I get asked this question a lot. This is one thing that is lagging behind the ‘recovery’. The
rates are great, there are a lot of homes for sale, but a lot of people have messed up credit – or, in this case, no credit at all, and they can’t qualify for a mortgage.
I talk to a lot of people that say “I’ve just always paid cash for everything”. While this is a very commendable way of making sure that you live within your means, and I would never criticize it, it doesn’t help you when you find something a little too big to pay cash for – like a house.
Just to be clear. I am not a credit counselor or credit repair expert. I am a mortgage loan officer with years of experience looking at credit reports and helping people qualify for loans.
So, how do we establish credit for the first time?
The first thing to know is that not every type of credit shows up on your credit report. Cell phone bills, debit cards, gift cards, rent payments, cable bills, etc. DO NOT show up on your credit report and do not help establish your credit scores. The story that I hear too often is the individual who thought that because their rechargeable gift card said VISA on it that it was a credit card.
The things that usually do show up are: car loans, student loans, and credit cards. And, of course, anything negative will certainly show up even if it isn’t one of the items on the list.
But, we are assuming in this example, that you have no credit at all, and no negative items either (medical bills, satellite TV collections, etc).
So, we are going to focus on the things that show up. But, even better than that we are going to focus on the things that have the most impact. And that means – credit cards. Installment debt is okay (car loans, student loans, etc.), but it doesn’t trigger the credit calculation apparatus the way that credit cards do. Just briefly, that is because the algorithm that they use seems to be most impacted by the concept of “credit utilization”.
Credit cards are the best way to analyze credit utilization because they have both a credit limit and a credit balance. Divide your balance by your limit and you have your utilization in a percentage. A high credit utilization percentage is bad, and a low one is good.
This is what we are going to do.
1. Get a credit card – right away if you haven’t already. The clock is ticking.
This is where I hear “no one will give me a card”. And I say, “if you don’t have messed up credit then someone will give you at least a “secured credit card””.
A secured credit card is basically a starter card with a small credit limit where you are required to keep an amount equal to that credit limit in an account with the issuer. That is how it is ‘secured’, by your ‘collateral’ so to speak. For the purpose of establishing credit, it doesn’t matter how high the credit limit is. It is about credit utilization and that is a percentage. We’ll talk about that in a minute.
Also, if you get the card from a smaller company – like your bank – make sure that they report to all three credit bureaus. The large credit card companies all do, so you are safer there.
2. Use the card regularly.
It is important that your card generates a billing every month. We don’t want it to become dormant. How long can it go before it becomes dormant? I don’t know, but I want to have you create a sustainable habit so that we don’t have to find out. After you close on your home, I don’t care if you ever use the card again!
3. Don’t let the balance get above 30% of the credit limit.
I know that sounds hard if the credit limit is only $300. That means I want you to never have more than $90 on the card? That’s right. Remember, you aren’t going through this process to all of a sudden become popular with all the retail stores that are so impressed with your ability to pay with a credit card. You are doing something VERY STRATEGIC to show the credit bureaus – and my underwriters – that you know how to handle this new toy called credit. You are proving yourself with something small so that you can be entrusted with something big. Got it?
“You mean, spend my whole limit and then pay it down to 30% when the bill comes?”
How can I say this, “”NO, NO, NO, NO, NO, NO!””. You must KEEP the balance low. You never know what day your credit card company will report to the credit bureaus. If your balance is high that day, even if you pay it down the next day, what they report that day is the number you get until the next month. The other problem with the “run it up, and pay it down” approach is that I’ve seen too many people “run it up” and “oops!” they can no longer “pay it down”.
I have been told by credit experts that having a small balance on the report is better than a zero balance. So, a lot of people are told erroneously not to pay off their entire balance when the bill comes. Most companies give you a grace period on interest if your balance is paid in full. So, here is what you can do. When the bill comes, you pay the entire balance and then go out and charge a few dollars on the card. That way there will always be SOMETHING on the card, but the BALANCE will be paid in full. Make sense?
4. Pay your bill – on time.
This may seem like common sense, but I don’t want to leave it out because it is too important. If you do all of the above and then forget to pay your credit card bill when it comes due, then you have just wasted all of this time. Because the one thing more prominent to the credit score calculation than credit utilization – is late payments.
With this approach, you will have 3 solid credit scores within 6 months. It used to be faster, but that seems to be what I have been seeing for the last couple of years. It’s worth the wait. And it is worth the effort.
Yes, you too can enjoy the part of the American dream that is – home ownership!
I am not a credit counselor or credit repair expert. The information provided here is based on observations that I have made over the years and information that I have put together from those expert sources. There is no guarantee of exactly how much your credit will improve by following this advice or if it will be enough to qualify for a specific program.
Sources: credittechnologies.com, myfico.com, consumerfinance.gov