Matt, 26, feels it’s time to stop renting and think about buying a home. He earns $48,000 a year at his IT job outside Washington, D.C, he has saved $20,000 he could use for a down payment (and more in his 401k), and he has no debt. And that’s the problem. Today, more and more twenty and thirtysomethings ready for home ownership are discovering their credit history isn’t adequate to qualify for a mortgage.
“I feel, well, shafted,” Matt says. “I thought I did everything right, avoided credit cards, saved and saved, and to [mortgage lenders], it doesn’t mean anything.”
Matt isn’t alone, and even consumers with some credit history (but not enough) are being turned down for much smaller lines of credit than a mortgage.
Kelly, 28, has a simple philosophy about money: “I pay cash for everything. My line of thinking is, if you can’t afford it, don’t buy it.” Even so, Kelly has carried one credit card since she was 18 and, at 26, financed a car specifically to continue building credit. You can imagine her surprise, then, when she decided to take advantage of same-as-cash financing for a $2,000 computer and the store declined her credit application for insufficient credit history.
“I wanted to show the sales associate my bank statement. I have cash. I have savings. I even have a beefy 401K and 403b!”
For consumers without a credit history, and even those with a limited credit history, getting new credit is hard to do.
“There is a small but vocal minority that has never used credit,” says Ken Lin, CEO of credit tracking Website CreditKarma.com in San Francisco. Although Lin understands some consumers’ decision to totally abstain from credit card debt, he says that when used properly “credit is a fantastic convenience”.
And for most consumers who want to buy a home or finance a car before they start going gray, a solid credit history is a necessity. And especially for those needing to start a credit history from zero, getting that first lender to take a chance on you has gotten even harder since last year’s crackdown on underwriting standards.
Ryan, a 29-year old sailor in the merchant marine was in a similar situation to Matt. Several months ago, with $20,000 in the bank but no credit, Ryan couldn’t get approved for a Bank of America secured credit card or even a piece of furniture. He wrote:
“Ever since high school I’ve known that the entire credit industry is a scam, that interest rates and fees are a shell game, and that once you fall just a little bit behind, it can be impossible to catch up…I’ve always been perfectly happy without a card, and only use my debit card…[but now] I can’t get a [mortgage] because I have no credit score. For the last month, I’ve been running around and racking my brain trying to figure out how to get credit.”
Eventually, BB&T approved Ryan for a credit card that his father co-signed. But it wasn’t easy.
How to Go From No Credit to Mortgage-Worthy
When you’re starting with no credit history, most mainstream credit cards and even in-store financing programs (like the loan Kelly tried to get for the computer) are out of the question. There are a few steps you can take.
Become an authorized user on somebody else’s credit card. Almost all credit cards allow the primary cardholder to add an authorized secondary user to the account. There is no credit check on the authorized user, who gets their own credit card and can make charges on the primary user’s account.
Lin recommends this as a good first step. It won’t build a credit history for the authorized user (since the primary user is responsible for the account), but “it does start a credit file,” Lin says. The only catch? You need somebody who really trusts you—most likely a spouse or parent—since you’ll be able to make charges on their credit card.
Apply for a secured credit card. A secured credit card works somewhat like a pre-paid debit card with a few critical differences. To open a secured credit card, you must make a security deposit that becomes your credit line. Unlike a pre-paid card, however, you must repay the charges you make against your security deposit every month, and those payments (hopefully timely) are reported to credit bureaus so you begin building credit.
Most secured credit cards do not check applicants’ credit history, says Lin, but applicants need to be careful when shopping for a secured card. “The pitfall of secured credit cards is they were built for people with poor credit.” That means many cards charge exorbitant fees for a tiny credit limit.
After a year or so, apply for unsecured credit cards. “The average consumer has seven credit cards in their wallet,” says Lin. “That’s probably overkill, but two or three are smart.” Lin recommends using the cards to buy a tank of gas or two each month. Then, pay the balance off every time. It’s a common myth that you have to carry a balance (and pay interest) to build credit. Not true. As long as you use the accounts and make timely payments (even if they are in-full), you will build credit.
Building credit from scratch takes planning and patience. If, however, you can open a few credit lines and pay them on, you should have the makings of a good credit history in 12-18 months. But even then, you not be able to qualify for the auto loan or mortgage you’re after.
“Theoretically you could have a 700 credit score [after 12-18 months of credit building] but may still get declined or pay a higher rate,” Lin says. That’s because lenders don’t just look at your credit score, but at a variety of factors, including the length and breath of your credit history. Making regular $50 monthly payments on a secured credit card with a $500 credit limit isn’t the same as taking on a $20,000 auto loan or $150,000 mortgage. Still, you’ll be in a much better position to get a loan than when you had no credit file.
What if lenders want to charge you a higher rate because of your limited credit history? It might be worthwhile to keep waiting. An article by TheStreet.com calculated that over a lifetime, somebody with poor credit could pay $1 million more in interest than somebody with good credit!