Updated March 04, 2020

How to Build Credit From Scratch

Credit Score

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We all know that one oddball friend or family member who lives completely by cash and has never had a credit card or loan.

They’re fiercely independent and swear up and down that their life has been better thanks to never owing “the man.”

Nobody wants to have bad credit. But is it really a good idea to have no credit at all?

Why Do You Need Credit?

Building credit is important even if you prefer to pay “cash on the barrel” and have no real intention of ever borrowing much money. But credit building can have implications beyond borrowing. That’s why it’s important to work on ways to build credit even if you see no apparent need.

For example, when you apply for a job, one of the criteria that will be investigated is your credit. Employers today routinely pull credit reports on applicants.

It’s possible having a blank credit report won’t hurt your candidacy. But there are situations when it might. For example, when a particular job may involve financial responsibility, the employer may want to see a credit report with a healthy credit score.

Another reason to have good credit is if you want to get an apartment. The landlord or apartment manager will investigate your report. With no credit history at all, they may be reluctant to rent to you.

Still another situation is when you apply for insurance. Both life insurance and auto insurance companies routinely pull credit reports. This is done not only to determine your acceptability for the policy, but also in setting your premium rate.

And finally, one day you may want to apply for credit. It may be a mortgage to purchase a home, an auto loan to buy a car, or simply a credit card for online purchases or international travel.

If any of these situations apply to you – and eventually several will – how to establish credit will be an important issue in your life.

How to Build Credit When You Have No Credit

There’s a bit of a conundrum here. To get credit, you need to have an established credit history. But if you don’t have that history, it’s extremely difficult to get credit. And if you can’t get credit, you can’t build a credit history. See how that works against you?

So, if this describes your situation, what’s the best way to build credit?

Fortunately, there are some ways to build credit that can help you if you use the right strategies.

Here are some of those strategies.

Apply for a Credit Builder Loan

This is a loan arrangement specifically designed for those who have either no credit or poor credit. It’s an opportunity to build a credit rating or improve on an existing one.

Credit builder loans work by providing you with a fully secured loan. Now, what happens if you don’t have any security for the loan? No problem!

With a credit builder loan, the loan amount and the security are the same. The lender will provide you with a loan – say, $1,000 – and the funds will be deposited into an interest-bearing savings account that serves as security for the loan.

You won’t be able to touch the funds in the savings account until the loan is fully repaid. And repayments can be made through direct draft out of a savings account. In that way, your payments are made automatically, ensuring on-time payment.

By the time the loan has been fully repaid, the savings account will be drained completely. You’ll also have to pay an out-of-pocket amount to cover the interest on the loan.

Even though the payments are automatic, the lender will still report your on-time payment history to all three credit bureaus. That will give you a positive credit rating, both as the payments are being made on time, and when the loan is fully repaid. At that point, it will show up as a paid loan, which is a very strong plus for your credit score.

You don’t need to have a credit score to be eligible for a credit builder loan. They’re typically offered by banks and especially credit unions. But you’ll need to open a checking account with the institution to qualify for the loan.

Check to see if you can arrange a credit builder loan with your bank or credit union. If not, here are a few loans worth exploring.

Examples of Credit Builder Loans

SelfLender is a popular credit builder program. It offers these terms:

  • Loans for $525, $545, $1,000 or $1,700
  • Plans for 12 or 24 months
  • Avaiable in all 50 states
  • Payments are reported to TransUnion, Equifax, and Experian

Another good example is the DCU Credit Builder Loan. It comes with the following terms:

  • Loan amount up to $3,000
  • Terms of 12 to 24 months
  • Fixed-rate loan, starting at 5% APR
  • Earn dividends in the securing savings account
  • Payments are reported to the credit bureaus

If you use a credit builder loan, it will take you several months – usually between six and 12 — before you begin to develop a credit score. And naturally, your credit score will get a big boost when the loan is finally repaid in full.

If you really want to make credit builder loans work for you, set up two or three at the same time (but with different lenders). The credit bureaus usually like you to have at least three credit references, so credit builder loans can make up two or all three. It’s probably the single best way to build credit.

Apply for a Loan With a Co-signer

Apart from a credit builder loan, it will be very difficult for you to get a loan on your own. But you may be able to qualify for various types of financing if you apply with a co-signer.

When lending institutions make loans, they evaluate the risk of the loan being repaid. If you have no credit, they’ll have no basis to approve the loan. After all, you’ll have no history indicating you’re capable of successfully managing credit.

But if you can add a co-signer — one with a well-established credit history — the same lender may approve your loan.

This will generally work best with installment loans, such as auto loans. Since installment loans are typically secured by collateral, they’re even less risky. The addition of a co-signer may be all that’s needed to get approval.

Even if you do get a co-signer, be sure to make all your payments on time. If you’re late on any payments, it will not only hurt your credit rating, but also that of your co-signer.

And should you default on the loan, it would become the responsibility of your co-signer to pay it off. That will not only ruin your credit score – and that of your co-signer – but it can also damage your relationship.

Just like a credit builder loan, a co-signer loan will need to be in effect for several months before you begin to get the benefit with your credit score. But this is one of the best ways to build credit, so be patient and be sure to make all your payments on time.

Become an Authorized User

This is not as effective a strategy for how to build credit as credit builder loans or getting a co-signer on an installment loan. But it can be a good way to build credit.

The strategy works best on credit cards. Another party is the applicant and owner of the credit card account. Qualification is based on that person’s credit and income. But he or she adds you to the card as an authorized user.

That means that, while you are authorized to use the credit card account, you have no responsibility to make the payments.

Even though you have no obligation to make the payments, an authorized user account can show up on your credit report and have a positive effect. This is particularly true if you have other loans in good standing on your credit report.

Caveats with authorized user accounts

However, being added as an authorized user on a credit card isn’t a perfect solution. There are several potential limitations:

  • Credit card issuers don’t necessarily report activity for authorized users since they don’t actually make the payments.
  • If the owner of the account makes late payments – or worse, defaults – the arrangement may not hurt you, but it won’t help you either.
  • Authorized user accounts have less weight in calculating your FICO score. That’s why they may work best as a supplement, and not as your primary source of new credit.
  • Authorized user accounts can affect your credit utilization ratio. The debt owed on the card — even if it isn’t yours — will be counted toward your total debt owed. If it’s a large amount, it can have a negative impact on your credit score.

Due to their limited impact on your credit score, authorized user accounts can work as a supplement but should never be your primary strategy for establishing credit.

For College Students Only: Apply for a Student Credit Card

Some credit card issuers, anxious to acquire future business from soon-to-be college graduates, issue student credit cards. This is something of a mixed bag, because some will require a co-signer on the card, while others will enable you to apply on your own.

But either way, it’s an opportunity to begin building your credit and credit score.

If you’re able to apply for a student credit card on your own, you’ll typically need to be at least 18 years old, be an enrolled student, and have a regular income.

Some credit card companies require a certain minimum monthly income, like $1,000. But it’s possible to earn that much working a part-time job. And if so, you’ll be able to qualify for the card without a co-signer.

If you’re concerned with how to build credit, there are a few important factors to keep in mind:

  • Student credit cards are for people have no credit or a limited credit history. If you already have a credit history, and it’s not good, you probably won’t qualify for the card without a co-signer.
  • You must make your payments on time. Simply having a card doesn’t build your credit score. Having a card and making your payments on time is what counts.
  • Be careful not to get overextended. Not only will that hurt your credit score in the short run, but it will also open the possibility of default if you get too far behind.

A Last Resort for Building Credit: Credit Cards for People With No Credit

I even hesitate to include this category in a discussion of how to build credit. That’s because, while it does have the potential to build credit, it comes with very severe restrictions. You’ll have to weigh out those limitations against the benefits these cards provide.

They come in two flavors, secured and unsecured.

Secured credit cards

Between the two, secured credit cards are usually the better option. They charge lower fees, you’re often working with well-known banks, and they have reasonable interest rates and fees.

Of course, the primary limitation of secured cards is that your credit limit will be determined by the amount of your security deposit. They work very similar to credit builder loans, except that you can’t use the loan to provide the security for the credit line.

If you have only $200 available, your credit limit will be just $200. That doesn’t buy too much purchasing power at today’s price levels. And even if you have a larger amount to pledge as security, like $2,000, you’ll lose access to those funds in your savings account.

Unsecured credit cards

Unsecured credit cards have the advantage that you don’t have to pledge security for the credit limit. But that’s about the only advantage they have over secured credit cards.

Unsecured credit cards typically start out with very low credit limits. You should expect no more than $300. But that’s compounded by the fact that they charge high annual fees. For example, a typical arrangement is a $75 annual fee in the first year of owning the card. After that, it rises to $99 per year.

The high fee is bad enough. But what makes it worse is that it’s deducted upfront. Let’s say you start with a $300 credit limit. If there’s a $75 annual fee, it will be immediately deducted from your credit limit. That will leave you with just $225 available on your card.

From a financial perspective, unsecured credit cards are mostly a disaster. The one thing they will do, however, is help you to build a credit score. If you have no other way to get credit, and you want to begin building credit, unsecured credit cards are an option.

As a final word on unsecured credit cards, they’re really designed more for people with poor credit than those looking for the best way to build credit. You should exhaust all other options before resorting to these cards.

Final Thoughts on How to Build Credit

Admittedly, it can be difficult to establish credit from a standing start. But if you want to get the job done with the least amount of difficulty, start with credit builder loans or apply for a loan with a co-signer. If you’re a student, you should certainly try student credit cards.

Being added as an authorized user on someone else’s credit card can help, but it’s hardly a complete solution. And if all else fails, save secured credit cards and unsecured credit cards only as a last resort.

Finally, be patient. It can take a year or more to build a respectable credit report. Open new accounts gradually, make all payments on time, and give the strategy plenty of time to work effectively.

Kevin Mercadante

Kevin Mercadante is a freelance personal finance blogger and the owner of his own personal finance blog, Out of Your Rut.  A recent transplant to New England, he has backgrounds in both accounting and the mortgage industry.

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