We’re all pretty familiar with 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 we have to wrap our brains around so we can be on top of our financial game. 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 play along.
“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?”
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, senior financial planner, Beacon Pointe Advisors, California
Why do students think credit is important?
“I think it helps you to be able to balance bills and a budget. In the long term, it will make it easier to get loans, buy a house, and rent an apartment.”
—Marisa L., third-year graduate student, Wayne State University School of Medicine, Michigan
“If you have insufficient credit, you may not be able to acquire a loan to purchase a new vehicle and home. In addition, if your credit isn’t good enough, you’ll end up paying more on interest in the long term for these loans than you would have otherwise.”
—Sasha P., second-year graduate student, Missouri University of Science and Technology
“It shows people you can pay what’s owed on time and have money to support what you spend.”
—Rishi N., online student, McMaster University, Ontario, Canada
Source: Student Health 101 survey of 1,246 students, September 2017
How credit works can be a little confusing, so we’re here to help you figure it out. Click on the questions below to find easy-to-understand explanations to common credit questions.
Essentially, purchasing something on 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, a car, or new furniture. 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 or student loan) 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, car dealers, and banks) to decide whether or not they’ll allow you do things like rent an apartment, open a new credit card, 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.”
Finding your credit score
Your credit report and score are freely available to you 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 once a year to make sure there’s nothing incorrect in them. To reiterate, we really mean once per year. If you check it more than that, it could negatively affect your score, though some banks and credit card companies also provide a snapshot of your score to you for free at any time. We know—confusing.
“[Building] credit history 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, senior financial planner, Beacon Pointe Advisors, 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, 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 things like credit cards and loans. Essentially, a higher credit score enables you better access to these types of products at a lower interest rate. Plus, people you’ll be dealing with regularly, 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.
“You need credit for everything. Having good credit saves you so much on deposits and interest charges.”
—Second-year student, Wake Technical Community College, North Carolina
This becomes even more important when making a bigger financial purchase, such as your first home (which, depending on where you live, can cost tens or hundreds of thousands of dollars). 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 (or at least a portion of the house after you pay a down payment) 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.
“The best way to start building credit 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, senior financial planner, Beacon Pointe Advisors, California
Whether or not you already have a credit card, we can all use a reminder on how to use one and avoid the pitfalls. Follow these steps:
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 doesn’t charge an annual fee. Consider a no-fee card designed specifically for college 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 haven’t actually paid for the item yet. The company supplying your credit card has temporarily covered the cost of the goods you bought.
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 interest (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 or when you finance something like furniture or 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.
Establishing your credit score is a bit of a catch-22: One of the biggest hurdles is a lack of credit history. For example, you often need a decent score to be approved for a credit card, but you need to have used a credit card or taken out a loan to establish a good score. Say what? Frustrating, we know. Basically, companies want to see that you have already established a credit history so they can see whether you usually make your payments on time. Without this history, they have no way to gauge your creditworthiness. So, when you have no (or very little) credit history, you have to take steps to build it. Here are three ways to do this.
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 must 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 S., third-year student, New Jersey Institute of Technology
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’re 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 cards tend to have higher interest rates compared to regular cards). 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. To find out if you’re ready, start by tracking your spending for a month or two to assess your financial habits. You can make a spreadsheet like one of these, input your daily expenditures, and tally up the total for each day, week, and month. If your monthly expenditure 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 a 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 N., second-year graduate student, Portland State University, Oregon
The caveat to using credit is that the company lending you the money will charge you interest on any unpaid balances (e.g., anytime 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, the 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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