How To Build Credit When You Don’t Have Any

To many young people, credit cards are like a "pull my finger" gag. It's all fun and games until you yank an index finger and end up in a flatulent cloud of financial doom. Arguably, previous generations viewed (and used) credit cards with less skepticism. Now, many millennials and Gen Z spenders see plastic as a gateway to destruction.

A 2016 Bankrate survey indicated that two-thirds of people under 30 had no "major" credit card, fearing the impact that misusing one could have, or stayed away after witnessing the negative experiences of people who relied on credit during the Great Recession.

Young people are right to be concerned about using credit irresponsibly, but avoiding CCs wholesale can spell trouble, too. Using a credit card is still the primary way to build a credit profile. Doing so can take time to establish, but it can also save you lots of money.

"The important thing with credit and why you should build it, is that you’re really just telling lenders how good you are at paying them back," says Shannon McLay, the founder of the financial planning company The Financial Gym. "That’s why you run the risk of having higher interest rates or not getting approved to begin with — because you get penalized if you haven’t showed it."

Here's how to get started on building a credit history if you're doing so for the first time, or want to make a comeback after hardship.

McLay says a lot of people in their early-20s avoid thinking about building credit because they aren't yet in the market to buy a home or a car, or because they want to focus on student loan debt. In reality, it can take years to build credit, so she advises starting sooner rather than later.

"When you do want to take advantage of having those things — a car or a house — a good credit score can impact you by the thousands of dollars. Even 10 to 20 points more on a credit score could mean thousands of dollars in interest you don't pay on loans."

People who are in legal partnerships and are seeking out loans can't rely on the partner with the higher score to even things out, either.

"If you’re married and are [seeking a loan] with a significant other, the bank will take the lowest of the two credit scores," says McLay. "So if one person has a 750, which is excellent, and the other person has a high-600s which is maybe good, your mortgage rate will be based off the lower score."

In the worst-case scenario, she adds, if one person's score is totally below the bank’s approval rate, you may be declined for the mortgage outright.

Paying off your student loans is kind of a one-way street: You may be penalized if you miss payments, but you don't get necessarily get benefits for paying them off.

"It depends on if your student loan servicer reports [your payments] to the credit bureaus each month, and then if they do, which credit bureaus they report to," McLay says. "Student loan debt is a different type of credit. With the former, you don’t really have a choice in the amount. But you have credit cards, you’re in more control [over the balance], and you’re telling a different story about how responsible you are about paying it back."

Additionally, McLay says, credit card companies tell credit card bureaus every month if you have "paid as due," while student loan servicers don't necessarily report with the same frequency — unless you miss a payment. You'll want to stay current with your student loans, but you can't rely on that in the same way.

If you’re new to credit, signing up for a secured credit card can be a great way to get going with a built-in buffer. Generally, the way it works is that customers pay money to a bank or lender upfront, using that cash as a limit in some cases, and as collateral in most. For example, McLay says, you might give a credit card company $100 in cash as collateral, and are then allowed to use up to $500 on the secured credit card.

This option is useful, but there are still some drawbacks. The first is that you must give up your cash first. The second is that your credit limit will be pretty low. The last is that you may have difficulty canceling the card and getting your money back. Because of the last two reasons, McLay estimates that only 5% of secured credit card users graduate to unsecured credit cards. One of the biggest problems she says they face is their apparent utilization rate.

"After your payment history, the largest component of your credit score is your utilization rate. To have a really good credit score, you should only use about 30% or less of your credit card." (So if you have a credit limit of $1,000, you should only use about $300.) "But people with unsecured credit cards [often] looks like they’re over-utilizing them because you could charge a plane ticket and you’re over the utilization rate," McLay continues. "It looks to the credit card company like they’re using too much of their available credit, percentage wise, when in reality, dollar wise, they just don’t have that much credit available."

As a result, she explains, people who use secured credit cards may often be rejected by credit card companies when they ask for an unsecured card. Or, they may have no choice but to keep their unsecured card open, as it is the only card reporting their credit history. That isn't a reason to avoid secured credit cards, McLay says, but it is something to be aware of.

"We tell clients that if a secured card is the way they’re going to go, get approved for it and then only put your phone bill on it. Most of us have cell phone bills and they’re about $100, so you won't go over your utilization rate. Put it on auto-payment, and let that do its thing for six months."

After that period, she says, check your credit score. People with scores in the mid-to-high-600s will be able to find "a number of credit card companies" that will consider them for an unsecured credit card. She recommends Ollo MasterCard as one company "focused on providing cards for relatively new users," and says that Capital One is "also very good about issuing unsecured credit cards to relatively new users."

"Start building the unsecured payment history, and then once that's [well-established], cancel the unsecured credit card and get your money back."

Sometimes building credit isn't about starting out for the first time, but starting over. People with maxed out credit cards, unpaid medical bills, and no access to new lines of credit fall into this category.

New credit cards are often unavailable to people who struggle to pay off existing ones. (Which is one of the reasons prepaid debit cards are ubiquitous among unbanked and underbanked groups.) But those with wrecked credit histories aren't shut out from the system forever, McLay says, even if the road back is rough.

Once someone is ready and able to start over with credit, she advises they start by reviewing their credit reports for any areas that need improvement. You can request a free copy of your full credit report once every 12 months from AnnualCreditReport.com. Go through that for any errors on your part, or mistakes by lenders, to see what you can fix.

Credit scores aren't as thorough as reports, but McLay adds that those can also clarify where improvements can be made. She suggests using free sites like Credit Karma or Credit Sesame for a credit score estimate. (Just make sure that you don't sign up for a recurring subscription.) Many banks now issue credit scores to their customers as well. Get in the habit of checking it at least once a month. Generally, if it goes up, you know you're doing something right. But if it goes down, something could be wrong.

"I had a client working on rebuilding her credit whose score was over 700. When we checked it this month, though, she was down 50 points," McLay says. "We pulled up all of her reports and it turned out that she’s a cosigner on a loan with her sister — and the sister didn’t make her loan payment that month. My client asked if her credit score could drop that much in a month, and the answer is yes. The biggest component of your credit score is your payment history."

McLay says these dips aren't permanent if the person pays the outstanding balance. If you miss a payment, she explains, you can work with the lender to change it back to "paid as agreed" and fix your credit score in the process. But once it leaves the lender and goes into collections, the damage is done.

"Even if you pay the collector, it won’t fix your credit score because the only one who can report on you [to the credit bureau] is that lender." The account will go into collections, and your credit score will face a more severe hit — one that takes seven years to be removed. If you get to that point, focus on a triage-style comeback instead of freaking out, McLay says.

"We see a lot of clients focus on paying off the debt collector, but at that point, they aren't going to tell the credit bureau if you’ve done so," she explains — a bill in collections is already out of the lender's hands. If possible, work with the collections agency to come up with a payment plan, but direct your full attention to other areas where you can make a difference. "Focus on your current bill and keeping those current, and then start rebuilding."

This is one opportunity where you may want (and have no choice) but to sign up for a secured credit card, she says. Put a small, recurring charge on that card, and set it to auto-pay.

"If you start doing all the right things again, even if your credit score doesn’t dramatically increase because that defaulted payment is there [for seven years], you will have lenders who will look past that as time passes. Actions speak louder than words. It’s not going to be the first time a lender has seen this, but what they want to see is that you’ve fixed the problem and have figured out how to pay your bills on time," McLay says. "Anything you do to your credit financially can be undone. I’ve seen clients with scores in the 400s end up in the 700-range. Sometimes it’s going to take a little more work, and more time, but you can always fix it."