Building or Re-building Your Credit

Last week I was in Athens, GA guest lecturing at the University of Georgia . I’m up there once a semester speaking with senior students who are about to graduate and go out into the “real” world. And while my agenda is to talk about credit reports, credit scores, and how the whole financial services system works, it usually ends up becoming a fairly lengthy Q&A session about how best to establish and build your credit. Here’s the deal…you have one chance to establish credit, that’s it. You can either do it the right way or the wrong way, but you can never have a mulligan. For those of you who’ve already built credit and managed it poorly (for whatever reason), you’re not going to have to build your credit; you’re going to have to re-build it. Here are some of the more common methods for each, and their pros and cons:

Opening A Secured Credit Card

A secured credit card is a legitimate credit card issued by a legitimate bank. You make a deposit at the bank and they will issue you a credit card with a credit limit equal to your deposit. Since you’ve essentially fully secured any purchases you’ll make with a cash deposit, banks are more willing to issue these cards to either new credit users or those who are trying to rebuild their credit. Additionally, you can open a secured card for as little as a $250 deposit, so it’s a nice option for people who have limited cash flow. Secured cards aren’t a good long-term option,however; the fees associated with these cards and the interest rates aren’t very good. But, you have to remember that you’re opening the card for a purpose and that purpose is to get something good on your credit reports. After a few years of paying the bills on time you may be able to convince the card issuer to convert the account to an unsecured credit card and refund your deposit. And because this is a credit building strategy, you’ll want to make sure you choose a card issuer who reports their secured card accounts to the credit reporting agencies. Otherwise, you’re just wasting your time.

Being Added as an Authorized User

An authorized user is someone who has been authorized to use a credit card issued to another person. Most of the time, parents will add their children to one of their existing credit cards, which allows them to have a card in their name but doesn’t convey any sort of liability for payment of the balance. The good news is that the account history is reported to the authorized user’s credit reports and can almost instantly establish them a solid credit history. This is my favorite option, as it really has no downside. I call the authorized user strategy “having a credit card with training wheels.” As long as the account is managed properly, then it’s a positive addition to your credit reports. And, this is a great option for consumers who have limited (or zero) cash flow or are already working hard to get out of debt. If the account is mismanaged by your parent (or spouse, as this is also common among spouses) then all you have to do is ask that your name be removed from the account and it will also be removed from your credit reports. In fact Experian, one of the major credit reporting agencies, will automatically remove the account history from the authorized user’s credit report if it becomes derogatory, “because an authorized user has no responsibility for repayment of the debt”, according to Rod Griffin, Experian’s Director of Public Education. “We will also remove the account at the request of the authorized user.” The good news for authorized users is that the FICO scoring system gives you full benefits for a properly managed authorized user account on your credit report, as long as you have a legitimate relationship with the primary cardholder. A few years ago, credit repair companies were trying to take advantage of the authorized user strategy to boost the credit scores of consumers who had bad credit. FICO figured out a way to filter out the consumers trying to game the system, so they won’t get the same benefit as a  legitimate parent/child or husband/wife relationship.

Co-signing For a Loan

Co-signing for a loan is when you sign the promissory note (the promise to pay back the loan) and accept equal liability for payments on someone else’s loan. The newly opened loan will likely end up on your credit reports and will help you to establish or re-build your credit. Co-signed loans are normally auto loans, personal loans, or mortgages. That’s where the good news ends. I don’t like this option for three reasons:

1) It’s unnecessary. You don’t establish credit any faster by obligating yourself to a huge loan than you do by opening a $250 secured credit card. Choose the path of least resistance!

2) You can’t change your mind. There is no such thing as “co-signing for credit only” although some consumers have tried to challenge this in court, unsuccessfully. When you co-sign you’re just as liable for payments as anyone else on the loan. If the payments start being missed, it’s your problem. You have to be prepared to make all the payments if you choose this option.

3) Missed payments will go on your credit reports. If the payments on the loan are missed then anyone who has signed for the loan (yes,  including you) will have a record of those missed payments reported on their credit reports.  And, if the loan goes into default any aggressive collection actions, including litigation, it will be targeted at you. I’m not a fan of co-signing for a loan EVER, unless you need two incomes to qualify for a mortgage.

John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a contributor for the National Foundation for Credit Counseling.  He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry. The opinions expressed in his articles are his and not of Mint.com or Intuit. Follow John on Twitter.