Saturday, February 6, 2010

How Credit Is Built

When most people think of credit they think of credit cards and why not credit cards are everywhere and nearly everyone has one. So I often get the question "Will getting a credit card help build my credit?". Of course it will however if you are not careful it can do the opposite and help bring down your credit. So the real question is what is credit and how can we safely build it?

Credit Is Debt

It's really that simple credit is based on your ability to pay back debt in a timely fashion. Of course many things are considered in your credit report however all factors revolve around your history of repaying debt. Your credit report is composed of 5 major factors: Payment History, Credit Utilization, Length of History, Inquires, and Different Types of Accounts. If you want to read about how much each of the factors impact your credit click here.

So How Do We Build It

Well if credit is debt then you build it by going into debt its really that simple. Credit is based on your ability to pay debt and if you have it and pay on it on time your credit score will go up. Debt comes in many flavors such as credit cards, secured cards, car payment, mortgages, and student loans. The traditional way people build their credit is through taking on these debt's but there is another way.

Build Credit Without Debt?

 I know I said that credit is debt but I wasn't entirely truthful. I simply say that because traditionally credit and debt are synonymous. You have an option when it comes to building your credit. You can build your credit with a secured card. Basically you give the bank $1000 or so as collateral then you go about using your secured card and paying it off as necessary this will build your credit. However you can also build your credit by paying your utilities and rent on time. When you go to get a loan you ask your utility companies and landlord to provide you with  references and guess what you will have instant credit. This is a safe way to build credit.

Why Do I Need Credit

You only need credit to borrow money that is why you want credit, end of story. You want to borrow money to purchase of a house, car, start a business, or go to school.  Of these I only recommend borrowing in order to purchase a house. I know you will hate me for being so different, "But everyone borrows money for school or to buy a car". The truth is you can do it without borrowing for all of these things and in the end you will be better-off for it.

Build Credit For One Reason

If you want to build credit to purchase a house only you can do it without ever going into debt, well except for the house. I think going into debt for a house is acceptable. So here is how its done:
·         Save up 20% to put down on the house
·         Pay all of your utility bills on time for 2 consecutive years
·         Pay all of your rent on time for 2 consecutive years
·         Show stability by staying with the same company or same career for 2 consecutive years
·         Make sure the house is no more than 25% - 30% of your net income
This is how people bought homes before FICO. It is still done today there are companies that do their own underwriting the old fashion way. See what they do is they look to see if you can actually afford a house then check a few references and grant you a loan based on actually facts not just a number. The truth is you should be saving up and buying stuff you need but that can be difficult for a house so many of us borrow for a home.

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