The other day I called my bank on the way to work and asked for credit limit increases on a couple of my credit cards. This isn’t because I need to spend more, but because it’s a smart financial decision to improve my credit score.

Lenders use credit scores for lots of things, but mainly when applying for a mortgage or auto loan. Although I won’t be buying a house in the next year or so, asking for credit limit increases on your cards is a solid move to make early and often. To understand why, let’s:

1. Talk about what a credit report is and who uses it,
2. What factors affect your credit score and,
3. How to improve it so that, when you are ready to buy a house, you’re able to get the best rate possible.

What a Credit Report Is and Who Uses It

A credit report contains information that potential lenders would want to know about you. It’s broken out into a few different sections. Here’s some information from MyFICO.com explaining each section and what it contains.

When you apply for a mortgage lenders use your credit report to determine your financial health to decide whether to give you a loan. They’re looking for lots of different things, but they’re specifically interested in:

1. Anything negative in the public record (like bankruptcies)
2. Whether you’re taking on more debt
3. How you’re handling the debt you currently have.

Those combine to give a pretty detailed picture of your ability to handle debt and pay someone back. Although the credit report and score get a lot of bad press, lenders want to know this stuff before they loan you anything.

Besides the detailed credit report, lenders can also request a credit score. There are three credit bureaus; Experian, TransUnion and Equifax. They each collect credit information and create a “score” that gives a picture of your credit worthiness. The scores are on a range from 300 – 850 and they affect the rates you pay on things like a mortgage, auto loan or credit cards.

Credit.org has a great infographic on the rate differences for different credit scores.

One of the most effective ways to track your credit report is by checking the reports yourselves. I’m not talking about FreeCreditScore.com, despite their catchy jingles. It relies on marketing other offers to pay for your credit report. The government mandates one free credit report per bureau per year at AnnualCreditReport.com.

The most consistent strategy is to schedule time every four months to request your credit report from one of the three bureaus. This allows you to take a look at your credit report often by utilizing each of the bureaus. I’d recommend setting a calendar reminder every four months so you don’t forget. You don’t receive your credit score without paying for it, but the report alone is a great way to gauge your health and progress.

Another noteworthy option is CreditKarma.com. This company will provide you with a health report and a credit score, and the frequency is improving. It’s important to point out that the CK score uses their own algorithm that is not going to match exactly with the official bureaus. The service is free and they make money by giving you offers of financial products they think might be good for you. I’ve never signed up for it myself but I’ve heard good reviews. Try to use it as a trend indicator and not an official credit score.

What Factors Make Up a Credit Score

Your credit score has such a HUGE impact on the rates you pay that it’s important to understand where it comes from. Although the three bureaus each have their own algorithm, the basic factors are the same. They are Payment History, Amounts Owed, Length of Credit History, New Credit and Types of Credit Used. Here’s the percentage breakdown of each:

• Payment History is all about how good you are at paying your debts in full and on time.
• Amounts Owed is the measure of how much debt you have on loans or on credit cards.
• Length of Credit History is pretty straightforward and is how long you’ve had some sort of credit for.
• New Credit can be recently opened credit lines or recent inquiries into your credit report. These inquiries could signal that you’re looking to take on more debt.
• Types of Credit Used is a measure of whether all your debt is on credit cards or whether some of it is in loans like an auto or home loan.

Increasing your financial health in any of these areas is a surefire way to improve your score.

The Simplest Ways to Establish Good Credit

If you’re young, you’re likely in one of three situations:

1. Either you have no credit history
2. You have limited credit history
3. You’ve been working on your credit history and you have a good credit score.

If you’re already in good shape, nice job! Regardless of your situation, the tips below can help jumpstart or improve on your credit report. We’ll go over:

• Establishing Length of Credit History
• Creating a Positive Payment History
• Improving our Amounts Owed via the credit utilization ratio

To get started your parents could add you to a loan or you could take out a loan just to pay it back. Instead we’re going to focus on the easiest route using credit cards. This won’t help your Types of Credit Used, but it’ll get you started down the right path.

Establishing Length of Credit History

The old saying goes “a year from now you’ll be glad you started today” and it fits perfectly here. Lenders like seeing a long credit history because it gives them more predictive data about your finances. It’s more important to take action and establish some credit than it is to get it exactly right. Maybe you have no credit history and you have a tough time qualifying for some of the well-known credit cards.

CreditCards.com has a decent section on cards for people with Little or No Credit History. One option is a secured or prepaid card. With these cards you either pay a deposit up front or provide access to an account with that money in exchange for a line of credit. In this example you might pay your bank $500 and they’ll give you a $500 limit credit card. That’s your collateral that you give the bank in case you don’t pay back what you spent on credit. If you ever decide to close that account or convert that card, you get your $500 back.

When I graduated college I had no credit history. I actually applied for a card that’s intended for recent immigrants to help them establish credit. Less than a year later I was able to graduate to cash-back rewards cards and soon after I qualified for travel rewards cards. If you take the time to get started now you’ll build up the credit you need in no time.

Later, once you’ve built up some credit history you’ll be able to qualify for cards with some rewards or other perks. At that time you may be tempted to close your first credit card, but the general rule is to leave it open. If you close a credit card, that credit history disappears from your credit report and punishes your Length of History!

Some people just leave their credit card at home and never spend anything on it, but in that case your bank may cancel it for inactivity. I think that the best way to handle an old card is to put a small recurring expense on it and then set it to be automatically paid each month from your checking. You might use Netflix or your gym membership. This way you have the peace of mind knowing that you won’t lose length of history and you won’t forget to pay a bill and get penalized for it.

Toolbox: 

• If you don’t already have any credit cards, find one that’s right for your situation and apply. Don’t apply to many at first, because it will look suspicious on your credit report.
• [Optional] If you have old credit cards that you no longer want to use, set up a recurring payment and auto-pay.

Creating a Positive Payment History

This one is pretty easy. If you can afford it, pay off your full credit card bills each month. In fact I wouldn’t recommend starting your credit history if you can’t afford to pay off your credit cards balances each month.

Here’s why – the credit card companies only charge you money if you don’t pay off your balance each month because at that point they’ve loaned you money. If you don’t pay off your credit card statement balance, that’s called carrying a balance. For every day after your bill is due and some part of your statement balance is unpaid, you build up interest that you owe the bank. That’s where the APR comes in. The APR is the annual percentage rate that you’re charged for carrying a balance, and it adds up.

By paying off your credit card statement balance each month, you’re doing two things:

1. Saving money that you would get charged for the balance
2. Showing the banks that you’re a strong investment and you’re able to pay off any money that they might lend you.

This contributes in a big way to your credit score, since Payment History makes up 35% of it.

Sometimes people assume your payment history includes utilities, cable, rent or cell phone bills. Sometimes where you can request that a company reports your payments to the credit bureaus, most of the time they aren’t. If you’re paying everything on time there’s no reason for the company to hassle with credit bureau reporting. The only caveat is if you fail to pay – then they are more than happy to report your debt. Pay those bills in full but don’t expect to improve your credit from it. You’re only protecting your existing credit score from going down, not improving it.

Toolbox:

• Pay off your credit card statement balance in full each month.
• Consider asking your property management, utility, cable or cell phone company to report payments to the bureaus.

Improving Your Amounts Owed with Credit Limit Increases

Since Amounts Owed makes up such a huge part of your credit score, it’s useful to improve that section of your report. One of the measures used in calculating the credit score is your credit utilization ratio. That ratio is the percentage of available credit that you’re currently using. Let’s do an example – at the end of the month, these are your balances.

• Credit Card 1: $2250 balance with a $5000 credit limit
• Credit Card 2: $1700 balance with a $4000 credit limit
• Credit Utilization Ratio = (Total Balances)/(Total Credit Limit) = (2250+1700)/(5000+4000) = 43.8%

CreditKarma.com pulled some interesting data on 70,000 credit scores and credit utilization rates. The results are pretty interesting:

The main takeaway is that a lower credit card utilization ratio is better. It shows that you’re able to control your spending which makes you more likely to repay your debts. You’ll notice the exception of 0% utilization causing a major hit. It’s an interesting caveat, and here’s why. If a lender looks at somebody with 0% utilization, they aren’t able to tell if that person is able to handle debt because they don’t have any. From a lender’s perspective, that 0% is about as helpful in understanding you as having no credit line at all.

Let’s compare two people – both make the same amount of money and start out with the exact same credit report and credit card limits.

• Mark asks for a credit limit increase when he needs one. As a result, his utilization ratio is very high until he asks for an increase and even then it’s still in the medium range. Since his utilization ratio is so high, his credit score is lower. When Mark asks for a loan he has to pay much more interest.
• Sara asks for a credit limit increase every six months from her bank, even when she doesn’t need one. Because of that, her utilization ratio stays low even when her spending goes up. Since her utilization ratio is low, her credit score is higher. When Sara asks for a loan the bank is happy to give her a low interest rate.

Most of the population works like Mark. Most people don’t know about utilization and only think about their short-term needs. Instead, if you think like Sara you’ll be ahead of 90% of people in your age group because you know how these thing work and you plan ahead. I’d recommend setting a calendar reminder to call your bank and ask for a credit limit increase every six months. When asking for the increase, read this blog post at CreditCardForum.com for a few tactics.

Toolbox:

• If it’s been more than six months since you got a credit card or since your last credit limit increase, call your bank and ask for an increase. It’s a 5-10 minute call and it’s easy, I promise.
• Set a reminder every six months to go back and check with your credit card issuer again.

There You Have It

Now you’re armed with some basic information on establishing and improving your credit. You know what a credit report is and who uses it. You know what factors make up a credit score. You know the credit card techniques for establishing and improving your credit score. You may not need a good credit score now, but your future self will thank you.

You Tell Me: what did you find most helpful? Have you found any good cards for people with no credit or have you tried to ask for a credit limit increase?