(Doug from Georgia) My credit score was low becuase I don’t have any credit cards. I use my debit card frequently and would like to avoid the risks of credit cards. Will a debit card help me build credit or do I also need credit cards?
Dear Doug:
A debit card is not factored into credit scoring formulas. Therefore it will not help you build credit directly. It could however indirectly help, since your responsible management of a checking account could be factored into the decision by your financial institution to approve a new credit account. Even other financial institutions will want to know that you have an active checking account at a bank or credit union as a sign of being banked.
That being said, you absolutely do not need to open credit card accounts to build a strong credit rating. There are other methods to build credit that do not involve the use of credit cards.
First, you should understand that installment loans are strong indicators of your ability to manage credit, especially when you are using them to prove that you can manage a similar type of credit such as a car loan or home mortgage. Installment loans can be a current or prior car loan, or they could be unsecured personal loans.
An unsecured personal loan is an easy method for building credit, and automating your monthly payment using your bank’s online bill pay service or ACH debit can make sure your payments are all made on time. While paying the loan off early can reduce how much you pay in interest, it will reduce the benefit on your credit report if you pay it off too early. Keeping the loan active for at least 6 months before paying it off early is a good rule of thumb. Of course, since credit scoring formulas are secret, there is no way to be absolutely certain of how to maximize the benefit.
If you have no prior credit, then it might be difficult to gain approval for an unsecured loan. Still, you can easily bypass this difficulty by presenting a security interest to your bank or credit union. A paid off car or a cash deposit are both possible sources of collateral for the loan. You can even put your cash deposit in a certificate of deposit (CD) to partially offset the interest you are paying on the installment loan. Just understand that even if you repay the loan early, you would not want to withdraw the CD or else face an early withdrawal penalty.
You can build a solid credit rating using this method without obtaining credit cards. You won’t reach a perfect 850 score without plastic, but you can get into the 700s which is easily enough to qualify for preferred rates on car loans or home mortgages.
Your credit score will be somewhat lower due to error codes relating to a lack of revolving account information if you do not carry and periodically use at least one credit card. That being said, you do not need to obtain a credit card to build credit.
If you do choose to open a credit card, make sure that you do so at least 2 years prior to making a major credit purchase. It takes a couple of years for a credit card to be considered “seasoned” and to really begin benefiting your credit rating. In fact, your scores will likely drop during the first 6 months that you open a new credit card. Your score can drop from 1 to 5 points following the initial inquiry plus several more points while your account is open with a very short credit history.
For more information about how credit is scored, you can review our listing of credit score factors. That can help you see what items are important on your credit report which may help you plan your use of credit to best meet your current and future borrowing needs.
Tags: card, credit, debit