You may have had the most wonderful parents in the world. They may have attended to your every need, but many of those same parents seem to miss the mark on preparing their children for the financial world that they will be entering. Today’s generation overcomes that lack of information by turning to the internet where they can find more advice than anyone should be subjected to. So, I thought I would throw my two cents worth out there, just to add to the information overload.
One of the first things that a person learns is that there are many things denied to them because they lack credit. Some things that they do have access to come with a higher deposit or interest rate for the same reason. Car loans are one of the big things that fall into this category. Without credit, they can be very hard to secure–at least sans co-signer–and even if you do secure one, the APR is bound to be exorbitant.
Building a credit score, even if you plan to use very little credit, is essential on many fronts. Unfortunately, credit is a double edged sword that can easily cut you off at the knees if you are not very careful. One of the aspects where you will find a plethora of advice, most if it worthless, is on how to build your initial credit profile. Here is my take on the best way to do that.
Start With Cash
Sounds a little odd that you need cash to build a credit profile, but hear me out. A credit card is the easiest way to establish a credit profile. There are plenty of companies willing to offer a credit card to someone without a credit history. They will start with a low limit, which is good for a credit beginner, but they come with an extremely high APR that may never go down. Here is where the cash comes into play. Secured credit cards. The credit limit of a secured card is set by the amount of money that you deposit into a savings account with the issuer. This allows you to still have a lower limit and manage your APR to some extent. The APR on these cards is usually lower than some other cards. Additionally, if you do some research, you can find an issuer who will pay interest on your deposit. That will help offset any interest you pay on a balance. While doing that research check for the annual fees associated with the card and opt for the lowest fees and APR.
Manage Your Credit
Just having a credit card will establish a credit history, but that is only the beginning. Once you have the card keep in mind that carrying a balance is not in your best interest. Yes, having to pay interest on the money is a negative, but it is the least of your worries. The Fair Issac Corporation, better known as FICO, builds your credit score on five facets. One of those facets is amounts owed. It accounts for thirty percent of your score. That is pretty significant if this is your first and only line of credit. How is that relevant? Well, your score gets a boost if you carry a balance that is less than 30 percent of your credit limit. On the other hand if that balance exceeds thirty percent your score suffers and yes, it can go below your default starting point on a brand new credit profile. Quite a bit below, actually. With a starting credit limit of $500, you would have to keep your balance under $140 or you would lose points.
Another aspect of your FICO score is the types of credit used. This accounts for ten percent of your score. That means you will need to have a revolving credit account (credit card) and an installment account (car loan typically) in order to boost your score as high as possible. Typically, a credit card has to come first. After making 6-12 on-time payments on your credit card, you should find yourself eligible for a car loan at a reasonable interest rate.
Thirty-five percent of your credit score is built on your payment history. That means making every payment on time…literally for the rest of your life. A single payment that is thirty days late can drop your credit score by as much as 100 points. After you lose those points it will take at least a full year to get them back.
That doesn’t just apply to your credit card and loans. That applies to all of your bills. Your utility company, cable company, cell provider, etc, usually do not report positive information to the major credit reporting agencies, but if you miss a payment guess who they will be in touch with.
Building a credit score can be tedious and slow. It can be risky and annoying, but it is worth it in the long run, especially if financing a car is one of your future goals.