5 Steps to Building Your Credit from Scratch

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Few aspects of your financial life are quite as important as your credit score. This little three-digit number directly determines your borrowing power. Whether you're applying for a credit card, mortgage, auto loan or any other form of credit, the most competitive terms and interest rates are typically reserved for those with the highest credit scores. If your score is too low, you could be denied altogether.

Starting with a clean slate? If you've never had any credit attached to your name before, the answer is yes. Many recent grads and young adults find themselves in the situation where they need to open new accounts (such as setting up electricity in a new apartment), but lack the credit history to get approved.

The silver lining is that it's more than possible to build your credit from scratch. Read on for five expert-backed ways to establish a solid credit score from the ground up.

How to build credit from scratch

Check your credit report

"Square one would be verifying first and foremost that you are working with a blank slate, or are at least aware of what's on your slate," Thomas Nitzsche, a credit educator for Money Management International, a nonprofit credit counseling agency, said. "Start by checking your credit report and making sure there's nothing unexpected on there that needs to be disputed."

Research from the Federal Trade Commission (FTC) found that 26% of consumers identified a potential error on at least one of their credit reports. You can pull your credit report from each of the three credit bureaus for free once a year at AnnualCreditReport.com. Making sense of your report can be tricky, but this handy guide can help you break down what it all means and provide instructions for disputing any errors you may come across.

Errors come in many shapes and sizes, from incorrect personal information to outright fraudulent accounts. Give your credit score a fighting chance by getting rid of erroneous information that may be dragging it down.

Opt for a secured credit card

Once you know your credit file is clean, you can begin establishing new credit. The best way to do this is to open new accounts, and then keep them in good standing. This demonstrates to lenders that you can be trusted to responsibly manage your credit. The problem is that if you don't have much of a credit history, getting approved for a regular credit card can be difficult; it's a classic Catch-22.

Enter secured credit cards, which require cardholders to put down a cash deposit from the get-go. If you put down an $800 deposit, for example, you'll be able to charge up to $800 in purchases. From there, you make monthly payments like a regular credit card that the lender reports to the credit bureaus. Just be warned that many secured credit cards come with high interest rates, making it a bad idea to carry a balance from month to month. (More on this shortly.)

"It's a way for people who can't get credit to build their credit," Steve Repak, a certified financial planner (CFP), CFP Board ambassador and author of “6-Week Money Challenge,” said. "Just be sure to shop around because there may be fees, charges and things like that to consider."

Become an authorized user

Another way to build your credit from scratch is to have a creditworthy person you trust add you as an authorized user to one of his or her credit cards. As you use your co-signed credit card responsibly, your credit score should rise in kind. The most important part of the equation is to partner with someone who has reliably good credit habits.

Repak warned that if the cosigner makes late payments, for example, it'll reflect badly on your score. He added that you'll also want to make sure that the creditor will indeed report your cardholder activity to the credit bureaus. Not all of them will, which defeats the whole purpose of becoming an authorized user.

Open a traditional credit card

Maybe you started with a secured credit card or as an authorized user on someone else's credit card. Once your credit history is strong enough, you can apply for a regular credit card in your name. You may not qualify for the most stellar rates right away, depending on your credit file, but Nitzsche said a subprime credit card may be within your reach.

These are credit cards that typically have lower credit limits and higher interest rates — not exactly ideal, we know, but you have to start somewhere. And if you pay off your balance in full every month, you won't get stuck in a high-interest debt hole. What's more, as your credit improves, you'll eventually qualify for credit cards with more favorable terms. Aside from regular credit cards, Repak said opening a gas card at your local gas station is another easy way to build your credit.

"Every time you use your gas card, you take money from your checking and you move it over to your savings," he said. "At the end of the month, you move that money back into your checking account and pay off your bill in full."

Keeping that money out of sight in your savings account will make you less likely to spend it before your bill comes due. Repak recommends a similar strategy for regular credit cards: Only charge purchases that you've already budgeted for, then pay off the balance at the end of each billing cycle. Keeping a running balance from month to month means getting hit with interest charges, making it all too easy to get caught in an endless debt cycle.

Research credit-builder loans

Looking into a credit-builder loan is another way to jump-start your credit. Available through some online lenders, credit unions and local banks, the lender will usually deposit a set amount of money into either a certificate of deposit or savings account. From there, you’ll make monthly payments, with interest tacked on, for a predetermined amount of time before those funds are released to you.

"They can be a little hard to find, but the local United Way should be able to refer you to a partner agency that offers them," Nitzsche said, adding that some local credit or housing counseling organizations may also be able to point you in the right direction.

4 Bad habits that can hurt your credit

Missing payments

"Credit works like trust; it takes a long time to build it, but a very short time to mess it up," Repak said. "At the end of the day, the most important thing to do is make sure you pay your bills on time."

This is a biggie, as your payment history makes up 35% of your FICO Score. When you fall behind on payments, the creditor will report that delinquent activity to the credit bureaus, resulting in a lower credit score. It's vital that you keep all your accounts in good standing, not just the ones that report your activity. While your landlord, cell phone provider or doctor may not report your positive behavior, they can still report your negative payment history to the credit bureaus.

Charging up more than 30% of your credit limit

How much you owe across all your open accounts determines nearly one-third of your FICO credit score. This is why experts recommend keeping your credit utilization ratio at or below 30%. In other words, don’t charge up more than 30% of your credit line. Maintain balances that exceed this threshold, and you run the risk of dragging down your new credit score.

Again, the best way to use credit cards responsibly, and boost your credit score in the process, is to only charge purchases you're able to pay off in full each month.

Not diversifying your credit accounts

Because credit mix represents an additional 10% of your FICO Score, it's important to keep some diversity in your open accounts.

"You don't want to have all revolving credit because that's kind of dangerous," Repak said. "Banks may worry that you could max them out at any time."

A healthy credit profile is one that has a mixture of credit accounts, from credit cards to installment loans like student loans, auto loans or a mortgage.

Applying for a bunch of credit all at once

Now that you're ready to get your credit up and running, be sure not to apply for a bunch of new accounts within a short time period. Credit applications usually result in a so-called hard inquiry into your credit file. According to FICO, single inquiries don't usually have a huge impact, but the story may change if there are multiple back-to-back inquiries. It suggests to lenders that you may be a risky borrower, which could lower your credit score.

"Do your research and maybe pick, say, your top two because too many applications will ding your credit," Repak said.

The key takeaways for building credit from scratch

Building your credit from scratch isn't an overnight process. But those who are patient, and handle their credit responsibly, will reap the rewards of their hard work.

"Beyond that, it's really just more about maintenance and building over time, and then graduating to whatever the next product is," Nitzsche said.

The key is to take it slow, make on-time payments, keep your credit utilization ratio in check, and diversify your credit profile.

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