There are many benefits in life to having a good FICO credit score. With good credit, you may not have to put down a deposit towards your electric bill, water bill, or cell phone contract when you open an account. You have a greater chance of being approved to lease the apartment you want. And when it comes time to apply for a mortgage, lenders will be trying to offer you the best rate possible to earn your business. Simply put, it makes your life easier and removes a lot of roadblocks from your path.
The great news is that, with a little planning and forethought, it is very easy to build your credit score and make your financial life that much easier. In fact, we’re going to tell you how to build credit in an incredibly easy way.
But first, let’s talk about what makes up a credit score and why it exists.
What Makes Up Your Credit Score?
There are three major credit reporting agencies - Experian, Equifax, and TransUnion - which all use an algorithm called FICO, named after the Fair Isaac Corporation that invented the model. While the credit bureaus keep their methods of calculation closely guarded, we know that a FICO score is roughly comprised of the following factors (according to NerdWallet):
- 35% Payment History
- 30% Amount of Debt Relative to Credit Limit
- 15% Age of Credit
- 10% Recent Applications for Credit
- 10% Number of Lines of Credit
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As you can see in this FICO breakdown, just having one credit card for a long time and making dependable payments on it is all it takes to satisfy about 90% of the FICO credit score model.
The philosophy behind the credit scoring system is proving that you are a responsible, dependable borrower. In order to prove as much, you need to have at least one line of credit extended to you. It’s really no more complicated than that - when you apply for a mortgage, banks will want to see whether you have been responsible repaying other loans, or credit, that you’ve taken out in the past. And since they don’t know you from Adam, your credit score is all they have to go on to assess your dependability.
A Note on the Credit Naysayers
There are some personal finance enthusiasts who would advise you to avoid credit cards and ignore your credit score altogether. Many follow Dave Ramsey, who, to his credit, is a well known proponent of avoiding debt and getting out of debt as quickly as possible. When it comes to avoiding interest-carrying debt, we couldn’t agree more. However, he seems to preach that having a credit card is an instant fast track to drowning in credit card debt. He advises that having no credit score is just fine, that you should just pay for everything in cash, and that when you need to apply for a mortgage, you can find a lender that does “manual underwriting” that will look at all your financial activities, instead of just your credit report.
Dave Ramsey likes to mischaracterize “building credit” as synonymous with going into unsustainable debt. In fact, having a line of credit and barely using it is an excellent way to demonstrate responsible credit stewardship. And he is also wrong to assume that people are generally so irresponsible and ignorant that they cannot resist maxing out their credit cards as soon as they get them in the mail. If people were truly as financially brutish and foolhardy as he presumes, we’d all be broke, credit cards or not.
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And while more banks and mortgage lenders are starting to offer manual underwriting as a last resort for finding a way to sell loans to folks with bad credit, the options are still limited, and the best rates will still come from the conventional lenders and innovative mortgage lenders like Quicken Loans. One of the big names in the manual underwriting market is Churchill Mortgage, with which Dave Ramsey has a financial relationship and affiliate links all over his website. So the more people Dave Ramsey can get stuck on the no-credit-score bandwagon, the richer he gets when they have to do business with Churchill Mortgage. That’s all a bit disingenuous.
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In reality, credit cards are a useful and almost indispensable feature in today’s economy. Because credit card companies make most of their revenues from 2%-3% transaction fees charged to merchants, they have an incentive to attract as many dependable cardholders as possible with perks like consumer protection, fraud detection, cash back bonuses, and credit monitoring, usually at no cost to the cardholder. The consumer protection offered by credit cards is a necessity in a world of online and digital commerce where scammers, skimmers, and identity thieves are running rampant. If you have a credit card with no annual fees, these benefits are free to you as long as you never miss your payments.
What’s the Real Meaning of “Debt”?
The word debt has become a loaded term in today’s world, where we hear news stories about so many people living paycheck to paycheck and running up their credit card balances to get by. The word often comes up when discussing overdue, unmanageable, interest-bearing debt, but the word has a more general meaning that isn’t nearly as scary.
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When you get your electricity bill in the month for around, say, $200, you are $200 in debt to the electric company. The electric company has extended a line of credit to you and lent you, up front, $200 worth of electricity over the past month. The bill informs you that you are currently indebted to the utility and obligated to pay for the $200 of value that has been provided on your behalf. In that sense, virtually everyone is “in debt” at all times. Whenever you get a bill after having received a good or service before paying, you are in debt to the “lending” entity.
Most consumers don't think about their electric bill, water bill, or cell phone bill as being a debt the same as their credit card bill, but functionally, they operate the same way. If you pay off the balance, you are not charged interest, but if you carry some of that debt over to the next month, you will pay interest on the outstanding balance. And while interest payments should be avoided no matter who the lender, you can avoid paying interest by only taking on debts that you can immediately repay.
The idea that you can go through life without ever being “in debt” is just a fallacy. Embracing the financial realities of our world and demonstrating creditworthy dependability can make your life progressively easier.
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So now we come to our super easy way to build credit. Our strategy revolves around everyone’s (not so) favorite thing: bills. Virtually every household has a monthly electric bill, water bill, cell phone bill, and Internet bill. Why not use those unavoidable bills to build your credit? Here’s how to do so.
Step 1 - Open a Credit Card with No Annual Fee and No Annual Minimum
If you don’t already have a credit card, find one you like and fill out an application. Only consider those that have no annual fee and no mandatory annual minimum. Your credit card shouldn’t cost you anything. We also suggest only considering credit cards that offer cash rewards, instead of those that offer airline miles or other rewards. It’s hard to beat cash, and cash rewards are less likely to expire since many cards nowadays let your apply your reward in full every month towards your balance, no matter how small.
The Amazon Credit Card, for example, offers 3-5% cash back on all Amazon and Whole Foods purchases, 2% cash back at restaurants and gas stations, and 1% cash back on all other purchases, all with no annual fee.
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And the Discover Card, for example, also includes no annual fee and offers 1% cash back on all purchases plus 5% cash back on different types of purchases throughout the year. In 2019, cardholders received 5% cash back on grocery store purchases from January through March, at gas stations and Uber/Lyft from April through June, at restaurants and PayPal from July through September, and at Amazon, Target, and Walmart.com during the holiday season, October through December.
Step 2 - Set up Automatic Payments for Your Utility Bills using your Credit Card
Utility bills are one of those expenses that remain relatively constant. While cash proponents will encourage you to pay for your purchases with cold hard cash to keep you in tune with how much money you’re spending, it’s hard to imagine your method of payment alone affecting how much water you use on a daily basis. So chances are you already have automatic payments set up for your utilities linked to your checking account. If your utility allows, switch your settings to put your balance on your credit card. While some water and electricity companies may not support credit card payments (in order to keep their prices low), your cell phone and Internet companies probably do.
If none of your utility bill payments accept credit cards as a method of payment, you can use your Netflix fees or your monthly car or renters insurance payments instead. If you happen to have none of those, amend this strategy and only use your credit card to pay for the gas you put in your car. Gasoline is much like a utility, in the sense that we need to pay for it just to go about life. Plus, with the spread of skimmers plaguing gas pumps nationwide, your credit card will give you an extra layer of consumer protection.
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A large factor in your credit score is your payment history. It would be nice if simply having a credit card and refraining from using it entirely would prove creditworthiness, but it does not appear to work that way. That’s why we advise putting your monthly bills on your credit card. If you have to pay your bills anyway, you might as well use them to your advantage.
Step 3 - Set up Automatic Payments for your Credit Card
Go ahead and set up automatic payments for your credit card to make sure you never miss a payment. In this way, you’re keeping the same auto-bill pay setup you probably already had for your bills, but you’re just putting your credit card in the middle. All your bills will still get paid automatically without you having to worry. Making every credit card payment on time will make a big impact on your credit score.
Step 4 (Optional) - Put your Credit Card in a Drawer
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Do you think you’ll be tempted to use your new credit card for extraneous purchases? Keep it in a drawer at home. Or, if you need to, cut it in half. Putting your few hundreds of dollars worth of monthly bill payments on your credit account is more than enough to build credit over time.
Remember the philosophy behind the FICO scoring system is proving responsibility with your lines of credit. Although this may seem like a simplistic way to game the system, it is actually not. How better to prove financial responsibility to your future lenders than by having a credit card over an extended period of time and only using it for regular, boring bill payments, and paying every month on time?
Plus, as time passes and as you continue to make reliable monthly payments on your line of credit, your credit card company will increase your credit line. This will improve your credit score, because your typical balance will decrease in proportion to your credit limit. Your “Amount of Debt Relative to Credit Limit” factor of your credit score, which potentially accounts for a whopping 30% of the FICO model, will look better and better.
Plus, you’ll accrue cash back rewards on your bill payments, which is free money you wouldn’t have gotten if you paid your bills out of your checking account.
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One of the realities of our world is that, unless you’re extremely fortunate, when you want to buy a house, you will need to finance at least part of the cost with a mortgage. Even if you go through much of life making all your purchases, including your car, in cash, that day will come when you need the bank to lend you a large sum of money. And with the interest rate of your loan being such a large factor in your monthly mortgage payment, even a small difference in your interest rate can amount to tens of thousands of dollars over the lifetime of the loan. It just makes sense to prepare for that inevitable day and make sure you look as attractive to mortgage lenders as possible by demonstrating a lifetime of responsible credit stewardship. And it doesn’t have to cost you anything.