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Quick Guide To Establishing Credit

Apr 8, 2008
Whether you've never had credit or the credit that you have is all bad, you essentially face the same challenges in opening a new account. Many lenders will turn you away if you don't have a recent history of responsible credit usage. But if you need credit to get credit, how do you start? Building or rebuilding credit can seem like an imposing task at first but it's actually easy to accomplish if you know where to begin and what to avoid.

Historically, consumers would get help from a family member to establish that first line of credit. A cosigner can certainly help you jumpstart your credit but it's very risky for the person cosigning. The addition of a new account directly affects their debt to income ratio and usually causes a drop in credit score, at least initially. If the cosigner does not take the step of having all bills sent to his address to ensure they are paid promptly, he is allowing the possibility of a single forgotten payment destroying his credit score.

Until recently, you could be added as an authorized user on a credit card and without ever touching the card or making a payment, the good (or bad) credit history would actually count for your credit score. This all changed thanks to some unscrupulous credit repair companies that would actually pay cardholders large sums of money to add strangers to their accounts as authorized users. The users never received a card but the credit history would appear on their credit report. Once the credit bureaus caught on, all credit scoring for authorized user accounts was terminated.

Your biggest problem right now is that you fall into a high risk category. With a purely negative credit history, you need something positive on your report in order to start the rebuilding process. Someone with no history at all is considered high risk due to the high default rate of first time credit users. So without a cosigner or the ability to benefit as an authorized user, how do you get credit? Very simply, you buy some. There are a few ways to do this. In each recommended method, there is a need for a financial commitment from the borrower. You are not ready for credit if you cannot save the money to use for one of these methods. If all of your cash is already going out, then adding another bill would not be a good decision.

Recommended Methods:

Secured Credit Card: It's a very simple concept. You put money into an account with a creditor, and they let you borrow against the account. In the case of the credit card, you will receive a credit line equal to the amount you have in savings with the creditor. After a while, sometimes as little as 6 months, they may allow you to convert the account to an unsecured card or at least increase your limit to an amount greater than you have in savings. By sticking with major banks you can get reasonable terms such as annual fees under $30 and reasonably low interest rates. Keep your balance well below the limit, pay on time and you will soon be able to get unsecured debt.

Secured Loan: The principle is the same as above. You put money into a savings account or a CD and then you borrow against it. Since the bank already has the money, there is no risk. For the cost of some interest, you can create a payment history. Some people will create several lines on their credit bureau all at once by repeating the process two or three times using the proceeds from the first loan. They make a few payments on each account, and then pay all of them in full. In the end, the only actual expense is a small amount of interest, but the result is several paid in full loans with payment histories. This can be accomplished with as little as $400.

Large Down Payment: Putting 30% down on a car will almost always get you credit from someone. Lenders see large down payments as a serious commitment from the borrower. The more down, the less likely someone will be to walk away from it. Since the loan amount is typically larger and the rate is probably going to be high, this can be a more expensive way to grab some new credit. Often, sub-prime loans come with additional cost to the dealer, so the markup on the automobile is usually higher as well. Be sure that you are borrowing less than the loan value of a car, and buy something conservative, that you can not only afford, but that you can pay off rapidly.

Avoid These Scenarios:

Buy Here Pay Here (BHPH) Automobile Lots: The cars are heavily overpriced and the interest is usually outrageous. By the time you pay the down payment and the taxes and tag fees they will require in advance, you can usually buy an inexpensive car with cash that will run just as well. Consider this: You put $1500 down and finance $7000 for 3 years at 29.9% interest which would give you a payment of $296.78. You would spend $10684 in payments alone. Including your down payment, the total cost to purchase this vehicle is $12184.08. Based on typical BHPH markup, this same car probably could have been purchased with cash from a private owner for around $2000 and you would have $300 a month to save for your next car and to maintain the vehicle. Is it worth over $10,000.00 just to have a loan? Most BHPH loans end up as repossessions, and while BHPH companies do not typically report good credit, almost all of them will report if it goes bad.

High Fee Credit Cards: There are unsecured card issuers that will approve almost anyone, but the cost is way too high. One card I recently reviewed offered a $250 credit line, but before you ever use the card, you already have around $180 in fees billed. Not only is there an annual fee, but there is a monthly fee. There are program fees and account set-up fees initially. You will even pay a fee if they increase your credit limit. Again, you don't need credit if you're not able to save and for those who can save, a secured credit card is a much better value.

"Gold" or "Platinum" Cards that look like major credit cards: When you first see the advertisement, it appears to be a MasterCard or a Visa with a credit limit of several thousand dollars. Look closely, however, and you will realize that there is no MasterCard or Visa logo. After you pay your account setup fee, you receive a catalogue of merchandise. Most of the merchandise is overpriced for the quality and there is a down payment required on almost everything. The down payment probably covers the wholesale cost on the item plus shipping so you are essentially financing the profit. These accounts are not free and generally come with monthly fees as high as $39. There may also be add-ons like telephone voice mail and ID Theft Protection which are automatically included on a "trial basis" with your new account. You are charged for the services unless you cancel them within two weeks of ordering the card. By not reading the fine print, you could pay as much as $70 a month without making a single purchase. It's a great way for them to make money, but a terrible way for you to establish credit.

Credit is expensive and really should only be used for emergencies or to buy something that you could not possibly pay for with cash, but will benefit financially by having it now. Unfortunately, you need to establish some credit first to be able to purchase something major such as a house. Don't make the mistake of letting a creditor tell you how much you can afford. You need to control your own budget and make sure there is always money going towards your savings and retirement. The smartest users of credit treat it as a tool and not as a crutch.
About the Author
Kevin Maher is the Agency Liaison at Debt Management Credit Counseling Corp (DMCC), a 501c(3) non-profit charitable organization offering free financial and budgeting education across the USA. For information call 866-618-DEBT or visit http://www.dmcccorp.org. Kevin's email is kevin@dmcconline.org
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