A few weeks ago, I wrote about making your credit card your best friend. I explained how it helps you build credit, provides security, and offers rewards if used correctly. I also mentioned how it helps you build credit. I want to dive into that more because a reader asked. I do believe that a credit card can be and should be an awesome financial tool, but it has a huge impact on your life that you may not be aware of. I jumped the gun a bit because nearly everyone I know has and uses a credit card. My mom set me up with a credit card before I started college. I’ve lived my entire adult life with access to credit and with a credit score. I took it for granted that not everyone had that coming out of high school, even though I know better. In another post I will talk about choosing a credit card and getting started with it.
While my mom wanted me to have the card in case of an emergency while I lived in another city, the secondary purpose of the card – the purpose for which I was more concerned – was to build credit. A credit card can help you build credit, giving you a good credit score, but how exactly does that work? What factors affect your credit score? What steps should you take to build good credit? And why should you care at all? So let’s break some of this stuff down so you can take the next steps in your financial journey.
Defining the credit score
A credit score is essentially your grade for being an adult. It tells you and others how responsible you are with money, to an extent. If you apply for a loan, the lender will examine your available credit scores and decide if you are a good investment. If you have a bad grade, you might not get the loan. If you have a good grade you could get better terms for that loan.
There are different companies that create the credit scores and for big loans, they usually look at the main three: Experian, Equifax, and TransUnion. Experian scores from 320 to 844, Equifax scores from 334 to 818, and TransUnion scores from 309 to 839. And just like school, the higher your grade, the better. You might have heard another score type: the FICO score. Each of these three scores are FICO scores. FICO stands for Fair Isaac Corporation, and is an analytics software company set up in the 50s for the purpose of creating a metric for lending risk. Try not to get too confused on that. I have two credit cards which show me my FICO score, but they don’t tell me if its Experian, Equifax, or TransUnion showing. Generally, 700 or higher for any score is considered good.
Why you need good credit
Credit has consequences and rewards all across the financial spectrum. The most obvious one is that your credit score affects the interest rate when you take out new credit. If you have a higher score, you will be given a lower interest rate, meaning you’ll pay less for borrowing money. My credit score fluctuates between 760 and 799 and that enabled me to get a good interest rate on the mortgage I just applied for. I got a better rate, compared to the average, than I did two years ago when I bought my car because I had two additional years of responsibility to show the lender. When you have good or excellent credit, all the different credit card companies will offer you good cards to try to get your business. These cards are often the travel or cash-back cards.
If you’ve ever applied for an apartment, you know they do a credit check. If you have bad credit, the landlord might ask you to have a co-signer, someone who has better credit. This person is responsible for paying your bill if you fail to do so. Many employers actually do credit checks now to investigate your responsibility. No one wants an irresponsible person working for them and a credit score is a quick way for that to be uncovered. Your score also impacts your car insurance rates. If you have bad credit, you’ll pay more for car insurance which is a legal requirement in my state. A lot of people do not realize how many areas of your life the credit score touches. So even if you didn’t earn good marks in school because you didn’t care what an external source thought of you, you should reconsider your stance now or you will literally pay the price.
How to build good credit
To have a credit score at all, you need 1) an account open for 6 months that 2) has been reported to the credit agencies in the last 6 months. That means if you are 18 years old, you might not have a credit score. Or if you have no credit cards or other accounts, you might not have a credit score. Getting a credit card with a low limit could be a great way to get you on the credit map, which is what I did when I was first starting out. When I was 19 and a freshmen in college, my mom took me to our local credit union and we applied for a card with a limit of $500. My mom wanted me to have it in case of an emergency (such as sustaining a concussion and needing to pay the emergency room copay and subsequently prescribed medications). While we were there, the banker told us that I should use the card to build credit by buying something small each month and paying it off. She recommended buying a tank of gas. That is what I did and that’s how I started off with a good credit score. That habit showed that I could handle credit; that is, I could borrow money for reasonable purposes and repay it. What would have looked bad would be spending $400 to $500 each month and not paying it in full each month.
Using a credit card is probably the quickest and easiest way to start building credit because credit card companies regularly report their information to the FICO credit agencies. Other types of accounts may be a part of your score calculation. If you have a store card like Macy’s or Target cards, those will be reported. Utilities and rent, though, are not usually reported unless you are not paying the bills. Many people think these basic accounts are part of a credit score but only if you are doing poorly paying them. One late payment, though not ideal, should not hurt you. Reporting to a credit agency takes time and energy. The only way your landlord is going to send information about your ability to repay, is if you’re not doing it. Once they send your account onto a debt collector will it become a part of your credit score. Thought paying those basic apartment costs won’t directly help you build credit, you don’t want to do poorly with them because it could destroy your credit! The same is true for cell phone bills, cable bills, medical bills, and insurance premiums. So when you’re very young, credit cards are going to be the main thing in your credit score. Once you add in any kind of loan, that, of course, will also be calculated in your score.
I just received a credit report in November because I applied for a mortgage. When you apply for a loan, they give or mail you a copy of the report. I also received a copy when I applied for my auto loan in October 2015. The items on my credit report are all of my credit cards, even if I haven’t used them, my student loans, and my auto loan.
The factors that make up the credit score
There are different categories that are graded or rated in your credit score. Some categories are more important than others. The two most important are payment history and credit utilization. Always pay your bills on time. It makes sense that paying on time is important in showing how good you are at handling credit. The other piece often gets lost for people. Credit utilization means how much of your available credit you are using. If you use the maximum amount, it is actually a bad thing. The idea is just because you can do something, doesn’t mean you should do something. Think about it this way: in college, I had a limit of $500 on that credit card. If I spent $500 every month, it implies that if I’d been allowed to spend more, I would have spent more. The only thing that stopped me from spending more money was that I wasn’t allowed. Lenders want to know that you have self-discipline. They want to know that you can control yourself; they don’t want to see you needing to be controlled. Credit utilization is recommended to never exceed 30% of your available credit. On my $500 limit, the maximum I should have ever spent is $150. Once I got to the point of wanting to spend $500, that means I needed a credit limit of about $1700.
As your credit score increases, credit card companies will “reward” you by letting you spend more. When I first started out with my credit union’s VISA card, I had to ask for an increase. I wanted to move my score up by showing I could be more responsible. But now, credit cards give me credit limit increases without me even asking. I have a limit of $5500 on two cards and $6500 on another card. The cards compete with each other; if one gives me an increase, it follows soon after that another one offers an increase. These higher limits mean my credit utilization usually hovers around 3% so I never have to worry about credit utilization negatively affecting my score.
Another factor that affects your score, but not as much, is the age of the accounts. This was the most disappointing thing I learned because it impacted me when I applied for my auto loan. Even though I had “excellent” credit, because the lender saw that my accounts weren’t that old, I was considered riskier. A lender can look at the scores and the reasons for the scores and make their decision. This caused my interest rate to be half a percentage point higher than the guys at the dealer had anticipated. There was nothing I could really do about it at that point. Basically, you just have to pay your dues. Let time pass and just be responsible with the accounts.
Other factors are how your debt is compared to its original amount, how long its been since you applied for any type of credit, and the type of credit you have. As I pay off my auto loan, my score should start to go up. At the beginning, my debt amount was equal to the loan amount. But now the balance of my loan is around 68% of the loan amount. As it approaches 0, my credit score will crawl back toward 800 and above. Right now, my score has dropped because I just applied for a loan. As time passes, that mark will eventually drop off. Whenever you apply for a credit card your score will drop. I’ve heard that it drops 15 points, but with my mortgage, my score only dropped 10 points. I knew this would happen and I also don’t care. I don’t need to apply for any more loans for a long time. The last thing is having different types of accounts. So just having a credit card isn’t enough. You want to show that you can handle variety. Auto loans and student loans are considered installment accounts, because you pay them in set installments until the balance has disappeared. A credit card is considered a revolving card because you can keep using it and paying on it at the same time. The credit revolves. Ideally you want a mix of installment and revolving accounts.
True or False: Carrying a Balance
There is a common myth about credit that is cycling out there, and I think it is because the phrase “carry a balance” is unclear. “Carry a balance” usually means keeping some balance on the card from one month into the next. In other words, it means not paying your bill in full. But it could also mean spending any money at all. If you mean the second thing, then, yes. Yes, you need to spend money on a credit card in order for it to build your credit. But, NO, you do not need to keep a balance on your card from one month into the next! In fact, never do this. Always pay your credit bill in full. Do not pay interest. Refer back to this article for the math on why that is a terrible idea.
How to check your credit score
I recommend using NerdWallet because they show you your TransUnion credit score and you can look at an analysis of why your score is the way it is for free. NerdWallet is also wonderful for its credit simulator: it will tell you how your score will change if you take certain steps. The simulator tells me that my score will go up by 3 points if I increase my limits by $10,000 and it will go down by 46 points if I increase my balances by $10,000. It also tells you how much your score will change if you let accounts go to collections or if your wages are garnished (taken away by legal automatic means to pay past due bills).
Many credit cards have an option to check your FICO score. Ask your credit card provider if that feature is available or just look around in your online account. Barclays Card and Huntington offer the ability to view your credit score. It is updated about every 2 months. You may also visit a variety of websites to request a copy of your credit report. You are legally entitled to this information at least once per year. The one I’ve used in the past is https://www.freecreditreport.com. A credit report is the long summary of all of your FICO scores, all of your accounts, and the factors influencing your scores.