Most of you are probably familiar with the idea of credit cards, but what about credit scores, credit reports, and what it means to be deemed “creditworthy”? How credit works is one of those confusing yet necessary concepts that you have to wrap your brain around so you can be on top of your financial game, especially as you get close to adulthood. Trying to avoid credit altogether might sound easier—but like it or not, it’s a vital part of modern society and it benefits us most when we understand how to use it.
“We live in a world of credit cards and debit cards, so it’s really impossible to avoid,” says Dr. Sugato Chakravarty, professor of consumer economics and management at Purdue University in Indiana. “The question that’s most important is: How do you manage the risk?”
Why do students think credit is important?
“In the short term, [credit] gives you financial security. Long term, it gives you options—like buying the kind of car you want or a house.”
—Nathan, senior, Orem, Utah
“Your credit score affects many things, such as being able to rent an apartment, buying or leasing a car, buying a home, etc., so it’s important to keep your credit score at a good number so that you don’t get screwed over in the future.”
—Maggie, senior, Houston, Texas
“Understanding and building credit will help you buy a house, pay monthly on a car, and apply for many higher-end purchases. Without the understanding of credit, credit scores, and how to build credit, the cardholder will have greater interest on loans, be declined for some applications, and may not even be able to get another credit card in the future.”
—Melodie, sophomore, Hamilton, Ohio
Advice from a senior financial planner
“The best time to start learning about managing credit is when you’re a student because it’s during this phase in life that it’s easiest to get into debt trouble. In conjunction with learning about credit and what creates credit, it’s important for students to learn about credit scores and how this particular score can affect their lives in many other areas, like buying a house or car, for example.”
—Kelly DiGonzini, CFP, MST, senior financial planner, Beacon Pointe Advisors, California
Source: Student Health 101 survey, September 2017
How credit works can be a little (OK, very) confusing, so we’re here to help you figure it out. Click on the questions below to find easy-to-understand explanations to your common credit questions.
Essentially, purchasing something with credit is like taking out an IOU, and this can come in the form of credit cards, loans, or monthly payment plans for expensive things like cell phones or a new computer. People usually use credit when they don’t have enough cash on hand to pay for a big purchase (e.g., that new $700 phone) or simply because they want to build their credit and reap the benefits (more on that later).
All of the IOUs you’ve taken out in the past seven or so years (e.g., every credit card purchase) are listed, and a report is compiled that shows all the times that you’ve paid the money back, any times you haven’t, and whether any of the payments were late. This credit report is then used by people, entities, and companies (such as potential landlords and banks) to decide, based on that information, whether or not they’ll allow you to do things like buy a new car or put that new gadget on a monthly payment plan.
Three main credit bureaus—Experian, Equifax (yeah, those guys who got hacked), and Transunion—make your credit report and use it to compile your credit score, the most common of which is called your FICO score. The higher your score, the better your credit. FICO scores range from 300 to 850, with any score over 750 regarded as excellent (the average American FICO score is 700, according to the FICO blog). Banks and other financial institutions use your credit score to determine how reliable they think you’ll be at paying back any money you owe—this is known as your “creditworthiness.”
Minors and credit scores
Since you can’t get a credit card without a parent or guardian until you’re at least 18, most minors won’t have a credit score yet. However, if you’ve been added as an authorized user on a parent’s or guardian’s card, you will have a score of your own. Once you turn 18, as soon as you get your first credit card, loan, or line of credit, you’ll start having a credit score.
Finding your credit score
Your credit report and score are available for free once per year from each credit bureau (Experian, Equifax, and Transunion). Just go to each of their websites to get your report. Your score will vary slightly between the three bureaus, and that’s totally normal. Aim to check your reports at least once a year to make sure there’s nothing incorrect in them. Some banks and credit card companies also provide a snapshot of your score to you for free at any time.
“Starting to build credit history at a young age will add additional years to [your] length of credit history, which is one of the five primary factors to building credit. The earlier [you start], the better.”
—Kelly DiGonzini, CFP, MST, senior financial planner at Beacon Pointe Advisors, Newport Beach, California
1. It makes buying expensive things a lot easier
It’s easy enough to pay for a $14 dinner out with cash or a debit card. But if, for example, you want to buy a used car for $5,000, it’s going to take you some serious time to save up for it. With credit, you can buy the car immediately (by getting a car loan) and then pay back the cost with a more manageable monthly payment over a period of time, such as five years. Bonus? When you have a good credit score, you’ll save money by being offered a car loan with a lower interest rate (an interest rate is the fee the lending company charges you for allowing you to borrow the money).
“Credit is borrowing money, which leads to a temporary increase in your purchasing power—that’s the big advantage.”
—Dr. Sugato Chakravarty, professor of consumer economics and management at Purdue University, Indiana
2. You’ll get a better deal
As we mentioned above, your credit score affects what interest rate you’ll be offered on financial products. Essentially, a higher credit score enables you better access to financial products at a lower interest rate. Plus, people such as auto and home insurers, cell phone companies, electric utilities, and landlords may use your credit score to determine how much they’ll charge you for annual premiums (the amount you pay them to keep your coverage active) or whether they’ll require you to pay a security deposit.
“When you have good credit, you’re more trusted when taking out a loan and may be able to save more money when making a big purchase.”
—Noelle, junior, California
One day, you’ll want to make a big financial purchase, such as your first home (which, depending on where you live, can cost tens or hundreds of thousands of dollars). This is where having a good credit score really comes in handy. Since most of us would struggle to save up that kind of cash, you’ll probably need to get a mortgage (a home loan) to pay for the house over a long period of time, such as 30 years. The better your credit score, the more likely you are to qualify for a lower-interest loan, which could save you thousands over time.
By now you might have opened a checking or savings account and started using a debit card—so you probably know what comes next. A credit card is a great way to set yourself up for a successful financial future. While you can’t get your own credit card until you turn 18, it’s never too early to get familiar with the basics. Plus, if a parent has added you as an authorized user on one of their cards, you’ll definitely want to make sure you’re using it responsibly (for your sake and theirs). Keep these steps in mind to learn how to use a credit card and avoid the pitfalls.
Step 1. Choose and apply for your card
When choosing a credit card, read the fine print carefully and make sure you apply for one that does not charge an annual fee. If you’re planning to go to college, consider a no-fee card designed specifically for students, such as these.
Step 2. Make a purchase
Once approved, use your credit card to buy something. (Pro-tip: Keep your first purchases small so you know you can pay them back easily.) Remember, you have not actually paid for the item yet. The company supplying your credit card has temporarily covered the cost of the goods you bought.
“Only use the credit card to purchase items that [you] could actually pay cash for—in other words, only charge what [you] would be able to pay off in full when the credit bill comes,” says DiGonzini.
Step 3. Pay off your balance
Now you have a balance on your credit card (like an IOU) that you need to pay back to the credit card company. You have two options:
Option 1 You can pay back the full amount immediately or at any time within that month’s billing cycle—check the date on your statement or log in online to see when the payment is due. If you pay off the balance in full by the due date, you will not be charged interest. Using a credit card this way is similar to using a debit card in that you’re avoiding fees and interest charges.
Option 2 Pay as much as you can within this billing cycle, which should at least equal the minimum payment. The minimum payment is the smallest amount of money the credit card company will accept from you without charging you a fee (again, log in to find out what your minimum payment is). The balance you have left after you make your minimum payment will then be used by the credit card company to calculate how much interest you’ll be charged, based on the stated interest rate of your card. For example, if your interest rate is 10 percent, a fee of 10 percent of your balance will be added to the amount you already owe. Check those terms and conditions to find out what your interest rate is.
What happens next
As long as you pay at least the minimum payment each month by the date the company states, you’ll build your credit score. This system works the same way for any line of credit, such as a student loan for college or when you finance a big purchase, like a TV.
If you do miss a payment, the credit card company will charge you both interest and a late payment fee, which can be upwards of $25. Missing payments will also cause your credit score to go down.
As your credit history builds over 6 months, 12 months, and on, you become eligible for larger amounts of credit. Your mailbox might start getting flooded with offers for credit cards with higher balances, different types of loans, etc. Just because you’re getting these offers doesn’t necessarily mean you should take them. Always read the terms and conditions on any financial product you’re considering, and think hard about whether or not you’ll use it wisely.
“The best way to start building credit as a young person is by getting a credit card and using it on small daily purchases and paying it off in full every month. Don’t miss the due date by even one day, as it might trigger a late fee, but more importantly, it’s tracked on your credit history and will negatively impact your score.”
—Kelly DiGonzini, CFP, MST, senior financial planner at Beacon Pointe Advisors, Newport Beach, California
Even though you can’t open a credit card until you’re 18, you can still work on building your credit with the help of a willing parent or guardian. “Parents [may] consider helping responsible children get a credit card linked to their account with a low credit limit to use for small necessary items, like gasoline, for example,” says DiGonzini. “This will help [you] build credit even prior to age 18.” Just make sure you’re able to pay off what you charge—otherwise, you’ll be hurting their credit score and yours. If your parent isn’t open to that idea (it can be a little risky, so don’t be surprised if they’re not), wait until you’re either 18 or at an age (over 18) where you feel responsible enough with your money to do one of the following:
1. Get a secured credit card
One simple way to prove to banks that you’re able to handle a traditional (unsecured) credit card is to get a secured credit card with no annual fee.
This is a bit different from a traditional (unsecured) credit card, in that you have to put a cash deposit down. Once you put down a deposit, the card issuer (lender) will give you a line of credit, usually for the amount of the deposit.
For example, if you get a $200 secured credit card, you can use that to buy anything up to $200, such as a $75 gadget. Now you have a balance of $75 on the card, so you either pay off the balance in full ($75) or make monthly payments to pay off the balance and bring it back to the $200 of available credit. After using your secured card over a period of 6–12 months and paying off the balance each month, or at least making your minimum payment, the credit card company will see that you’re able to consistently buy and repay items, and will then consider giving you an unsecured (or traditional) credit card.
Keep in mind that a secured credit card doesn’t actually show up on your credit report or help you build your score, but it proves to banks that you’re able to take the next step of handling an unsecured card, which will help you establish your score.
“I opened a secured credit card with a $300 deposit with my bank. I used it for small purchases I knew I could pay off by the end of the month. After several months, I was eligible to open up a non-secured credit card.”
—Reizh, Newark, New Jersey
2. Apply for a small loan with your current bank
“If you don’t have any record or credit history at all, then one way of building it is to take out a loan that you don’t necessarily need but can easily pay off,” says Dr. Chakravarty. “A lot of banks will advance you the money as long as you have an equivalent amount in your savings account.”
How it works: The bank will give you a loan, usually for the amount or less than the amount you have in your savings, and then you’ll pay it off in monthly installments, such as over 12 months. Taking out the loan and showing that you make your payments on time each month will establish a good credit history and will start building your score.
3. Get a store credit card (i.e., a credit card offered by a big retail chain store)
“Store cards are much easier to qualify for and they are also used to build scores,” says Dr. Chakravarty. This doesn’t mean you should go on a shopping spree at the store your credit card is from (in fact, this is a bad idea, unless you have the cash to pay for it). Store credit cards can be used anywhere and should be managed in the same way you’d use any other type of credit card—by only purchasing what you can afford and paying off the balance in full every month.
Many students are nervous about the idea of using a credit card because they worry they’ll get into unnecessary debt. Tracking your spending for a month or two to assess your financial habits is a good way to see if you’ll be ready to open a credit card when you turn 18. You can make a spreadsheet like this one, input your daily expenses, and tally up the total for each day, week, and month. If your monthly spending is less than your income (or the amount of money you have coming in), then you can probably afford to have a credit card. If not, try to reduce how much money you’re spending and reevaluate at a later date.
“Get a credit card only if you have steady income with some savings. This way, you can use the credit card to make purchases, but you can immediately [pay off the] balance with a bank transfer.”
—Jordan, Portland, Oregon
The caveat to using credit is that the company lending you the money will charge you interest on any unpaid balances (e.g., any time you don’t pay the full amount you owe each month). For a credit card, this can be very high, such as 26 percent per year. This is called the annual percentage rate (APR). The better your credit score, more likely you are to be offered cards with a lower APR.
The largest risk to your credit is yourself. It’s vital to build money management skills to ensure that you only buy items you can afford to pay back. When using credit, always ask yourself:
- Do I need this?
- Can I afford to pay the money back before I’m charged interest?
- If I can’t pay it back before I’m charged interest, can I afford the amount of interest I’ll be charged?
If your answer is “no” to any of those questions, you probably should walk away.
Sugato Chakravarty, PhD, professor of Consumer Economics and Management at Purdue University, Indiana.
Kelly DiGonzini, CFP, MST, senior financial planner at Beacon Pointe Advisors, Newport Beach, California.
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