When businesses are considering whether to extend you credit-whether a bank, a credit card company, a mortgage company, even a landlord to whom you’ll owe rent-and under how favorable or unfavorable terms to extend it to you, they base their decision largely on your track record, which is to say how you’ve handled credit in the past. So unless you intend to never seek credit in the future, or do anything else (like apply for certain jobs) where people will judge you on this record, you need to care about your credit report, which means caring about your credit history.
In order to build a good credit history, what you don’t do is as important, or really more important, than what you do. So the number one factor to keep in mind is to avoid doing the sorts of things that constitute red flags on your credit report.
Most of these are pretty obvious. Filing for bankruptcy, needless to say, heads the list. Missing payments, having accounts go to collections, and going over your limit on a credit card are other examples of things that damage your credit.
Another one that’s maybe a little less obvious is reaching a settlement with a company to pay them less than the balance owed. For example, if you are struggling to pay a $1,000 credit card bill and the company fears you may declare bankruptcy or otherwise stiff them entirely, they might be amenable to a lump sum partial payment-say $700-to settle the matter. Pay them $700 all at once now, and they’ll close your account and not come after you for the other $300. The problem with this deal from the standpoint of your credit history is that this gets logged onto your credit report as a $300 remaining balance that you never paid. Other companies then see that at least once in your history an account was closed on you when you only paid part of what you owed a company.
Avoiding these negative hits on your credit is mostly a matter of common sense precautions. Be disciplined in your use of credit, live within your means, defer gratification, don’t spend money you don’t have that you anticipate you might have some time in the future, etc.
But companies check your credit report not just to see if you’ve handled credit poorly in the past, but to see if you’ve handled it well. So what factors tell them you’ve handled credit well and are a good risk to them?
* Long credit history.
The longer you’ve had credit, the better. So if you’re young and don’t have any credit history at all yet, don’t wait. When you’re trying to get a mortgage at age 30, you’ll wish you had had continuous credit since age 18 rather than age 29.
* Long credit history with the same active account.
Let’s say you have two credit card accounts in good standing with $10,000 limits, one that you obtained in 1995 and one that you obtained in 2007, with pretty much all the same perks and interest rates and such, and you are going to close one of them because you really don’t need as much credit as you currently have. Strategically, you should close the 2007 one, because it looks especially good to have an active account from 1995 to the present.
* Moderation in amount of credit available.
On the one hand, the more credit you’ve had without screwing it up the better. If you’ve had a lot of credit available to you for twenty years and never gotten in over your head accessing it, then that looks very good. On the other hand, you don’t want your history to look like you’ve taken advantage of every bit of credit offered to you, that you’re already so potentially overextended relative to your income that a company will be taking a risk by giving you even more credit. If you make $40,000 a year, but in principle if you maxed out all your credit cards you could go $200,000 in debt, companies see risk there.
So be strategic in obtaining credit, and be strategic in closing accounts when you’ve got more than you need. Use moderation in both directions though. If you have credit limits totaling $50,000 and you can live with $10,000, that doesn’t mean you should go out today and close all your accounts except one with a $10,000 limit. Any major changes in your credit history like that look suspect. Companies will wonder what caused this mass closing of accounts. So don’t add an excessive amount of credit all at once, and don’t cancel an excessive amount of credit all at once.
* Variety of types of credit.
All else being equal, it looks better to have a history of success with multiple forms of credit than just one. A person whose only credit history is two credit card accounts with $5,000 limits won’t impress quite as much as a person with a credit card account with a $5,000 limit and a $5,000 automobile loan.
* Moderation in amount of credit used.
Even if you have always managed to pay your bills on time, companies can still be wary if you’re carrying a lot of debt already. If you have $30,000 in credit available on your credit cards, and you owe $28,000 currently, and that’s why you’re seeking more credit now, companies have to wonder how long you’ll be able to live life on the financial edge like that.
* Use your credit.
On the other hand, your credit also won’t look as good as it could if your accounts are all lying dormant. If you’re using credit all the time, and paying it off all the time, you have a much more impressive track record than someone who never is late paying his bills because he never uses his cards. Even day-to-day things like groceries you can get in the habit of paying for with credit. If you then pay the charges off right away, you won’t even have to pay any interest. In fact, with most cards you’ll probably get some kind of rebate or airline miles or other perk.
* Monitor your credit report.
Legally you’re entitled to see any or all three of the reports kept on you by the three main credit bureaus-Equifax, Experian, and TransUnion-free once a year. The reason it’s important to check these periodically is that mistakes are quite common. You want to know anything negative on your report-accurate or inaccurate-so you can deal with it promptly.
In summary, in order to build good credit, use credit but not excessively, avoid getting a large amount of credit all at once or canceling a large amount of credit all at once, use a variety of types of credit, keep at least some accounts active as long as possible, make sure your credit report reflects your responsible use of credit and is free of errors, and most importantly, avoid late payments and non-payments. You want your credit report to tell a prospective lender: “No need to be concerned about me. I’ve been using credit responsibly for years.”