Leverage for the Next Generations: How to Build Credit Effectively

According to a study done by Sallie Mae recently, the younger generations, from teens to young adults, are much more likely to make payments by debit card, cash, or mobile transfer (Venmo, Paypal), than by credit card. In fact, only around 50% of them have credit cards at all. This statistic is leaving some analysts, like those at Fortune magazine (Bloomberg) wondering if credit cards will soon go the way of the video store or Toys R Us. But what are some possible reasons for this shift away from debt lending instruments in young adults, and what lessons can they learn to ensure that picking one up doesn’t lead them to further financial struggles?

One of the big reasons that can easily be identified as an answer to the first question is the looming student loan debt floating over most of those adults’ heads. The average student leaving college in 2017 had roughly $28,650 in student loan debt. On top of this, about 11% of outstanding student loans were 90 days or more delinquent or in default. With the risks of this debt compiling and carrying out, students and young people entering the workforce are less concerned about credit scores and more concerned on making sure they can pay their monthly loan amount, on top of any other recurring expenses. However, the one piece of good news coming out of paying these student loans is that by doing so, one can build up significant credit that will help take the place of missing out on credit card payments. While this avenue won’t leave much room to start borrowing to buy discretionary items, making these payments on time and for the right amount will allow young folk to build a strong credit foundation for the future.

In addition to student loans, many other issues impede those looking to get a credit card early. In 2009, the Credit Card Accountability Responsibility and Disclosure Act set forth a precedent that banks needed to have more stringent policies with which they lend money, including not offering credit cards to anyone under the age of 21 without a co-signer or proof of income. Even if these are available, with little to no credit history available, some will be turned down for credit card offers. However, most companies offer some sort of secured debt instruments at the least which ask for a deposit upfront as a collateral credit limit. These will allow those with low or new credit scores to earn it while keeping the banks/credit card companies from being at risk. One additional method for those who choose not to use these types of cards is simply to be added as an authorized user on a parent’s credit card. While at a slower pace, this can help out a young person get started even if they don’t use it at all.

Additionally, once their credit is established and starts going in the right direction, they must remain diligent to avoid having what they worked for diminished. There are many different factors that go into a person’s score, however following some key principles will be more than enough to continue pushing this score up:

  1. Use 30% max of the allowed total credit line. This 30% rule is used to ensure that one’s spending habits are in-line with how much they can borrow.
  2. Pay all bills on time. Either through setting up auto-pay or keeping a calendar with important payment deadlines written down, this is one of the most important factors.
  3. Continue using the debt instrument. Even if it’s only being used to pay for small monthly charges or gas bills, continuing to use the card will build up credit.
  4. Pay as much as is feasible. The balance set on the card is not nearly as important as the fact that it’s being used. In order to keep interest down (some go as high as 17%!), one should pay off as much of the balance as they can each month. This is especially important since roughly 25% of millennials have carried a credit card debt for over a year!

All in all, younger generations of people have sincere trepidation when it comes to using credit cards or any other item causing them to incur more debt than they’ve already been exposed to through student loans. They’re still fearful, having grown up through the Great Recession, and face several hurdles even if they decide to pursue getting a credit card. However, once they have them, and through loans, they can still build up a reasonable credit score and attain their financial dreams by remaining diligent and following advice like those points listed above. Please let us know if you have any questions on the above information for you, your family, or your friends.

Ask DWM: What do I need to know about (and do with) my credit scores?

CreditScoreRangesAnswer: Great question. Banks severely tightened their lending standards after the subprime mortgage crisis, making your credit score more critical than before, even for high net worth individuals. When lenders are determining whether to extend credit and at what interest rate, one of the most important factors they look at is your credit score.

Actually, you don’t have one score, but several. You have a Fair Isaac Corp. (“FICO”) score from Equifax, Experian and TransUnion. Each is a score on a particular day of how much of your available credit you have used, payment history, length of credit history, types of credit, and new accounts and inquiries. They vary slightly because some creditors don’t report to all of the credit bureaus, and some bureaus may have errors on your report. The balance of how these factors affect your score depends on your length of credit history and other factors, and their impact on your score changes as your credit profile changes over time.

Before extending you credit, a lender will not only consider how much credit you have available to you, but also how much (as a percentage) of that credit you are currently using, as this could be an indicator that you are experiencing financial difficulty. For example, if you have a $50k total credit card limit (spread over several cards), and are carrying a total of $20k in balances (40% utilization rate), it will have a negative effect. This is true even if you use your credit cards to earn reward points and pay off the balance in full each month. You want to keep your utilization ratio below 30%, and people with the best scores generally use less than 10% of their available credit at any given time. Of course, lenders take into consideration how much credit is already available to you, whether you are utilizing it or not, because they want to make sure you would be able to afford all your payments if you did choose to use more credit. So, it’s a balancing act.

Avoid late payments. One late payment can hurt your score for more than a year. If you’re out of town or just flat out miss making the payment on time, call the credit card company and ask them to waive penalties and most importantly, not report this infraction to the credit bureau. Consider signing up for automatic payments to prevent this situation. Credit cards and most other loans offer the option of having the minimum payment deducted, and if you wish to pay more or pay early, you may still do so.

The length of your credit history gives a lender an idea of your behavior over time. This includes how long you have had credit, how old your oldest account is, and how long it has been since you used certain accounts.

“Types of credit” generally makes up a small part of your score. This may include installment loans, retail accounts, credit cards, and mortgage loans. Lenders like to use this to gauge how you handle installment vs revolving credit for example.

Credit inquiries hurt your score. When you shop for a mortgage or a car or education loan, those inquiries count slightly against your score. However, multiple inquiries about your credit within a few weeks, typically count only as one “demerit”. Additionally, opening several accounts in a short period generally signals a greater risk to creditors.

Once a year, you can get a free credit report by going to www.annualcreditreport.com. You may order a report from all three bureaus at once, or order one from a different bureau every four months to keep a more diligent eye on your credit throughout the year. Be sure to dispute any errors you find. This will provide details of what’s in your credit file but not your score. If you are planning to apply for new credit in the next year, you should check your score and take steps to improve it if needed. Generally scores over 740 receive the best mortgage rates. (Scores range from 300-850). There are several ways to keep an eye on your score over a period of time. Discover credit cards provide a score for free on your monthly statement, or you can check it any time you log in. You can also get a free FICO report on several websites like Credit Karma, but the score on the free one may not necessarily be the score a potential lender would receive. The same goes for buying your score directly from the bureaus. (There are actually 56 different versions of your FICO score, depending on which software and industry-specific versions the lender is using- auto, mortgage, credit card, etc.) A general version FICO report for one bureau costs $19.95, or $59.85 for all three, and includes ratings for different factors that are helping or hindering your score.

We encourage you to take a look to see where you stand and take steps to maintain great credit scores. Like your other assets, they need to be maximized and protected.