Whether starting out or starting over, building a solid credit history is the key to better borrowing. Here's how to do it right.
Like classes before you, if you are graduating from college this year, you are leaving a world where you are measured by your test scores and entering one where you are measured by your credit scores. That make it important to create, build and maintain an A-plus credit history.
First, watch the video below to see how I barged into a local graduation ceremony to do my stand-ups, then we’ll continue on the other side.
As I said in the video above, according to the Society of Human Resource Management, nearly 60% of all employers did some sort of a credit check on job applicants last year. It’s not just them. Some car and life insurance companies will use a credit check to establish your insurance rates. A landlord is likely to check your credit before he agrees to rent to you. And, of course, lenders check your credit before they give you a credit card or a mortgage to buy a house. A clean credit history is critical.
Here are a few tips to build and maintain good credit:
Just because you can doesn’t mean you should.
For many students, college is a time of poverty. It’s hard enough just to keep tuition and other bills paid, much less to indulge in luxuries. So when you land that first job, the temptation to borrow and spend is powerful. Resist it.
Every dollar you pay in interest is a dollar you don’t have. And dollars add up. Save just $5 a day, invest it at 10% for 30 years and you’ll end up with $340,000. If you pay $5 a day in interest, your lender will end up with your $340,000. Think about that before you borrow, especially when financing things that go down in value.
To establish a good credit history, be well-rounded.
When you begin establishing your credit history and credit score, be aware of how that score is compiled. Here are the factors that determine the most-used credit score, a FICO score:
- 35%: payment history.
- 30%: amount owed.
- 15%: length of credit history.
- 10%: new credit.
- 10%: type of credit used.
If you’re a novice borrower, you lack the data that constitutes half your credit score: You start with no payment history (35%) and without a lengthy credit history (15%). Only time will establish that part of your file, so focus on the other factors: the amount owed (30%), new credit (10%) and type of credit used (10%).
As it implies, the amount owed refers to how much you owe, but more specifically it measures how much you owe relative to how much you can borrow. To maintain the highest possible credit score, you’ll want to keep that ratio around 30%. For example, if you have a credit card with a $1,000 limit, you shouldn’t allow your balance to go above $300.
“New credit” refers to new applications for credit. Applying for a lot of new credit makes potential lenders nervous and could hurt your credit score. Obviously, there’s no way to establish credit without first applying for it, but as you begin to establish a credit history, it’s something to keep in mind.
“Type of credit used” refers to being well-rounded. There are various ways to borrow money: primarily revolving loans, also known as open-end (credit cards) and installment loans, also known as closed-end (car loans, mortgage loans). The more types and lines of credit you successfully control, the higher your score. The rule of thumb is to ultimately master three separate lines that include both revolving and installment loans.
It’s hard to create a credit history if nobody will grant you credit because of your lack of a credit history. Here are three tips to get started:
- Credit unions or smaller community banks. One of the first things you should do after getting that new job is ask if your employer has a credit union. Credit unions tend to be a bit more flexible than the big banks and may more readily offer you a credit card, especially if you open a savings account at the same time. If your employer doesn’t have a credit union, you can still join one. There are plenty around. Here’s a search engine that will help you find one. And check out this story for more information.
- Secured credit cards. You’re guaranteed to be accepted, because you put a fixed amount of money in a separate account that secures the debt. While these cards can be a good way to build credit, be aware that they often come with high fees and lousy terms, and some might not even report to credit bureaus, which is the whole point. This is a place where you really need to read the fine print. Here’s our secured credit card search. And here’s an article from Bankrate.com that explains these cards in more detail.
- Prepaid credit cards. While they may appear similar to secured cards – you’re making a deposit up front, then using the card as you would a credit card – a prepaid card is really more like a debit card. Unlike with secured cards, you’re not borrowing money, which means there’s nothing to report to the credit bureaus and you’re not building a credit history. They also often come with high fees. Avoid these cards. Check out this recent story for further warnings about prepaid plastic.
- Co-signer. Having a friend or family member co-sign for you can help you qualify for a credit card or other credit. But make sure that payments are being reported to the credit bureaus in both names on the account – yours as well as your co-signer’s. And once you’ve persuaded someone to do this for you, don’t ever do it for anyone else. It’s a really bad idea to bet your credit score that someone else is going to pay their bills.
The most important thing is the most obvious.
As you go forward creating and maintaining your credit, the single most important thing you can do is to always pay your bills on time. Your test scores in high school and college mattered only until you graduated. But your credit score is going to follow you for the rest of your life.
You can’t control things like lay-offs, recessions and disability. But you can control how little you owe and how much you save to meet emergencies. Make saving at least three – and preferably six – months of living expenses a priority.
Want to know more about managing credit? Check out my latest book, Life or Debt 2010.