Building a Credit History
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Books on personal finance used to have a chapter on building a credit history, because it used to be harder to do. Young people used to find themselves in a classic chicken-and-egg situation, unable to borrow money without a credit history, but unable to build a credit history without borrowing.
Things changed about twenty years ago, when the credit card industry started giving anyone who could scrawl their name a credit card. That's become a little less true since the financial crisis, but only a little.
So, it's pretty easy nowadays to build a credit history. Even so, it's worth giving the topic some careful attention, because building a good credit history can save you a lot of money over the course of your life. (See also: How Debt Fools People)
How to Build Your Credit History
The procedure is easy. There are three steps:
- Borrow money
- Make payments on time
- Make the last payment a little early
As I say, that first step used to be tricky, back when lenders insisted that their borrowers be credit worthy. Nowadays, it's not so tough.
Don't just skip to the last step, though. You might imagine that you could just borrow some money, then pay it back, and you'd be done. But that's not the sort of credit history that borrowers want. What they really care about (and they care about it more deeply than you might imagine) is that you can make payments on time.
They care for two reasons.
First, because a proven ability to make the payments turns out to be a very good indicator of your ability to eventually pay the money back, even if you run into problems. (That is, they're not interested in your ability to borrow money, stash it in a bank account for a month, and then pay it back.) They care about your demonstrated ability to be organized enough to get the payments made. They care about your demonstrated willingness to make the little sacrifices needed to make the payments even when there's some glitch in your income or an unexpected expense.
Second, that's how they make money. A borrower who pays the money right back is of no particular interest to a lender, because he or she pays much less interest.
Making the last payment a little early is no longer as important as it used to be, but it can't hurt. (It was important back in the days when the records were kept on paper — when an actual person had to look down a row of entries in a ledger to see if your payments had been made on time. Lazy people would just check that you made all the payments, and then check that the loan was paid in full by the due date.)
Building Your Credit Score
Be aware that your credit history is only one piece of minimizing your borrowing costs; you also want a great credit score.
Happily, if your credit history shows you can make monthly payments on time, you're most of the way there.
The other important factors for your credit score are:
A Longstanding Credit History
If all your debts are new, it hurts your credit score. Solution: Keep your oldest credit card active.
Plenty of Available Credit
If your cards are maxed out, it hurts your credit score. Solution: Don't approach the limits on your cards.
Few Credit Checks
If your credit history is checked by multiple potential lenders, there's no way for the lenders to tell if you're just shopping around, trying to get the best deal on a loan (fine), or desperately trying to arrange more credit because you're overextended (not fine). Solution: When shopping for additional credit, apply to a small number of lenders, and apply to them all at once.
A good credit history and a good credit score can save you a huge amount of money on a mortgage and a modest amount of money on a car loan. But remember — you're just "saving" money compared to what it would cost to borrow if you had a crappy credit history. In actual fact, borrowing costs you money, no matter how good your credit history is. The real way to save money is not to borrow in the first place. That's not to say that credit can't be a reasonable choice at certain times — it's just never the cheapest choice.
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