It seems like the original Catch 22: You need a credit history to get credit but you can’t build a credit history until you’re approved for credit. This modern-day financial conundrum isn’t as insolvable as it might seem. There are ways to build credit even when you’re just starting out in your financial life. You’ll need some patience and a focused mindset. It’s also important to understand which steps can help, which steps might actually harm your credit, and which steps may not move you any closer to your goal of building credit.

A recent study showed that forty-five million Americans don’t have a credit score.¹ This situation is often referred to as “credit invisibility” and it can cost you money even if you don’t plan to use credit.

There are two categories of credit invisibility. The first are people who don’t have any credit history at all. A second category includes people who may have some credit history but who are “unscorable” because their credit history is too thin to generate a credit score; they haven’t had credit long enough or don’t have enough meaningful entries on their credit history. Besides the risk of being denied credit in an emergency or facing higher interest rates, people with credit invisibility often pay more for everyday expenses like insurance or may have to make large deposits to start a contract with a service provider or utility.

Why building credit is important

Your credit score and your credit history — different, but related things — can affect many parts of your financial life. The most obvious effects are your access to sufficient amounts of credit to navigate an emergency, purchase a vehicle, or purchase a home. But even seemingly non-related areas like job hunting or purchasing insurance can be affected by your credit history. Prospective employers can’t access your credit score — but with your consent, they can access your credit history, which may affect your opportunity for employment. Insurers routinely use a metric they call an “insurance score”, in which your credit history is a meaningful factor.

With a strong credit history, you can lower your overall cost of living, possibly improve your earning ability, and reduce the cost of borrowing if you need to access credit.

Ask before you apply

There are three different credit bureaus that rate consumer credit history:

• Equifax
• TransUnion
• Experian

Not all credit card issuers report new account activity to the credit bureaus. This might be true of some store credit cards or specialty cards, like auto repair credit cards. However, negative information, like late payments or defaults, is likely to be reported. This means that some cards might not help you build a credit history but can hurt you if you miss a step. If you’re considering applying for a card to help build your history, ask if they report the new account and payment history to any or all of the credit bureaus. Be honest with the credit representative if you’re on the phone. Explain your goal. If that particular card doesn’t aid you in your goal of building credit, you may want to reconsider before applying for that card.

Debit cards can be used in ways similar to credit cards but don’t affect your credit score. Similarly, off-the-shelf prepaid cards neither hurt nor help your credit score. In both cases, these products can be convenient alternatives to cash but they aren’t true credit.

Bank accounts or credit union accounts

If you already have a savings or checking account with a bank or a credit union, this is often a good place to start a credit account as well. Typically, payments can be automated online to ensure that your credit payments are made on time every month.

Your bank or credit union may also be more flexible when approving credit accounts or have another solution for approval. Banks have an interest in expanding their financial relationship with existing customers, hopefully becoming your go-to source for other credit or investment products as you continue through your financial life. Credit unions are member-owned and have their own credit underwriting criteria. If you’re a member of a credit union, you may find it easier to be approved by your credit union then by other lenders.

Secured credit cards

If you have some cash that’s not committed but need to build credit, a secured credit card provides another option. As the name suggests, this is credit that is secured by your deposit. For example, you might make a $500 deposit which then grants you $500 in credit. Your payment history is typically reported to the credit bureaus but because the credit line is secured by your deposit, there is no short-term risk to the lender, making secured credit cards an easy solution to the credit history Catch 22. Secured credit card providers usually hold your deposit in an interest-bearing account until the credit card is converted to a non-secured card — or until you default, which hopefully won’t be the case.

Beware of the interest rate on secured credit cards. Many have interest rates approaching 20% to 25% interest, which can be costly if you carry a balance. If you choose to use a secured credit card with a high interest rate to help you build credit, consider only using it for small purchases that you can pay off in full when your statement arrives.

Prepaid cards

Secured credit cards and prepaid cards are often compared or even confused as the same product but there are some important differences. With both prepaid cards and secured credit cards, you’ll be required to make a deposit before you can use the card. What makes a prepaid card unique is that there is no credit granted to you. In essence, you’re spending your deposit when you use the card. Because you’re not actually borrowing, a prepaid card can’t help you establish credit.

Store credit cards

For many, the credit journey begins with a store credit card. In the past, department stores often became the first to issue a credit line. Now, some online retailers are filling the same role. Store credit cards often aren’t from major issuers, like Visa or Mastercard, and not all retailers report new accounts to the credit bureaus, so you’ll want to ask about the details before applying. It’s common for store credit cards to offer a discount off a first purchase or an extended payment offer, like “90 days same as cash”, which means you’ll pay no interest if you pay the balance in full within 90 days.

Store credit cards can be a pricey way to get started building your credit because the interest rates tend to be high. As with all types of credit, try to keep purchases small enough that you can pay the balance in full and demonstrate that you can use credit responsibly.

Credit builder loans

If you don’t have a credit history, a credit builder loan is another option to help you get started. Your payment history for a credit builder loan is reported to all three credit bureaus, so this type of loan can help you build credit but it’s important to make your payments on time. Where a credit builder loan differs from other types of credit is that you don’t receive the funds for your loan until you’ve paid off the loan. In effect, you’re loaning money to yourself but a credit union or another financial institution facilitates the loan and reports the timeliness of your payments.

Credit builder loans are usually between six months and thirty-six months and can be for a few hundred dollars or a few thousand. If you choose a credit builder loan, you’ll pay interest on the loan, part of which will be returned to you as dividends on your accrued funds.

Getting a co-signer

In most cases, there are ways to get approved for a starter line of credit based on your income but sometimes people choose to use a co-signer for certain types of credit. This is most common with auto loans. A co-signer is another person who helps you to qualify based on their credit and who accepts responsibility for making timely payments along with you. You’ll be making the payments, but the co-signer is equally responsible for being sure the balance is paid. Late payments or defaults can affect both your credit report and the credit report of your co-signer.

Life can be unpredictable and any of a number of financial changes can affect your ability to make timely payments. When using a co-signer, your temporary hardships can affect someone else so you’ll want to consider this carefully and explore your other options as well.

Become an authorized user on someone else’s credit

If you’re added as a user to someone else’s credit card, your credit history can benefit slightly but not as much as you would benefit from the credit you establish in your own name. Some credit issuers don’t report authorized users to the credit bureaus. Ultimately, you’re not the person responsible for making payments so the bump in your credit score is often minimal or none at all.

Student credit cards

Banks and financial institutions are eager to build relationships with college students, many of whom will be higher income earners in the decades ahead. To qualify for a student credit card, students usually just need to demonstrate the ability to pay the minimum monthly payment through income from a job or through other assets, like savings. Expect a low credit line to start and interest rates on student credit cards can be high. If you choose to utilize a student credit card, keeping your purchases small can help ensure that you’ll be able to pay the balance in full to avoid costly interest charges.

How to manage your new credit

Building credit isn’t as simple as establishing a credit line. There are a few considerations you’ll want to prioritize to help ensure the credit history you’re building is healthy.

• Credit utilization – Credit bureaus and lenders consider your credit utilization, which refers to how much of your credit you’re using in comparison to your available credit. If you have a $1,000 line of credit and you have a $300 balance, your credit utilization is at 30%, a level that lenders and credit bureaus will view favorably. By comparison, a 90% credit utilization may hurt your credit score. Carrying a larger balance also means you may not be able to pay the balance in full, which can lead to interest costs. In general, you’ll want to keep your utilization as low as possible while still using your credit occasionally to build history. Consider making small purchases that you can pay off in full each month.
• On-time payments – Credit bureaus are also looking closely at your on-time payment history. Late payments can affect your credit score for prolonged periods and can be particularly damaging if you’ve begun to build a higher score; a single late payment can drop your score by up to 100 points. Additionally, late payments usually result in additional fees and can trigger a higher interest rate.
• Limit credit applications – Multiple requests for credit can also affect your credit score. Every time you apply for credit, the result is a “hard pull” on your credit report. Inquiries by employers or insurers are “soft pulls” and don’t affect your score but a request for credit will have a negative effect so you’ll want to limit the number of times you apply for credit. Choose your credit-building strategy carefully to minimize the number of hard pulls on your credit report. This is one area where the “shotgun approach” can backfire. Choose your goals strategically and inquire about credit products carefully before applying.

Understand the true cost of credit

Credit is a tool, and like many types of tools, it can be useful — but can also be dangerous if not handled carefully. Establishing a good credit history can save you money and provide options for many of life’s expenses, including vehicles, housing, and insurance. However, credit can also allow you to live above your means artificially, a trick that can’t be done forever and that can cost thousands of dollars in interest over time.

According to recent reports, the average credit card holder who carries a balance is paying nearly $1,000 in credit card interest every year.² Consumer credit card debt is paid with after-tax money making it more expensive than tax-advantaged debt, like mortgage interest. That $1,000 in credit card interest might be the equivalent of $1,300 or more in taxable earnings. What could you do with an extra $1,000 per year?

Endnotes

1. https://files.consumerfinance.gov/f/201505_cfpb_data-point-credit-invisibles.pdf

2. https://www.thesimpledollar.com/heres-how-much-the-average-american-pays-in-interest-each-year/