Ask A CFP®Professional
Howard R. Pressman, CFP®
Financial Planner
Egan, Berger & Weiner, LLC
Vienna, VA

Question:

“After many years without credit I have recently begun working to establish a credit history.  I don’t have any big purchases (like a new home) planned in the near future, but I want to make sure my credit is in order before a big purchase comes up.

I took out a secured credit card and have been making monthly payments for about a year.  I've been looking for other ways to improve my credit, and I'm considering taking out a student loan I don't need solely for this purpose.  Is this a good idea? 

Is there anything else I should be doing to help build my credit?”

-DC Saver Meredith

Answer:

Hi Meredith, thank you for your question.

You’re very smart to focus on your credit long before you intend to make a big purchase. For most people it’s an afterthought, so give yourself a big pat on the back.

Now to your question.  A secured credit card is the best way to begin building a credit history. For readers not familiar with the secured credit card, it is in many ways like a regular credit card except that you place an amount equal to your credit line on deposit at the bank. For example, if you deposit $1,000 in a Certificate of Deposit (CD), the bank will give you a credit card with a $1,000 limit. This makes the bank feel better about giving you credit because if you skip town, they can get to your CD. Remember, as long as the credit card is open, you can’t access the funds in the CD.

In your case, Meredith, you said that you’ve had a secured card for about a year. If you typically carry a balance from month to month, I suggest making sure it’s no more than 9% of your credit limit. While there are many components that make up a typical credit score, payment history and the ‘utilization ratio’ will be of particular importance in your case, since your credit file doesn’t contain a lot of other information. The utilization ratio looks at the amount outstanding on your card, relative to your credit limit. So if your limit is $1,000 I would suggest carrying a balance of no more than $90.00. Keeping this ratio low can have a significant positive impact on your credit score.

Your next step should be to request a copy of your credit report. Don’t go to that website that has the catchy jingles I often can’t get out of my head, go to www.annualcreditreport.com. This site was created by the three main credit reporting agencies - Equifax, Experion and TransUnion. Under federal law, you are allowed one free credit report each year. Unfortunately, these free reports don’t show your credit score, so you’ll need to pony up about $25 for a detailed version. Hopefully your score is above 600 at this point; if not, you’ll need to figure out why.

A great resource for helping you interpret “credit report-eese” is www.myfico.com. By clicking on “Credit Education” you can find a lot of helpful information.

If your score is 600 or better, I suggest you apply for an unsecured credit card. You’ll want to be careful about where you apply, since your credit score can be dragged down by too many consumer-initiated credit inquiries. This is when a bank or credit card company pulls your credit file (with your permission) to help determine whether to extend you credit. Too many of these inquiries can indicate someone who is in bad need of credit and is opening up accounts all over the place.

So, start with the bank that gave you the secured card, since many banks will automatically approve you after you’ve successfully paid the secured card for a period of time. Ask about your bank’s policy, but don’t allow them to pull your credit report until you’re satisfied that you have a good chance of being approved.

If you’re not automatically approved, things get a little more complicated, because we want to find the highest chance of getting you approved with the least number of inquiries. Department store and gas credit cards are typically easier to obtain, so if you have a favorite store you might try there. Aside from that, it may be hit or miss because different banks have different requirements - and they won’t tell you what they are.

Assuming that you are approved for an unsecured card, don’t close your secured card right away. Another factor in your score is average account age, and closing your secured card would adversely affect this number. This is the reason that you will probably see a drop in your credit score right after you open the new account. If you have one card that’s been open for 12 months and then you open a second card, your average account age is now six months. You should see most of the decline reversed in three months and the rest within a year.

Another idea is to be added as an authorized user on another person’s account. Just make sure that this person has good credit and is keeping up with their payments.

In my opinion, it’s not a good idea to take out a loan you don’t need just to establish credit. I think you will see a greater impact to your score from a credit card than an installment loan such as a student loan.

Credit scores are pretty complex, but sticking to these principles should help you increase yours. Good luck!