It’s official. Credit scores are
the most confusing aspect of personal finance. The FICO formula remains largely
a mystery. And don’t get me started on the multiple versions of credit scores
out there. By one account, you may have 49 different FICO scores, not to
mention dozens of credit scores calculated using non-FICO formulas.
So it’s understandable when folks (myself included) get a bit
lightheaded when thinking about our credit. And that brings me to a great
question sent in from a reader and podcast listener named Esther:
Thanks so much for writing a fantastic blog and sharing your
podcasts. My husband and I just started listening a few weeks ago and have
learned a great deal. We’re still in our 20s, but we often tell each other how
we wish we would’ve known about financial independence and building credit
earlier on in our lives to prevent all of the mistakes we made in college. We
really want to teach our children about financial independence so they can
avoid the same mistakes we made. So my question is: how can an 18 year old
start building their credit the right way?
Esther’s question is a good one, and one I’ve given a lot of
thought to as my children are now young adults. I’ve written before on how to
build credit for the first time. In this article
I’ll share some new perspectives, tips, and resources on this topic.
First Things First
Let’s start by making sure we put the question of credit and
credit scores into the right perspective. There are three main financial
priorities every young adult should have:
1.
Spend less
than you make
2.
Invest
wisely
3.
Avoid debt
Pretty simple. In fact, these are the three main financial
priorities we all should have. Why? Because these priorities will enable us to
achieve financial freedom. Financial freedom, in turn, will allow us to pursue
our life’s purpose, whatever it may be.
So what’s this got to do with building credit? A lot. Building
credit can involve some financially dangerous moves, particularly for those
with little experience managing their finances. As will see below, credit cards
are a great way to build credit. They are also a great way to ruin your
finances. So as we walk through credit-building strategies, keep in mind the
three priorities listed above.
Become an
Authorized User on a Credit Card
The first and easiest way to establish credit is to become an
authorized user on a person’s credit card. For most young adults, this will
mean becoming an authorized user on a parent’s credit card. There are some
important things to keep in mind with this approach:
·
An
authorized user doesn’t have to use the card to build credit
·
As an
authorized user, your credit can be harmed if the account holder makes payments
late
·
If your
credit is being harmed, you can call the credit card company and asked to be
removed as an authorized user
·
Not all
credit card issuers report authorized user status to the credit bureaus (here’s
a thread on the myFICO forum that lists credit cards that report)
As a final word of caution, avoid what is known in the industry as
piggybacking. With piggybacking, an individual becomes an authorized user on a
credit card for a fee. These transactions usually involve complete strangers
and are brokered by financial
intermediaries and credit counselors in an effort to
artificially inflate an individual’s credit score. FICO has worked hard to
detect these situations and to exclude them from the FICO formula.
Get a Credit Card
and Use it Wisely
The next step to building credit is to obtain a credit card.
Consistent with the financial priorities listed above, however, care must be
used when selecting and using a credit card.
There are excellent reasons to use a credit card beyond building
credit. The security of using plastic and the potential rewards are the two
primary reasons. If used responsibly, however, plastic can help establish
credit as well.
Here are some things to keep in mind:
·
Prepaid
cards and bank debit cards do not build credit
·
Some credit
cards are designed for those with no credit history, including student and
secured credit cards
·
Keeping your
credit limit low to start is an excellent way to remove the temptation to
overspend
·
Paying the
card off in full each and every month is a must
Store branded credit cards are also an option, but not one I
recommend for two reasons. First, store cards encourage frivolous spending.
With a generic card, you can by everyday essentials, such as gas and groceries.
A Macy’s store credit card doesn’t qualify as essential. Second, the interest
rate that comes with these cards is usually very high.
What About Other
Loans
I’ve not included other types of loans, such as car loans and
student debt. These types of loans will of course affect your credit. Further,
having different types of loans (revolving credit like credit cards and
installment loans like a car loan) can affect your credit score. For me,
however, it’s not worth going into these types of debts just to build your
credit. Pay cash.
Pay Your Debts on
Time, Every Time
It is absolutely critical that any monthly payments on credit
cards or other debt is paid on time. Payment history is the single most
important factor in the FICO formula, accounting for 35% of the overall score.
A late payment, moreover, remains on your credit history for seven years.
Establishing Credit
is Different Than Repairing Credit
Finally, there are some important differences between establishing
credit for the first time and repairing credit. When repairing credit, keep a
few things in mind:
·
Checking
your credit report for errors is a must. It’s the quickest and easiest way to
improve your score.
·
Baggage on
your credit report stays there for a long time (7 years for late payments as
noted above). However, the effect this baggage has on your score decreases over
time.
It’s generally hard to get a credit card with bad credit than it
is with no credit. A secured credit card is generally the best option for those
recovering from a bankruptcy, foreclosure or other credit mishaps.
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