This is a guest post by Tom at Fired Up Millennial.
When you first start working as a young adult, the focus is money. This includes making it, saving it, and learning to budget it appropriately. One thing that many young professionals forget about, however, is equally as important and can have just as lasting of an effect on your life…
That critical thing is credit.
If you don’t build credit, you can find yourself incredibly hampered. This may even mean areas that have nothing to do with your finances. So, why is your credit score so important? What else does it affect? Read on to learn more and make credit work for you.
Why Credit Matters
Credit used to just be a measure of how likely you are to pay your bills. Banks and financial institutions used your payment history and credit usage to determine if you were reliable to lend money to.
Now, those scores are looked at by far more than just your local bank. The decisions made based on the numbers are often far outside the realm of whether you’ll get approved for a new loan or not.
When you’re applying for jobs, many companies will have you sign a release authorizing them to check your credit. To them, a history of late payments means you might have problems following through on commitments, or that you can’t be relied on. Both undesirable traits for an employee.
Landlords also look at credit scores. They want to know that their would-be tenants (you) can be trusted to pay rent on time. If you have a history that says you don’t pay your bills, they’re not going to want to rent to you.
Later, you may want to buy a house or get a credit card that offers great rewards. Or, maybe you’ll need an auto loan to buy a car, a personal loan to consolidate credit card debt or a private student loan for grad school. With poor credit, you’ll find that many of these avenues will not be available to you. Even if you manage to find a lender that’s willing to take a risk on you, you’ll be looking at much higher interest rates and fees, which means overall higher cost.
How is a Credit Score Calculated?
The short version is that a credit score is your “rating” once all factors have been considered. Credit bureaus take into account everything from your payment history to how much credit you have available. And, how much of it you’re using. Your credit score is a number that reflects this combination. The higher the number, the better chance you have of being approved for credit or getting a good interest rate.
Something that tends to complicate the process is that different bureaus and lenders have different criteria and even different scoring models. As a general rule, however, scores can run from 300—absolute rock bottom—to 850, considered premium credit. Anything over 700 is good. But, some lenders or other creditors will go as low as 620. Below 600 is considered “subprime.” If your score drops that low, you can expect to have some problems getting credit—or even getting an apartment.
How to Build Credit
If you’re just starting out, you might be wondering how to build credit. It can seem like a frustrating cycle. You need a good credit history to get approved for a credit card. But, you can’t get that good history if you can’t get approved.
The good news is that there are ways to break that cycle. The first is by applying for a student or secured credit card. Credit card companies know that students are just starting out. As such, they usually don’t have any credit history built up. So, they offer cards that don’t require a high credit score or lengthy history. They generally have higher interest rates and lower credit limits. But, this is a good option for a starting point.
To maximize the effectiveness, you’ll want to pay your card’s balance in full each month—a good habit to get into.
There are other ways to help build credit at a young age, too. For example, taking out student loans, making on-time payments and getting your parents to co-sign with you. Or, even in some cases just paying rent.
I’ll talk a little more about how to use these products in order to build credit the fastest in the following sections.
What Makes a Credit Score Change?
Lots of different factors can affect your credit score a few points one way or another. But, you only need to be aware of a few factors. These can greatly affect your score in a nearly real-time kind of way. Every 2 weeks, the scores are updated. A change in these factors can mean a significant change in even that short a time.
The single biggest thing affecting your credit score is your payment history.
Even one late payment will drop your score. The record of that late payment will stay on your record for years to come. Even being one day late on your credit card payment can result in showing late on your credit report.
Credit utilization ratio is another critical factor. This measures how much of your available credit you’re using. A high ratio can signal current financial problems or a tendency to live outside your means—which will also result in financial problems later.
Creditors like to see less than 30% of your credit being used. If you have a $5,000 limit on your credit card and you are using less than $1,500 of it, that tells creditors that you can responsibly manage your credit. If that $5,000 card is maxed out and creditors see that you consistently reach your limit, that signals trouble and will decrease your score.
How to Improve Credit
It’s always best to start out on a good foot and build your credit in a positive way from there on out. But what if you’ve already made a few bad choices and find yourself with less-than-stellar credit?
The bad news is that once you have poor credit, it’ll take work and time to repair it. The good news is that it’s possible to go from poor credit to amazing credit, if you’re willing to put in the work.
Where to focus on rebuilding credit
The #1 most critical thing to do if you’re in credit trouble is to stop digging that hole you’re in and start working to get out of it. That means stop using your credit cards. You’ll never fix your credit if you keep adding to your debt. So, switch to using your debit card. If you can’t afford to pay for it with cash on hand, you really have to consider if the purchase is essential or not.
Secondly, you’ll want to make sure that all payments are always on time. If that means paying the minimum on your credit cards that month, so be it, but even the minimum payment is far better than no payment or paying less than the minimum. Making that payment means helping your payment history—which will only help your score. If you can afford it, pay far more than the minimum or the entire balance. If you stop using your card and put all available cash toward paying it down, you’ll be able to get that balance down a lot faster, and you’ll see your credit score go up as a result.
Another objective is to get your utilization ratio below 30%. Keep track of how much of your credit limit you are currently spending so you know can make sure it is always below this threshold.
A number of apps exist that can help keep you focused on your journey to build credit by offering ways to help and letting you know when you may be close to doing something that will damage your credit – such as spending too much of your available credit. Seeing your progress—even if it’s only a few points at a time—can help keep you motivated when you’re tempted to use your credit card.
Being a young professional is difficult. There’s a lot to learn. There’s a lot of ways to get on the wrong track, even if they aren’t immediately apparent.
Paying attention to your credit is one of the most important habits to get into. To build credit is one of the most critical ways you can set yourself up for future financial success. Building a solid credit history now will ensure that when you do need a loan or need to rent an apartment, you can. It’ll also help you look good to employers, landlords, and others.
Don’t let your credit stand in the way of your life. Build credit or repair it now. Start letting your credit score show you to be dependable, trustworthy, and an excellent manager of your own finances.
Tom runs FIREd Up Millennial – a blog about his relentless pursuit of Financial Independence so he can Retire Early. You can stay updated with his latest articles and random thoughts by following him on Twitter.