Before we can determine the best way to build our credit, we first need to understand how our credit score is calculated.
A personal credit score is typically determined by credit reporting agencies based on five primary factors related to your credit history:
1. Payment History (35%)
This is the most significant factor, approximately 35% of your credit score is determined by your payment history. It considers whether you have made your credit payments on time, including credit cards, loans, mortgages, and other debts. Late payments or defaults can negatively impact your score. The more late payments that you have had, and the later the payments were made, the lower your score will be.
2. Credit Utilization (30%)
This refers to the amount of credit you are currently using compared to your available credit limit. It is best to keep your credit utilization ratio below 30%, however below 10% will result in the best utilization ratio. So, if you have a credit limit of $10,000 then your balance should not exceed $1,000 - $3,000. Higher utilization can suggest financial strain and may lower your score.
3. Credit History (15%)
The length of your credit history is very important. A longer credit history provides more data for evaluating your creditworthiness. It takes into account the age of your oldest and newest accounts, as well as the average age of all your accounts.
4. Credit Mix (10%)
A diverse credit mix, including a variety of credit cards, loans, and mortgages, can positively impact your credit score. When you have a variety of debt, it can positively affect your credit score because lenders see you can manage different kinds of debt responsibly.
5. New Credit (10%)
Opening multiple new credit accounts within a short period may be seen as a sign of financial stress and can negatively affect your score. Each new application for credit generates a hard inquiry, which temporarily lowers your score.
Now that we understand the factors that influence our creditworthiness, let's determine the target credit score we should aim for. Credit scores typically range from 300 to 850. Generally, a credit score of 700 or above is considered good, while a score of 800 or above is considered excellent. If you are looking to build your credit, set a target goal between 750 and 800.
With our desired credit score in mind and an understanding of the factors that impact it, let's explore the most effective approach to achieving our goal. It's essential to differentiate between credit card usage and credit card debt. If you are someone who does not struggle with overspending because your means of payment is credit rather than cash, we recommend obtaining a credit card with a maximum limit that allows for a utilization of no more than 10%. For instance, if you are approved for a limit of $1,000, request the issuer to set your limit at $100.
During this phase of your financial journey, it is crucial to establish healthy financial habits. Shifting your expenditure from cash to credit can have negative long-term implications for your wealth. To create an efficient and automated system, choose a small bill that you pay regularly, such as a utility or subscription, and set up automatic payment using your credit card. Additionally, arrange for your credit card to be automatically paid in full, eliminating concerns about late payments or accruing interest. To avoid temptation and overspending, store your credit card in a secure place at home, such as a drawer or safe.
By consistently making these small automated payments each month and refraining from taking on additional debt, you can achieve your goal within 6 to 12 months. While building strong credit is a prudent thing to do financially, you will not build wealth on the foundation of your credit score, it will be built upon your financial habits. Therefore, do not prioritize building strong credit at the expense of your overall financial habits.
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