How to build credit without going into debt

Your credit score is one of the most important numbers in your financial life. It’s a key factor in whether you’re approved for loans and lines of credit, along with the interest rates you’ll be charged. This has become even more important the past couple of years as the Federal Reserve has raised interest rates to fight inflation and lenders have tightened their underwriting standards in response to rising delinquencies.

Unfortunately, 49 million U.S. adults (roughly one out of every five) can’t be scored by the most common credit scoring algorithms, according to Experian. That’s because they don’t have enough credit information on file.

How credit scores are calculated

There are a few different details that go into calculating your overall credit score — the number lenders use to determine your creditworthiness.

FICO (the Fair Isaac Company) created the most widely used credit scoring formula. The most important factor in your FICO score is payment history, which makes up 35 percent of your score. It’s followed by how much you owe (30 percent), the length of your credit history (15 percent), your credit mix (10 percent) and how much credit you’ve applied for recently (10 percent).

In general, it’s best to pay your bills on time, keep your debts low and show that you can successfully manage various types of credit over the long haul (without applying for too much credit in quick succession). These are the habits that can help you build and maintain a great score.

Credit scores are widely used by lenders and are generally viewed as a reliable predictor of whether a prospective borrower will repay their financial obligations in a timely manner. Your credit score is similar to a student’s standardized test score, like an SAT score on a college application. But just as some people feel standardized testing is not an accurate barometer of academic prowess, credit scores have their detractors, too.

Why some people cry foul about credit scores

One of the most prominent naysayers of credit scores is Dave Ramsey, the bestselling author and anti-debt crusader.

As his organization’s website puts it, “Remember, when it all comes down to it, a credit score is really just an ‘I love debt’ score. That’s right, a ‘good score’ simply shows how well you’ve played the debt game. It doesn’t reflect your actual net worth or the amount of money you have in the bank. In other words, it’s really nothing to be proud of. The only way to keep your stellar credit score is to live in debt and stay there — no, thanks!”

While there is some truth in some of those statements, there are also a few questionable assertions that deserve a deeper examination. Most importantly, it’s entirely possible to build your credit score without taking on any debt whatsoever.

How to raise your credit score without debt

Credit cards

Any credit card will help you build credit as long as you use it responsibly (meaning you pay on time and keep your debt low), assuming it reports to the major credit bureaus (which just about every credit card does).

As long as you pay your balances in full each billing cycle, you can avoid interest. But unlike debit cards, credit card usage counts toward your credit score. Of course, there’s a reason why some people say credit cards are like power tools (as in, they can be really useful, or they can be dangerous). There are ways to use credit cards with guardrails if you’re nervous about overspending and carrying debt.

Think of it this way: you wouldn’t take out a mortgage or car loan just to build credit. But a credit card, while technically a loan of sorts, can be an interest-free form of credit as long as you pay in full each month. Plus, credit cards offer valuable rewards programs and buyer protections and represent a convenient way to make purchases you would have made anyway.

Starter credit cards

Student credit cards, secured credit cards and retail credit cards are common entry points into the credit card market, since they tend to be easier to qualify for than other credit cards. These products can have high interest rates, however, and it’s possible to get into a considerable amount of debt, so be careful to pay in full and on time without overspending.

These and other starter cards often have lower credit limits, which can limit the potential for debt, although it can also be easy to use a lot of this available credit (which isn’t good for your credit score). Going back to the power tools analogy, it’s all about how you use them.

Credit cards with cash-flow underwriting

TomoCredit, for example, offers the Tomo Credit Card*, which is an excellent starting point for many people. It operates on the Mastercard network but, unlike most credit cards, it’s a charge card (so you’re not allowed to carry a balance). In fact, it even offers an optional seven-day automatic payment cycle (like most credit cards, the standard option is a monthly billing period). This short-term, pay-in-full structure helps limit risk for the company and the cardholder.

TomoCredit practices cash flow underwriting. That is, the company doesn’t rely on credit scores. Instead, it takes a detailed look at applicants’ bank accounts to examine how much money is coming in and how much is going out each month. Its target audiences are immigrants and young adults who may not have a FICO score because they’re new to credit (at least in the U.S.), but manage their finances responsibly; for example, by spending less than they earn each month.

Signing up for a TomoCard (which costs $2.99 per month) — or enrolling in the company’s TomoBoost program — can be a smart way to begin your credit journey. Cardholders’ account usage is reported to all three of the major credit bureaus, so responsible payment habits will build credit without accumulating debt. TomoCredit can offer much higher credit limits than secured cards (credit cards that require a deposit). 

Note that, while there are potential advantages to having more available credit, such as expanded purchasing power, someone who is nervous about overspending might find a secured card to be a safer starting point.

Authorized users

I also like the idea of getting on a parent or relative’s credit card account as an authorized user. This can jumpstart your credit score without any downside, since you can remove yourself from the account at any time if things turn sour (for instance, if the primary account holder pays late or accumulates too much debt). The primary account holder is responsible for making payments in this arrangement.

When you’re an authorized user on an account with positive payment habits, those translate to you. That’s why this is a low-risk, high-reward tool for building credit. Two of the biggest obstacles to building credit are getting approved for an account and showing that you can successfully manage it over time. When you’re added as an authorized user to a well-established account in good standing, you’ve overcome those hurdles and are better-positioned to obtain credit in your own name.

Other less-conventional ways to build credit

Alternative credit monitoring programs

Alternative credit monitoring programs such as Experian Boost, Experian Go (which is intended for consumers without credit information on file), eCredable Lift and the Altro app are great ways to build credit based upon things you’re already doing. All but eCredable Lift (which starts at $9.95 per month) are free.

These programs incorporate existing payments that haven’t traditionally counted toward your credit score — such as rent, utilities and streaming subscriptions — into your credit report. Signing up for one or more of these services could potentially pull in a lot of beneficial information that could lead your credit score to jump very quickly.

Credit-builder loans

Some financial institutions offer credit-builder loans. These are basically a form of forced savings. You put money aside each month for a period of time (often six to 24 months), and then you get to keep most of it at the end of the term. There are typically some fees involved, but these loans can be a low-risk, debt-free way to improve your credit score and save money at the same time.

Kikoff

Kikoff is a credit-building platform (similar to the aforementioned TomoBoost program) that allows users to build credit without a credit check. For a small monthly fee, users gain access to a credit line that reports to the major credit bureaus. The cheapest option costs just $5 to keep a $750 credit line active each month. It’s basically a gimmicky way to create a “loan” out of thin air. Having this available credit and using very little of it looks good to the credit scoring algorithms.

The bottom line

At some point, just about everyone is going to be in the market for a loan or line of credit. That could be a student loan, mortgage, car loan, credit card or something else. Credit checks are also common for certain obligations that don’t involve debt, such as renting an apartment or signing up for utility or cellphone service. Some employers even check prospective hires’ credit reports.

Having a strong credit score can open a lot of doors, whereas a low or nonexistent score can lead to a lot of rejection. Make sure to monitor your credit regularly, and consider following these steps to improve your credit score without breaking the bank.

Have a question about credit cards? E-mail me at ted.rossman@bankrate.com and I’d be happy to help.

*The information about the Tomo Credit Card has been collected independently by Bankrate and has not been reviewed or approved by the issuer.