Heading Out on Your Own — Day 11: Understand Credit

by Brett & Kate McKay on August 11, 2012 · 26 comments

in Heading Out On Your Own

Credit. When it comes to understanding personal finance, this component looms large. For some it is a dirty word, to be avoided at all costs. For others, it is an intoxicating license, an opportunity to reach for a lifestyle well beyond their means.

In truth, credit can be extremely helpful or harmful depending on how it’s used. In many ways, credit is more of a tool than anything else – simply a means of achieving some desired outcome. In the hands of an uneducated, unskilled, and inexperienced person, a fire, a table saw, or a gun can cause havoc and harm. But in the hands of a responsible and educated individual, they can be immensely useful. So it is with credit.

A bad use of credit would be buying a huge flatscreen television with a credit card; you’ll receive little return on the interest you’ll pay on that balance. A good use of credit would be taking out loans to get an education, or for a car to get you to and from a job; these things put you in debt in the short-term, but will improve your financial prospects in the long-term.

When you need to use credit in a positive way, your ability to do so will be based on the credit history and score you have been establishing for years, starting when you first headed out on your own.

What Is Credit?

As the dictionary defines it, credit is: “The ability to obtain goods or services before payment, based on the trust that payment will be made in the future.” Student loans, car loans, home mortgages, and credit cards are all types of consumer credit instruments — you’re getting money now to pay for something you otherwise couldn’t afford, based on the lender trusting that you’ll pay them back later.

Sometimes credit is completely free, but it usually comes at a price. Most banks and institutions will charge interest on the money they lend you (aka, the principle) in exchange for giving you the funds, along with the opportunity to pay it back slowly over an extended period of time.

Different types of credit have different interest rates. Student loans often have lower interest rates than other types because many of them are guaranteed by the U.S. government. Even if you can’t pay them back, the lender will still get their money from the government. Credit cards, on the other hand, often have the highest interest rates among the various types of credit because: 1) there’s a higher risk that the credit card lender won’t get repaid and 2) it’s more expensive to manage credit card debt (at least that’s what the credit card companies say).

Even among the same kinds of loans, you’ll find different interest rates. That’s because people have varying degrees of “creditworthiness”. You’ll often hear banks refer to people as having “good credit,” bad credit,” or “no credit.” People with good credit have a reputation for being a responsible borrower. They pay their bills on time and manage the credit available to them responsibly. People with good credit not only have access to more money, they also get lower interest rates on their loans.

People with bad credit have a reputation for not paying their bills on time or even not paying them at all. Banks and other businesses are less willing to extend credit to these individuals. Even if they’re able to get a loan, a person with bad credit will be charged a higher interest rate.

Folks with no credit simply don’t have a history of using credit, so they’re kind of a wild card. They might be good with credit, or they might not. When banks loan money to people in this situation, they’ll usually start off charging a higher interest rate, but they’ll be willing to bring it down as the debtor demonstrates they can repay the balance owed on a consistent basis.

How Do Banks Know If You’re Creditworthy?

So how do banks or credit card companies know whether you have good credit, bad credit, or no credit? When you apply for a loan, the person reviewing the application probably doesn’t know you from Adam. How can they possibly discern whether or not they can trust you to pay them back?

Put on your tin foil hat folks, because the answer is that there are three big credit agencies keeping track of how you use credit — from how much you borrow to how often you are late on payments.

You’ve probably seen the commercials on TV about how to get your hands on a free credit report. That’s the record those Big Brother-like agencies have on you. These commercials will also typically mention something called a credit score. That’s the number that banks use to indicate whether you’re a trustworthy borrower or not.

Many young people just getting their feet wet in the world of credit often confuse credit reports with credit scores, and vice versa. It’s an easy mistake to make, but one that can be corrected with a quick primer on the difference between the two.

What’s a Credit Report?

Credit reports explain what you do with your credit. They state when and where you applied for credit, whom you borrowed money from, and whom you still owe. Your credit report also tells if you’ve paid off a debt and if you make monthly payments on time.

Federal law mandates that all three major credit reporting agencies must each give you a free credit report each year. So, when those TV commercials talk about getting a free credit report, the above information is what they’re offering.

But, getting your free credit report from a heavily-advertised site like FreeCreditReport.com or FreeCreditScore.com isn’t a good idea. In return for getting a free credit report and score, you have to enroll in their monthly credit-monitoring service for $15 a month. If you cancel within seven days, the report and score are indeed free, but if not, your subscription to their service will begin. The pain is that you have to call to cancel — you can’t do it online — and you might forget (that’s what they’re counting on).

Instead, get your free credit report with no strings attached from AnnualCreditReport.com. This site offers you a truly free report from each of the three credit agencies. You can get them all at once, but I would recommend staggering them throughout the year so you can keep more regular tabs on your credit score.

Why You Need to Request Your Credit Report Every Year

There are a couple of reasons why you should request a free credit report each year. First, it allows you to check for and correct mistakes that have crept into your report. You don’t want those mistakes to affect whether you get a higher or lower interest rate, or whether a bank will approve a loan for you at all. When you spot a mistake, you can start taking actions to clean it up.

The second big reason you want to request a credit report every year is to protect yourself from identity theft. With the right information, a con-artist can apply for a wallet full of credit cards in your name without you knowing it. Then you start getting calls out of the blue from collection agencies asking you to pay up on purchases you never made. A yearly credit report lets you check to see if anybody is fraudulently using your name to apply for credit cards or loans without your knowledge and take action if needed.

What’s a Credit Score?

Your credit score is determined by the information in your credit report. Credit scores are used by companies and banks to evaluate the potential risk posed by lending money to individual consumers. Your credit score determines if you qualify for a loan, what your loan’s interest rate will be, and what your credit limit is. It’s basically your trustworthiness score for lenders.

The company that came up with the idea of a credit score was the Fair Isaac Corporation. That’s why you’ve probably heard credit scores referred to as a FICO score. Because each of the three credit agencies collect slightly different information about you, you’ll have three different credit scores, although it’s possible for all of them to be the same.

Credit scores range from 500 to 850. If you have a FICO score of 500, you’re going to have a hard time getting a loan. Even if you manage to get one, the interest rate on it will be high. With any score above 720, you’ll receive the best rates available. Whenever you apply for a credit card or car loan, banks and credit card companies will check your credit score to determine whether to lend you money or extend the credit card to you in the first place. If they do decide to extend you credit, they’ll then use your credit score to determine the interest rate they’ll charge you for borrowing money.

Unlike credit reports, which are free, credit scores cost money to view. They cost about $15 to access, and you’re given the offer to purchase your credit score after you get a credit report. Bankrate, however, offers a free FICO score estimator. The estimator asks you 10 questions about your loans and credit card balances and then spits out an estimate of your credit score. While not 100% accurate, you’ll at least have an idea of where your score is at and make adjustments in order to improve it.

How Your Credit Score is Determined

Because your credit score can possibly make or break some important financial and lifestyle decisions, it’s important to understand how the credit agencies determine your score so you can take actions to ensure it’s the best it can be.

When coming up with your FICO score, credit reporting companies look at several factors, including:

Payment record. 35% of your score depends on your ability to pay your bills on time. Payments that are more than 90 days late will hurt more than a payment that’s just 30 days late. Also, recent late payments hurt more than older ones. A single late payment won’t kill your score, so don’t panic that you’ll never be creditworthy because you missed a payment. Just pay the bill and try not to let it happen again.

Amount borrowed relative to available credit. This factor accounts for 30% of your score. The credit companies want to know if you’re borrowing to the max. If you have $10,000 of available credit, and you consistently run a balance of $9,999, that’s a red flag that you’re not very prudent about your debt. However, if you usually have a balance of $200 of outstanding debt, that’s a sign you’re more responsible with credit. To improve your score, try to keep your debt to about 10% or less of your available credit.

Length of credit history. This is 15% of your score. The longer you have successfully borrowed money and paid it back, the less risk you are to a lender. If you pay off a credit card, it’s good to keep it open, even if you never use it. When you close it, you lose that credit history, which could in turn affect your score.

“Hard” Credit Pulls. This is 10% of your credit score. A pull is a type of inquiry into your credit. Hard credit inquiries are made by lenders for the purpose of extending you credit. These will lower your score because having multiple hard inquiries is a signal that you’re looking for loans and are possibly a poor credit risk. So, when the cashier asks if you want to sign-up for a store credit card to get a 10% discount, tell them “no thanks” in order to avoid the hard credit pull.

If you’re shopping around for a car loan or mortgage, lenders will have to pull your credit score every time you ask for a quote. Don’t worry about those types of pulls hurting your score. Similar inquiries made within a two-week period won’t ding your score.

Types of debt. This is the final 10% of your score. It’s best to have a mix of car, home, student loans, and little to no credit card debt. If you’re up to your eyeballs in credit card debt, you’ll be seen as bigger risk.

Other factors. In addition to your FICO score, lenders will also to take into account other factors when determining whether to loan you money. Things like your income, job history, and assets you own can factor into whether you can secure a loan.

How Can I Build and Improve My Credit History and Score?

Because your payment record and length of credit history make up about 50% of your credit score, it’s important you begin building a solid credit history as soon as you can. A good credit history along with a high credit score will serve you well later in life.

The fastest and surest way to build up your credit history is to simply open up credit accounts and pay back the money when it’s due. Opening a credit card account is an easy way for young people to begin establishing their credit history.  A low interest, low minimum balance credit card can give a young person just starting out in life the opportunity to pay a credit balance on a regular basis in order to establish a solid positive payment record. Also, the earlier a young person obtains a credit card, the longer his credit history will be when he applies for that mortgage later in life.

There is a danger, though. Credit cards can be a big time hazard for a young man just starting out on their own, as they allow you to spend money you don’t have. And because a young man’s schedule can be hectic and his life disorganized, he may forget to pay the monthly balance, incurring penalties and interest, and potentially plunging him into debt. If you don’t have the income and level of responsibility to pay off your credit card balance every single month, don’t get a credit card.

Even if you are responsible enough to get a credit card, maybe you just don’t like the idea of having one and want to avoid credit card debt altogether during your younger years. Smart move.

So what if, for whatever reason, you want to avoid getting a credit card, is there any way to still build up your credit history or are you doomed to high interest rates when you apply for a mortgage later on?

Despite what some people may tell you, it is possible to establish a credit history and improve your credit score without a credit card. If you’re a college student, you likely have student loans. As soon as you graduate, start paying your loans back on a consistent basis. Boom. You’ve got a credit history.

Another way to establish your history without a credit card is to apply for a small loan through your bank and have your parents co-sign on it. Make regular payments and pay it off as fast as you can. More credit history.

But let’s say you’re a complete Dave Ramsey devotee and decide to not use credit at all: no credit cards, no student loans, no car loans. Nothing. How can you secure a low interest rate when you’re ready to buy a house if you don’t have any credit history (assuming you haven’t reached the Ramsey pinnacle and are able to buy a house in full with cash!)?

By applying for a PRBC Alternative Credit Score. A PRBC Credit Score shows lenders you’re financially responsible and trustworthy by keeping track of how well you pay non-credit bills like rent, utilities, and insurance on a regular basis. It’s relatively new, but many lenders will accept a PRBC Alternative Credit Score when determining interest rates for mortgages and other loans.  Unlike your traditional credit history or scores that begin tallying as soon as you use credit, you’ll need to self-enroll to obtain a PRBC Alternative Credit Score.

Any other things a person heading out on their own for the first time needs to know about credit? Share them with us in the comments!

{ 26 comments… read them below or add one }

1 Josh Zytkiewicz August 11, 2012 at 2:02 pm

CreditKarma.com allows you to get your credit score totally free.

They make their money by offering/suggesting different financial products, similar to how Mint.com works.

2 TR August 11, 2012 at 2:47 pm

Another easy, no cost way to improve your credit score if you have a credit card is to request an increase in your credit limit. (My bank lets me do this online.) This will lower your utilization percentage assuming you don’t change how you use the card.

3 Antonio August 11, 2012 at 3:12 pm

I’m so following this blog and this series of posts.
They are amazing and it feels like it reads my mind.
But I have a question.
Does this posts about finances wrks in another contries like Argentina?
I don’t know if it is the same in every part of the world.

4 Tevin Carter August 11, 2012 at 3:16 pm

Very well written post. I just turned 18 and will be looking if I can get a credit card soon, to begin building up my credit. I have always had family with bad credit, and little financial knowledge. I am determined to have a score of 800 going into my years…

5 Andrew K August 11, 2012 at 3:52 pm

I’d like to point out that while having an established credit rating is important, I think what’s more important is planning for those budget items whether it is saving up money for them or knowing what kind of terms of agreement are you likely to expect. Obsessing about getting a certain score is sort of unhealthy and even if you have a perfect score, the likelihood of getting a loan is a lot lower than it used to be.

6 Tom G. August 11, 2012 at 4:41 pm

Tevin,

I recently was in the same position you are (I just turned 22), and like you, I wanted to get a credit card for the sole purpose of building credit. However, I had to go through a couple hurdles before finally being able to get through a card, maybe I can save you (or others) some stress and headache.

My major problem in applying for credit cards was the fact that I had no previous credit history for the company to base their approval on… (the irony of needing to have credit to build credit), so I was denied. I even tried applying twice for different “student” credit cards, but the same result. Be careful about this – getting denied from credit cards (even for this reason) can hurt your credit history.

I looked into taking out a loan from my bank, for the sole purpose of paying it back and building a credit (which seemed ridiculous to me, essentially paying for a credit score), when my banker presented me with another option: a credit card through the bank, backed by a special Certificate of Deposit for the value of the credit limit as collateral. I went with $500.00, got the credit card, and managed my payments very carefully – never fall behind! Fast forward four years; I applied and was accepted for a standard credit card. Looks like I have a credit history!

My bank was a local bank and I feel fortunate to have had that option, but it worked out well for me, and I would recommend it to anyone looking to build credit for the first time!

Good luck, and great responsibility!

Tom

7 commenter5 August 11, 2012 at 5:10 pm

daveramsey.com

That’s all.

8 Josh Knowles August 11, 2012 at 5:10 pm

Another thing which I think should be mentioned is store credit. Stores often offer great deals like, “No money down, no interest for six months,” or something like that. But there’s usually a catch. The catch is that the “no interest” is actually DEFERRED interest. That means that if you don’t pay off what you owe within the time period you suddenly get charged all the interest that has been accumulating. And sometimes it can be pretty steep. Check the fine print, they have to inform you, but they don’t usually make a big deal out of it.

Of course, this doesn’t mean that you should never use a plan like this. Just don’t be a sucker: Pay the amount within the time period. Like Brett said, it’s a tool.

Personally, I try to avoid credit as much as I can. At the same time, I can’t quite go the Dave Ramsey route and have no credit card. I just make sure to pay that principle off every month when my statement comes.

9 EK August 11, 2012 at 5:38 pm

IMO instead of taking a credit card and spending money you don’t have, get a debit card—seriously—and use credit for paying your education fees, accommodation, etc. But must admit that I’m advising it because here in Europe credit cards are seldomly used.

10 Ike Hobbs August 11, 2012 at 6:49 pm

Thanks a lot! I’ve been living on my own for a couple of years now but this whole series has been a great refresher and this article in particular was about something that I’m not real familiar with. Very helpful.

11 TJ W. August 11, 2012 at 8:16 pm

Tom,
Most banks call it a secured credit card. I got one for $500 with Wells Fargo when I turned 18. After one year of making payments on time, they automatically switched it to a regular card and gave the $500 back.
When I turned 20 and got my first car loan the dealer told me he had never seen someone my age with so high a score. Secured cards are great for building credit if you use them properly.
TJ

12 Mike August 11, 2012 at 11:40 pm

Tom mentions that he had to give the bank $500 to get a secured credit card and that he felt this was ridiculous. I feel like we don’t listen to ourselves enough sometimes. The truth is most credit use *is* ridiculous and how banks calculate risk and whether or not to offer us credit and how much has little to do with how we think the world should work.

A FICO score is a score based on how we manage our *debt*. You can go glass half full if you want and say it’s how we manage our credit, but the reality is the former. I’m not anti-credit, but as I get close to 40, I am amazed by my own stupidity in this area and the poor choices I made that seemed right at the time.

If you feel you must participate in this game, fine. But my advice is to never leave a running balance and pay it off every month. On a personal level, the only thing you should take a loan out for is a house. Save up for the cars, truck and other toys. And *absolutely*, marry someone who has the same financially ideals as you. Lastly, take Dave Ramsey’s Financial Peace University. It should be required for every senior in high school.

13 Brad August 12, 2012 at 1:54 am

I work for a credit card company that delas almost exclusively with department store,furniture store,jewelry store,etc lines of credit-my advise-NEVER sign up for a store credit card. the interest rates are insane and if you ever have to call the bank for anything, they will always try to sell you membership services, account upgrades and a bunch of other useless crap

14 Bryce August 12, 2012 at 7:43 am

Here’s a little nugget of wisdom from a former teacher and current friend and mentor of mine: “They don’t call it MASTER Card for nothing!”

15 Patrick August 12, 2012 at 7:46 am

Honestly, I wouldn’t touch a credit card with a ten foot pole. Companies these days will work their tails off to get one of their cards into your hands because they know it’s an easier way to get you to spend money. Studies show you’re more likely to buy something with a credit card than with cash because it takes less time, and with this whole tap thing you can do now, it’s even easier. Paying with cash is harder to do because you actually see the money leave your pocket and go into the cashbox. You have the ouch factor of losing that cash. I think it much better to save your money, be wise with it, and pay cash for everything. Debit cards are fine, but only if you use them sparingly.

As far as student loans go, I’m still hesitant to encourage people to use them, especially considering that, two years after graduation, my wife and I have only just paid off our first loan, and it was only $6k. With this economy and poor job market, it’s really, really difficult to get into a position where you can feasibly pay off your loans quickly, even if you have a very practical degree (I don’t, but my wife does). It might take longer, but if you can manage it, I’d lean more toward part time schooling and full time work.

And just to state the obvious, yes, I am a Dave Ramsey devotee. :)

16 Jacob Gardner August 12, 2012 at 1:38 pm

Another thing to note about secured credit cards is that (at least with mine) when you move in to the next billing cycle, the full amount on deposit is not available to you until you pay off the previous billing period. For example if you have a $500 secured card and spend $250, even if you go into the next billing cycle the limit is $250 until you pay off the previous balance. This way you can never go over the amount on deposit, but it still gets reported as a credit-based transaction.

17 Jr August 12, 2012 at 2:49 pm

@TR: watch out with that approach. As you look for loans, your available credit could cost you as this increased available credit ,which you have no intention to use, will limit how much your next loan can be.

Also, if you like to stay on top of finances regularly, do not freak out when your score changes (can lower) after large purchases like a vehicle or mortgage. Its part of the process

18 De Klerk August 12, 2012 at 5:31 pm

Here a small comment all the way from the Netherlands. Apart from student loans and mortgages, we consider it to be quite ungentlemanlike to use credit. Why? Because one should not spend more than one can affor.

A healthy financial household does not need credit. And an unhealthy financial household does not need a car or a flatscreen.

But I admit that our government has been giving extremely bad examples during the last decades.

19 Ian August 13, 2012 at 9:22 am

Most bankers and financiers refer to people who pay back their debts on time, or ahead of time, as “deadbeats.”

http://credit.about.com/od/usingcreditcards/a/deadbeatcredit.htm

Also the magic formula for devising credit is kept ridiculously secret and protected by the three major credit bureaus. Treat all of the people who broker in credit (particularly those who know they are backed by the US Taxpayer) with extreme caution. Their top officers are not in the business of helping you.

20 Ryan August 13, 2012 at 12:17 pm

I was fortunate to turn 18 shortly before the 2008 crash so I was able to open a no-frills, no-fee Wells Fargo credit card (a regular one, not a secured card) which has given me a stellar four year credit history.

I never carried a balance and never paid a penny in interest. I just graduated from college and I now have a 750 credit score.

Moreover, if you know what you’re doing and *you are extremely careful about it* you can parley a high credit score into some serious free travel. Over the last 18 months I’ve opened three Chase cards: Sapphire Preferred, United Explorer (actually the Continental version before the merger) and the United Club card. The first two netted me 50k United miles a piece. Combined with 40k miles I’d earned from actual flying I was able to spend the summer in Southeast Asia and get there on a free first-class ticket.

I turned 140k United miles into a first class award ticket, spending a month and a half in Hong Kong, Thailand, Malaysia and Singapore. I paid for the rest of the trip expenses out of my savings (I worked all through college in IT support and later as a software developer).

The third card I opened not for points but for the included United Club lounge membership. I’m starting a job in software which will have me travelling on a weekly basis so despite the high fee the card will pay for itself pretty quickly.

So, I disagree with the posters arguing against credit cards. The right cards can open doors that would otherwise be prohibitively expensive. Had I bought my ticket it would’ve been over $20,000. I paid about $200 in annual card fees and $64 in airline taxes/fees.

However, you must be *extremely* careful and do your research before you attempt this. You’ll also need a stellar credit history.

21 Jeff B August 13, 2012 at 1:55 pm

As some people have said… check out daveramsey.com even if you disagree… it’s better to find out you want to be out of debt when you’re 5,000 in debt rather than 50,000. My $.02.

22 Joshua Postema August 13, 2012 at 6:34 pm

After going almost 30 grand into debt for student loans, I can now safely say that I will never recommend them again. I even got them in a field with a great job outlook and good pay. It will still take me several years to pay them off and it will make it difficult to buy a house.

I can understand taking out a mortgage for a house (something that overall gains value), but student loans don’t guarantee a job. I’d much rather have worked my butt off before and during college and pay for it myself

23 danny dailey August 15, 2012 at 7:47 am

Two things:
1) If you decide to go totally debt free free besides a mortgage, you have two options to purchase a house:
a) pay for it in cash (which requires the death of a wealthy relative or saving for a long, long time while paying rent).
b) build alternative credit. If you choose option b, you’ll need to get some bills in your name. So paying your mom $50 a month for your portion of the family phone plan won’t work any more. 2) If you choose to build credit with a credit card, here’s a tip: only use your card when you have equivalent cash in your wallet. Take that equivalent cash and paper-clip it to the receipt. Store your receipts and cash in a safe place until you get the credit card bill, at which time just deposit the cash and write a check. You’ll never overuse your card and never miss a payment.

24 Tarcas August 29, 2012 at 4:39 pm

I strongly recommend that everyone get a credit card (possibly more than one) when they turn 18 in order to build that credit history, but I also strongly recommend that they seek financial education. An old credit history is great, but if at the same time you’re building a bad payment history, that negative impact will have a far greater effect on your score.
I would call Dave Ramsey Finance 101. Summary: get out of debt) It’s great advice if debt is your problem, or if you want to create a solid foundation for yourself.
Kiyosaki would be on a much higher level, maybe 300-level. (Summary: borrow to invest.) It’s a great way to get ahead, especially if you already have that solid foundation. If you had a poor financial upbringing, definitely start with Dave Ramsey or Suze Orman and master their strategies before tackling the riskier ones. Also find a real-life mentor who you can talk with and ask for advice rather than just read general strategies.

25 John Weiss October 11, 2012 at 7:55 am

As an individual who fell for the credit card trap in his younger days, this post is critical for the up and coming man.

In fact, I believe that understanding interest payments in our modern world is so important that I would like to suggest a book called The Interest Direct by John Weiss. From the description

“This book intends to provide a basic mathematical understanding of the underlying rules of interest bearing debt taking no prior understanding of mathematics for granted. This book is tailored to take the student all the way from addition to continuous compounding interest in the least painful and most efficient path possible. The mathematics of interest is not a hard subject and I prove this through an easy to read and obvious approach.”

Remember, debt is a form of servitude. One should understand what they are giving up their liberty for and how they can gain it back.

26 Newlyn November 30, 2013 at 2:16 am

Speaking from a property manager’s perspective, having a good to great credit score is key to claiming stakes to an apartment in cities like NY and SF, where the rental market is red hot. It’s tough renting out to recent graduates, who have lower than average credit scores. It’s easier to decline applicants who have low credit scores than to put up with having to chase down rent every month.

As for building up a credit, it’s OK to have debt, like student debt. Don’t pay it all off at once though, even if you could. The best way to do it is to pay the exact amount due consistently on time. This will help repair and build your credit score in the long run.

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