8/20/2012 2:15 PM ET|
Build your credit without credit cards
The fastest way to build or rebuild your credit scores is by using both of the two main types of credit:
Revolving accounts -- including credit cards, which allow you to build up and pay down debt.
Installment loans -- mortgages, auto loans and other debt that's repaid in periodic installments.
But some people can't get credit cards in today's tight environment. Others don't want to use them, often because they don't trust themselves not to overspend or because they don't trust credit card companies.
Fortunately, these folks don't have to give up on having great credit scores, which is a good thing. These days, getting a good rate on a mortgage or most other loans -- or even getting approved at all -- depends on having decent scores.
Even if you don't plan to borrow, having good credit is important, because credit information is also used by cellphone companies, landlords and employers to evaluate applicants and by insurance companies to set rates.
There are several ways to build or improve a credit history without using credit cards. Among them:
1. Get a secured loan from a credit union
Often called a share-secured loan, this type of borrowing is backed by money you place in a credit union savings account or certificate of deposit. The interest rate you pay is typically a few percentage points above the rate you earn on your money.
These loans may be easier to get than bank loans, since credit unions are often willing to look at more than just your credit scores, said Susan Tiffany, the director of consumer publications for the Credit Union National Association. (Find a credit union near you.)
"(Credit unions) don't treat credit scores as the only source of information about you," Tiffany said. "They're looking for ways to say yes. Are you responsible with your checking account? Are you demonstrating that you're trying to be a regular saver? Those behaviors can help."
But you need to know something important about these and other installment loans: After they're paid off, creditors may stop building your scores.
The leading FICO credit-scoring formula is designed to predict people's risk of default, and it responds best when people actively and responsibly use credit. A history of responsible credit use will get you only so far.
"All things being equal, it's better to have at least one open account as opposed to having them all closed," said Barry Paperno, the manager of consumer operations for Fair Isaac, the company that created the FICO.
Eventually, your old loans may not help you at all, because they'll be dropped from your credit reports. How long that takes depends on the lender and its policies. Some report closed accounts indefinitely or for 10 years, while others stop reporting them within months. Once a loan disappears from your credit reports, it stops helping your scores.
And yes, there is irony here:
- You don't have to pay a dime in interest if you use credit cards to build your scores. If you use them and pay them off on time and in full, you can improve your credit without paying finance charges.
- If you refuse to use credit cards, however, you may have to stay in debt to build your scores.
You'll also want to make sure your loan is reported to all three major credit bureaus: Equifax, Experian and TransUnion. Some credit unions and smaller banks save money by reporting to only one. You want all three of your credit bureau reports to reflect the loan so that you get the benefit no matter which bureau is used by future lenders, insurance companies, landlords or employers.
2. Consider peer-to-peer loans
Peer-to-peer, or social, lending sites such as Lending Club and Prosper aim to connect borrowers with individual investors. The rates borrowers can get on three-year fixed-rate loans depend on their credit and their applications, Prosper spokeswoman Tiffany Fox said. Investors "bid" on the borrowers' applications, with the investor willing to provide the lowest interest rate winning the contract.
3. Student? Get a federal student loan
Federal student loans don't require credit checks, but you do need to be at least a half-time college student and to have submitted a Free Application for Federal Student Aid, said Mark Kantrowitz of FinAid. You don't have to show financial need, and rates for unsubsidized federal Stafford loans are fixed.
Your loans may not show up on your credit reports until you're in repayment mode, but once they appear, your on-time payments will help boost your scores.
4. Become an authorized user on someone else's card
When you're added as an authorized user to someone's credit card, his or her history with that card is typically imported to your credit reports. If the person is responsible with the card -- charging lightly and paying on time -- that could enhance your scores. Conversely, if the other person messes up, that could hurt you, although you just need to be removed as authorized user for the bad stuff to disappear from your files.
The other person doesn't need to give you access to the card to add you as an authorized user, but you should make sure the credit card will export the information to your credit reports. Some issuers report authorized-user information only for spouses or family members.
Also, don't go overboard. The newest version of the FICO formula limits the number of authorized-user accounts that are counted, a step that was taken to discourage credit repair firms that were adding people to strangers' accounts.
Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.
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