In order to borrow money for something big and important like a house, you must first demonstrate that you are “credit worthy“. You must show that you are ready, willing and able to repay smaller debts before you will be allowed to take on a large one, such as a mortgage. And you have to have a track record of doing it so that banks will consider you a good credit risk.
This is a tricky balancing act. While it’s well known that many credit card companies solicit college students with easy-money offers and it’s very tempting for young people to get into financial trouble that way, it’s less known that the other extreme of going many years without buying on credit can also be harmful. Why is that? Because you won’t be able to get credit when you need it if you don’t have a history of using it responsibly.
Many of us have been raised to avoid credit cards, car payments, student loans and the like. But if you have none of them, you will not be able to qualify for a home mortgage, either.
The best path is often the middle way, and that’s the case here too. Building credit is a positive thing but requires caution. The right time for credit cards or small debts is when you can use them responsibly (meaning: hardly at all) and pay them off monthly. Age 18 might be too young, but age 30 is likely a bit late to dive into this pool of credit!
What is the best way to get started in creating your good credit history? Start with something simple, with a credit card fro a reputable institution (they are not all equal!) that you can use a little, regularly, and pay off each month. (Please take a lot of time in finding the right one – check online reviews, read the fine print etc. because some of them have draconian clauses that can really hurt you.)
The little things, like paying on time, matter a LOT – this will be true when you buy a home, too. Make your scheduled payments late and you will be penalized both with costly late fees (also likely a higher interest rate) and a “ding” on your credit! You can do this while still a college or graduate student (your folks may need to co-sign) but be very very careful not to get in over your head or the whole effort will backfire.
After you are out of college or a graduate program and into the work force, you will probably want to get an apartment. You may need to get your parents or someone with more credit to co-sign initially. This, too, can build your credit.
An auto loan also can help you establish good credit, but again, don’t bite off more than you can chew – get something manageable and make sure you pay it on time, religiously, without fail. In other words, when you buy, spend less than what you think you can afford. (I have known parents to sometimes give their kids a car when graduating from college. What might be better is to pick out the vehicle together, have the parents pay for most of it and allow the student to take out a loan for the balance. The newly minted graduate could have the balance of cash in savings or even a dedicated bank account with automatic payment deductions, if need be, but the car loan payments would establish a positive credit history for their son or daughter.)
Student loans, too, are not all bad in that they can help to establish you as credit-worthy, as long as you (or your parents) get them paid off on time.
Credit Scores are used for more than just borrowing money
Having a strong and positive credit history will give you the all-important FICO score that is used for much more than just big purchases or loans such as a home mortgage. Insurers use that rating, too, to decide how much of an insurance risk – they’ve found that people with lower credit scores tend to have more insurance claims. Low credit scores may result in either no insurance offered or insurance at a higher cost.
Further, some jobs require good credit. Why is that? Employers (such as top-security posts) want to make sure you are organized and not vulnerable financially to being extorted. Low credit is a bad mark on not just your bill paying, but more. Some people who’ve lost their homes in foreclosure have also lost their security clearances – and their jobs!
Whichever way you go to build your credit, be conservative and use credit not as a crutch but as a strategy. Ideally you’d pay cash for everything and never have debt. But unfortunately that plan would render you unable to get a loan for the big, important stuff. So sneak up on borrowing quietly and carefully, using less than you can afford, paying off bills earlier than due and living very peacefully within your means. Do that when you buy a house, too, and you will have real peace of mind.
For more reading on credit, loans, mortgage and financing:
Q & A on credit (on my popehandy.com website)
Mortgage Q & A (also on my popehandy.com site)
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