It’s official. Credit scores are the most confusing aspect of personal finance. The FICO formula remains largely a mystery. And don’t get me started on the multiple versions of credit scores out there. By one account, you may have 49 different FICO scores, not to mention dozens of credit scores calculated using non-FICO formulas.
So it’s understandable when folks (myself included) get a bit lightheaded when thinking about our credit. And that brings me to a great question sent in from a reader and podcast listener named Esther:
Thanks so much for writing a fantastic blog and sharing your podcasts. My husband and I just started listening a few weeks ago and have learned a great deal. We’re still in our 20s, but we often tell each other how we wish we would’ve known about financial independence and building credit earlier on in our lives to prevent all of the mistakes we made in college. We really want to teach our children about financial independence so they can avoid the same mistakes we made. So my question is: how can an 18 year old start building their credit the right way?
Esther’s question is a good one, and one I’ve given a lot of thought to as my children are now young adults. I’ve written before on how to build credit for the first time. In this article I’ll share some new perspectives, tips, and resources on this topic.
First Things First
Let’s start by making sure we put the question of credit and credit scores into the right perspective. There are three main financial priorities every young adult should have:
- Spend less than you make
- Invest wisely
- Avoid debt
Pretty simple. In fact, these are the three main financial priorities we all should have. Why? Because these priorities will enable us to achieve financial freedom. Financial freedom, in turn, will allow us to pursue our life’s purpose, whatever it may be.
So what’s this got to do with building credit? A lot. Building credit can involve some financially dangerous moves, particularly for those with little experience managing their finances. As will see below, credit cards are a great way to build credit. They are also a great way to ruin your finances. So as we walk through credit-building strategies, keep in mind the three priorities listed above.
Become an Authorized User on a Credit Card
The first and easiest way to establish credit is to become an authorized user on a person’s credit card. For most young adults, this will mean becoming an authorized user on a parent’s credit card. There are some important things to keep in mind with this approach:
- An authorized user doesn’t have to use the card to build credit
- As an authorized user, your credit can be harmed if the account holder makes payments late
- If your credit is being harmed, you can call the credit card company and asked to be removed as an authorized user
Not all credit card issuers report authorized user status to the credit bureaus (here’s a thread on the myFICO forum that lists credit cards that report)
As a final word of caution, avoid what is known in the industry as piggybacking. With piggybacking, an individual becomes an authorized user on a credit card for a fee. These transactions usually involve complete strangers and are brokered by financial intermediaries and credit counselors in an effort to artificially inflate an individual’s credit score. FICO has worked hard to detect these situations and to exclude them from the FICO formula.
Get a Credit Card and Use it Wisely
The next step to building credit is to obtain a credit card. Consistent with the financial priorities listed above, however, care must be used when selecting and using a credit card.
There are excellent reasons to use a credit card beyond building credit. The security of using plastic and the potential rewards are the two primary reasons. If used responsibly, however, plastic can help establish credit as well.
Here are some things to keep in mind:
- Prepaid cards and bank debit cards do not build credit
- Some credit cards are designed for those with no credit history, including student and secured credit cards
- Keeping your credit limit low to start is an excellent way to remove the temptation to overspend
- Paying the card off in full each and every month is a must
Store branded credit cards are also an option, but not one I recommend for two reasons. First, store cards encourage frivolous spending. With a generic card, you can by everyday essentials, such as gas and groceries. A Macy’s store credit card doesn’t qualify as essential. Second, the interest rate that comes with these cards is usually very high.
What About Other Loans
I’ve not included other types of loans, such as car loans and student debt. These types of loans will of course affect your credit. Further, having different types of loans (revolving credit like credit cards and installment loans like a car loan) can affect your credit score. For me, however, it’s not worth going into these types of debts just to build your credit. Pay cash.
Pay Your Debts on Time, Every Time
It is absolutely critical that any monthly payments on credit cards or other debt is paid on time. Payment history is the single most important factor in the FICO formula, accounting for 35% of the overall score. A late payment, moreover, remains on your credit history for seven years.
Establishing Credit is Different Than Repairing Credit
Finally, there are some important differences between establishing credit for the first time and repairing credit. When repairing credit, keep a few things in mind:
- Checking your credit report for errors is a must. It’s the quickest and easiest way to improve your score.
- Baggage on your credit report stays there for a long time (7 years for late payments as noted above). However, the effect this baggage has on your score decreases over time.
It’s generally hard to get a credit card with bad credit than it is with no credit. A secured credit card is generally the best option for those recovering from a bankruptcy, foreclosure or other credit mishaps.