective and cheapest way to build a good credit score. This is TRUE.
[TRUE or FALSE] A co-signer is NOT at risk of harming their own credit score. FALSE. A co-signer IS at risk of harming their own credit score when they co-sign for you.
[TRUE or FALSE] Making a minimum payment is the best way to use a credit card. FALSE. Paying the total amount in full at the end of the month, so no interest is gained, is the best way to use a credit card.
Out of all three types of loans, revolving accounts, or credit cards, can provide the most benefit to all five factors of your credit score, more so than any other type of loan. Plus, they are the only type of loan that can be used and paid in full each month so that you can avoid paying interest charges, while still building credit. Even if you never use another type of loan like an installment loan, you can still build a good solid score by properly using a few revolving accounts.
So there you are. Understanding credit and loans is not so tough is it? Let’s summarize what we’ve learned:
- You always avoid finance company loans because they will not build your credit score, and are extremely expensive.
- Installment loans will usually build mediocre scores, and will be expensive due to monthly interest charges.
- Finally, revolving loans have the highest capacity to build credit, and can be virtually free of interest charges if used properly.
As you begin building a higher credit score, you will see some remarkable benefits, like reduced insurance premiums, loan costs, as well as increased opportunities for buying or renting a place to live, finding utility and professional services, and even better opportunities for employment.
Thank you for participating in this presentation. We hope you will find it useful and relevant to your life.
A special thanks to the U of I Extension office for their content expertise.