Building Credit History

Some day you will graduate. And you will have a fancy job. And you will want to buy a house. The bankers, see, they don’t care that you have a Ph.D. When you go ask them for hundreds of thousands of dollars in loan, what they want to know is how reliable you are and how safe their money will be in your hands. That’s where having a good credit score comes in handy. (I remember reading that these days, even jobs, insurance rates etc are tied to the credit score. Since I don’t know enough about that yet, I will leave that topic for some other post.)

I cannot emphasize enough about how important it is to have a good credit score. So here’s an example. On a 30 year mortgage of $200K, 0.5% increase in your interest rate can mean $23K extra paid in interest, a 1% increase in interest rate translates to $47K extra dollars in interest and 2% increase in interest rate equals a whopping $95K additional dollars paid by you. The bankers save their lowest interest rates for the best credit score. So, you see my point right?

Here are some rules for building a good credit history

  • Start Early. It is not clear what the exact formula is used for calculating your credit score, but the age of the account is a definite parameter. If you are not sure if you qualify for a credit card yet, start with a store card or a student card (Update 12/28/2006: Look here for a well-written review of the current best student card). The interest on these cards will likely be very high, but that should not matter to you because of the next rule

  • Never charge more than what you can pay off in full every month to your credit card. If you lack the discipline to follow this rule, then keep your credit card at home and don’t take it anywhere with you, EVER. Set one of your recurring bills (eg. utilities, cell phone bill etc) to get direct billed to your credit card, and when your utilities/phone bill comes in every month, instead of paying it, pay your credit card immediately (This can easily be done online for most cards these days). Apart from the initial set up, nothing else changes and you will be able to build good credit score without risking defaulting

  • Never use the full 100% credit limit even if you can pay it off in full. 100% card utilization will bring your credit score low. Try to keep the utilization below 50%. And certainly Never go over limit! . You need to be particularly careful if this is your first card and it came with a low credit limit to make sure you do not accidentally overcharge it

  • Never ever be late with your payments. This is where being able to pay the card online will come in very handy. Also, some credit cards allow you to choose your statement date. When I was a student, here is what I did. I contacted my credit card companies and requested my statement date to the end of the month so that the payment is due by the 15th of the next month. I set a monthly reminder for myself (through yahoo reminders) for the 1st, so I would pay both the rent and credit cards on the same day. That way, I would never be late.

  • Do not apply to a lot of cards Look on the Internet and find out which card is the best for students (Update 12/28/2006: Look here for a well-written review of the current best student card) and apply only to one card that you have a good chance of getting accepted. Once your receive your card, wait for at least a year or so before applying for another card

  • Do not close old credit cards. Say after a year you apply for another card and receive much higher limit and much lower interest. Do not close your first card. Use it infrequently to avoid being closed due to inactivity. The reason is, closing that card will bring the average age of your credit history down

  • Take measures to protect yourself from identity theft . Keep you card in a safe place. Either file away monthly statements in a safe place or make sure to shred them before disposing them. If you receive mails soliciting you for “pre-approved” cards (you will likely start getting some of these “junk” mails once you get approved for one card) and you don’t want to use them, shred them before disposing them. Check your credit score annually for free at My ex-roommate's spouse was a victim of identity theft – believe me you cannot afford to have your credit score thrashed by some low life!

  • If you are married, repeat above for spouse . Credit score is for individuals. It will help in the future if both you and the spouse have pristine credit scores. Suppose you want to apply for two separate loans, say one for the car and one for the house, then you can take the two loans separately on each of your names and avail the good interest rates. Also, in the unfortunate event that the primary head of the household dies, it will help for the other person to have their own credit history.

Wow, that is one long post! And these are just the basic rules. There’s a lot of other interesting aspects to credit cards (fees, rewards, bonuses etc etc). We will just have to come back to it in another post, i guess :)

To read the benefits of good credit history and large credit lines, check out this post.

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Yan said...

Very interesting. I have heard though that carrying a small balance may help. I myself never did that though. It took me around 5 years (and 2 cars) before I was able to get a house loan at a decent interest.

ispf said...

Hello Yan,

I am strongly against carrying balances. Having fallen in that trap once before, I do all I can to avoid carrying a balance (unless it is a 0%BT and I have the proceeds parked in a safe place earning me some interest :) That said, my understanding is that "requiring to carry a balance" is a myth. If you make your payments on time, then it will show revolving credit but low utilization, which is GOOD for building a high score.

Jonathan said...

Here is the breakdown for how FICO credit scores are created:

Payment History - 35%
Amount Owed - 30%
Length of Credit History - 15%
Recently Opened Cards/Inquiries - 10%
Types of Credit ( mortgage,home equity line, credit cards, etc ) - 10%

I have more details on

Great blog!

Jonathan Leto

Corey said...

Here is another great article about building credit....