A teen's guide to credit scores
A good credit rating is a real asset in your financial life. Here's how to get off to a great start.
This post comes from Rob Berger at partner blog The Dough Roller.
As my children move into adulthood, the question of establishing credit for the first time is arising. Does a bank account affect your credit? Will a prepaid debit card establish credit? Should you get a credit card?
As I work through these issues with my children, it seems like a good time to cover this topic in some detail. A credit history and credit score are the single most important aspect of a person's financial life. Seem like an exaggeration? Consider the following:
- A good credit score can save you tens of thousands of dollars in interest payments on everything from a home loan to a car loan to credit card debt.
- A good credit score will reduce the cost of auto insurance premiums.
- A good credit score may help you rent an apartment or get a job.
- A bad credit score can prevent you from getting cable or a cellphone at the best rates.
Whether we like it or not, our credit history and score matter. A lot.
Establishing a credit score, however, can be a bit of a Catch-22. You build a credit history primarily by taking out loans, but you can't take out loans without a credit history. So how do you establish credit for the first time?
Begin with the end in mind
As Stephen R. Covey advised in "The 7 Habits of Highly Effective People," start with the end in mind. The objective is to establish good credit, not just a credit history. Before you start borrowing money left and right, think about how each decision will impact your long-term financial future.
In addition, understand why you want to establish good credit. For many, credit is important when applying for loans such as a mortgage. Your credit history, however, affects more than just your ability to borrow money, as noted above. The point is that with bad credit, you may get passed over for a new job, have your application for an apartment rejected, or pay higher insurance premiums.
So keep all of that in mind as you go about this plan for establishing your credit history.
Understand what makes up your credit score
First, let's talk about what actually goes into your credit score. While there are many credit scoring formulas, they all look at roughly the same things. The most commonly used formula is from Fair Isaac Corp. Scores developed from this model are known as FICO scores.
Just to confuse things a bit more, there are actually a number of variations of the FICO formula. Regardless, according to MyFICO.com, your credit score is based on these factors:
- 35% payment history.
- 30% amounts owed.
- 15% length of credit history.
- 10% new credit.
- 10% types of credit used.
This means that the most important element in your credit history is your payment history -- whether you make payments on time. The second most important element is how much you owe compared with how much credit you have available.
Since these are the two most important elements in your credit history, our plan focuses on these two elements. But we'll talk about the other three as well.
Establishing a payment history
Did you know that you don't actually have to take out a loan or credit card to establish a payment history?
According to the Federal Trade Commission, utility payments (phone, water, electricity and natural gas) can affect your credit, too. While it may seem odd, keep in mind that you're getting services now and paying for them later.
Since utility credit is easier to get than most other types of credit, consider moving utilities into your own name if they aren't already. If you're living with your parents, begin establishing credit by purchasing your own cellphone plan. If you're out on your own, make sure that necessary utilities are in your name.
Not all utilities report positive payment history to the credit bureaus (they report late payments). A forum thread at myFICO on this issue is worth reading. One interesting note is that signing up for payment-smoothing plans with your utility company may increase the odds that it will report your payments. It's worth calling your utility companies to find out.
Once you have utilities of any sort in your name, make sure your payments are on time, every time. Making on-time payments will help you establish good credit, although the process can be somewhat slow. On the flip side, a single late payment can have a huge negative impact on your credit history.
Work with your own bank
If you haven't already, open savings and checking accounts in your own name. The process is easy, although you might want to compare different checking accounts to find the best option for you.
The Federal Reserve Bank of San Francisco notes that regularly depositing and withdrawing money, while always being careful never to overdraw an account, will show the bank you're responsible with your money.
Your financial history with your bank doesn't directly affect your credit score (unless you overdraw your account and end up in collections for overdraft fees). But once you have shown a bank you're financially responsible, you can apply for a low-limit credit card through your bank. Often they'll let you get a credit card on the strength of your history with them alone, even if you haven't established credit yet.
If you can't or prefer not to take out a credit card through your bank, consider applying for a secured loan that is well within your means. A secured loan -- like an auto loan -- means the bank has some collateral if you fail to pay, which makes it easier to qualify for the loan.
Check into secured credit cards
Secured credit cards can be used just like unsecured cards, but you have to put down a security deposit as collateral. They're a great place to start when it comes to establishing credit because they're easy to get even with no credit history.
For a secured credit card, you'll have to put about $300 to $500 down, and you'll have a relatively low credit limit. As you use and pay off the card responsibly, you can get your security deposit back and raise your credit limit -- all while building a great credit history.
Not all secured credit cards are created equal, though. Many come with terrible terms, including high fees, so select carefully.
Apply for one or two unsecured credit cards
After you've established a good credit history by paying your secured credit card off in full every month, consider applying for one or two traditional credit cards. Find a couple of cards that will give you some good benefits, such as low interest, cash back or travel perks. If you get those cards, be sure to use them responsibly.
It's best to only use credit cards for amounts that you can pay in full every month. One idea is to use a cash-back credit card to pay only for gas. Since this is a basic expense, it's part of your budget every month, so there's not much chance of being unable to pay of the credit card in full. Swipe your card at the pump, collect cash-back rewards, and pay off your gas purchases every time you get a credit card bill.
Keep your debt low
So far we've been focusing on establishing good credit by making payments on time, every time. But once you have a credit card or two, it's time to look at the other big chunk of your credit history -- amounts owed on revolving debt.
Revolving debt is debt that fluctuates constantly because you can add to it or pay it off at any time. Credit cards and a personal line of credit are two examples of revolving debt. It's different from installment-based debt like student loans and car loans, where you take on a one-time loan and pay it down with set payments every month.
The amounts-owed portion of your credit history is based on how much you owe in total compared with how much total credit you have available. If, for instance, you owe $500 between two credit cards with a combined $3,000 limit, that's a great ratio. But if you rack up $2,500 worth of debt on your cards, your credit score will take a hit. Why? Because the more available credit you have, the better able you are to handle a financial emergency without being late on your other payments.
Carrying a zero balance on your credit card is the best way to boost this portion of your credit score. But if you do carry a balance, experts recommend keeping it at 30% of your available credit limit or lower.
Consider using other types of credit
As you can see from the breakdown above, your particular blend of credit accounts also affects your credit score. So don't just focus on credit cards. Consider other ways you might need to use credit, such as an auto loan.
One word of caution here: Avoid taking out credit you don't need or can't handle financially just to build your credit history. That will only hurt you in the long run. Remember, the end goal is to have a healthy, long-term credit history, not to build credit as quickly as humanly possible.
A car loan is one common credit-building option for young adults. But since you'll have to pay interest on a car loan, it will cost you (unlike credit cards that you pay off in full every month). The best way to take out a car loan with the goal of building credit is to actually save up to pay for your car in cash first.
If you can save up enough to pay for a car in cash, even if it's just an old beater, here's what one Investopedia article suggests you do:
- Pick out a car that's within your price range.
- Take out a loan for the car, either through the dealer (which can sometimes get you a decent discount) or through a local bank.
- Make the first month's payment on the loan.
- Pay off the rest of the loan in full a couple of weeks later.
This process will let you skip out on most of the interest payments for your car, saving you money in the long run. You'll add another type of credit to your credit history, and you'll show that you're capable of making other kinds of payments on time.
Of course, if you really do need a new car but can't afford one at the moment, you can take out a small, affordable car loan. Your best option is to work with a bank or credit union, since they usually offer better financing terms on used cars than dealers. Then, make all your payments on time, and try to pay off the loan as quickly as possible to save on interest payments.
If you're going to college, opening student loans in your name will also help you add in different types of credit.
Leave accounts open
You can't rush establishing a long-term credit history. It will just happen naturally over time. But you can keep from cutting your credit history short by leaving old accounts open, even if you aren't using them anymore.
If your first real credit was a secured credit card, you may want to leave that secured card open for several years, since it will continue to add to the length of your credit history. Once you have other accounts that have been open and in good standing for several years, you can close older accounts that you no longer use. This strategy is best used for credit cards that do not charge an annual fee.
Don't apply for too much credit
As you're applying for credit to help establish your credit score, be sure that you don't apply for too much. If 15 credit card companies pull your credit report, the credit bureau will assume you're trying to take out more credit -- possibly more than you could pay back -- so this lowers your score.
There are two situations in which this doesn't apply, though.
The first is when you're releasing your credit information to a non-lender. Checking your own score -- or allowing potential employers or landlords to do so -- doesn't affect your credit score. Only inquiries from actual lenders count.
The second is when you're applying for a larger loan, like a mortgage or an auto loan. In this circumstance, you can shop around with different lenders without incurring multiple negative inquiries. An article from MyFICO.com says that as long as you apply for loans for big-ticket items within 14 days, your credit score will only get hit once. So if you shop around with five different mortgage lenders, make sure they all check your credit within a two-week period.
Keep track of your progress
As you start this process of building your credit, it's easy to track your progress. Simply pull a copy of your credit history and credit score every few months. This is a good idea anyway because it lets you quickly find any mistakes or fraudulent accounts in your credit history.
Keeping track of your credit is easy with several free credit scoring services. One of my favorites is Credit Sesame. You don't need a credit card and you'll never pay a dime for the service.
As you can see, there's no one single path you should take when you're trying to establish credit. Maybe you'll start with a secured credit card, but maybe you'll be able to get a small unsecured credit card to start. You might need an auto loan at some point, or you might use student loans to pay for college.
The point is to have some sort of plan for establishing credit in the way that works best for you. And be sure you follow the basics of establishing and maintaining great credit: Pay everything on time, and don't take out more than you can pay back.
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