Young Adults and Credit

It is more crucial than ever for young adults to begin building a positive credit history well in advance of taking out an auto or home loan. Building a foundation of good credit and scores will determine interest rates and overall creditworthiness. To that end, this is a helpful guideline for young adults to understand how to build a good credit history and why it’s so critical.

It is important to know how to utilize credit to make it work for you instead of against you. Having a credit card with a $300 credit limit is not the same as having $300 in cash. It is very easy to purchase those designer jeans you have been wanting with a credit card, even if you don’t have cash in your checking account. But you may not realize the $175-$200 you just spent on those jeans could cost you $300 or more if you choose to make payments over several months.

Starting with the basics, your credit score is a three-digit score that ranges from 300-850. Borrowers with high credit scores can expect better interest rates on all types of loans. Each of the three major credit bureaus, Equifax, Experian and TransUnion, collect data from your creditors about your history of borrowing and how you pay back what you have borrowed. Your credit history can be different at all three bureaus since your creditors may not report to all three. They are not required to report to the bureaus, however most do. Each of the bureaus use a different scoring model developed by Fair Isaac Company (FICO). These are statistical models and your scores can change daily depending on when and if your creditors report to the three different bureaus.

According to statistics the average student now graduates with more then $8,000 in credit card debt. In addition to student loans, this means the graduate could be paying off debt for a very long time. Now, students under the age of 21 must have a cosigner or provide financial information indicating they have the ability to independently repay the debt. There will also be no more campus solicitations or marketing for credit cards allowed, and an application must be submitted for any credit card.

There are several good ways for younger people to establish credit. A parent can add their child as an authorized user to one of their existing credit cards. While not having access to the credit account, they will still “inherit” the credit rating. A secured credit card is another way to establish credit. These are similar to savings accounts and most banks and credit unions offer them. The student sets up an account with a refundable deposit (i.e. $300-$500) and the bank or credit union gives them a credit card with a line of credit based on the deposit. The card holder makes monthly payments based on their balance while the account is secured by the original deposit. . Once you have established good payment history with the company (usually 18 months) they will often upgrade to an unsecured card and refund the initial deposit. A very good place to shop for and compare secured credit cards is at Gas and Retail cards are easy to obtain with limited credit history, but be careful as these tend to have very high interest rates.

What about other types of credit? Most companies will access your credit report when you attempt to open an account. This includes cell phones, auto loans, student loans, utilities, insurance, rent, etc. If you do not have established credit, the company may require a cosigner or a deposit. The rate you pay will usually be based on your three digit credit score, even the cost of your health and auto insurance can be dictated by that credit score.

Once you have an established credit history it is very important to maintain a good credit rating. The first rule is to always pay your bills on time. One 30 day late payment on one credit card or any financed account such as an auto or student loan can lower your score 100 points or more…also, that late payment will remain on your credit report for 7 years! Even though cell phones, utilities and insurance don’t actually report directly to the bureaus, if you fail to make your payments, they will turn your account over to a collection agency and these agencies DO report to the bureaus. Again, just like a late payment a collection account can lower your score 100 points or more and remain on your credit report for 7 years.

It is always best to pay off your credit cards every month so you do not incur finance charges. If this is not possible, you want to keep your balances on revolving debt (credit cards, lines of credit) below 30% of your credit limit. For example, you should keep your balance below $90 on a credit card with a $300 limit. Your credit score will drop if your balance exceeds 30% of the credit limit and your credit score will drop even more as the balance percentage goes up.

The perfect credit mix for a good FICO score is 1) two installment loans (auto, student loan or mortgage); 2) three credit cards with balances below 30% of the high credit and; 3) additional credit cards with long payment history and no balances.

Most important – do not close credit cards that you have had open for a long time. The biggest positive impact to your FICO score is payment history, which makes up 35% of your score. When you close an account you are closing out any good history and this can lower your credit score.

Establishing a good credit foundation when you are young is a very good idea. You just need to be smart about it and remember the two most important things: Pay your bills on time and don’t run up high balances!