As a young adult entering the real world, life can get hectic. With the desire to do well in school, be attractive to the right employer for a good internship or job among other things, building a credit record is not even on the radar. However, for many young adults, a good credit record is crucial when it the time comes to make significant purchases such as a car or a home. Building a strong credit profile can take several years, and it is important to start early to establish and maintain a history of credit-worthiness.
We have experienced young adults who did take a proactive approach to building their credit become discouraged after being declined credit multiple times due to lack of credit history. It is essential to use the right techniques to build a good credit history while minimizing financial downside to both children and parents. However, we know how to get it done and we can help!
The FICO Score
Credit worthiness is determined by your FICO score. The FICO score, introduced in 1989 by FICO, then called Fair, Isaac, and Company, is used by banks and credit grantors alike, as well as other companies. The score is based on consumer credit files from the three national credit bureaus: Experian, Equifax, and TransUnion. Because a consumer’s credit file may contain different information at each of the bureaus, FICO scores may vary depending on which bureau provides the information to FICO to generate the score. Having a good FICO score means getting the best interest rates on loans, and cheaper premiums on some insurance policies which could total thousands of dollars in savings.
How FICO is calculated: http://www.myfico.com/crediteducation/whatsinyourscore.aspx
Secured Credit Cards
A secured credit card is similar to a pre-paid credit card; you must put down an initial security deposit from which you borrow against. For example, in most circumstances a $200 initial security deposit establishes a $200 credit limit. What is the benefit of borrowing your own money (and possibly paying interest to the bank for the privilege)? The ability to build your credit history by having the account open (length of credit history is 15% of your FICO score), and making on-time payments (35% of your score). Not all secured credit cards are created equal, however. As is the case with many financial products, you want to be mindful of interest, fees and hidden charges. Most importantly, in order for this technique to work, the card must report to the three major credit bureaus (Equifax, Experian, and TransUnion). The best cards also provide a small return on your deposit through the use of Certificates of Deposit (CDs).
Student Credit Cards
Student credit cards work just like normal credit cards, but are made available to students who have little credit history or experience, with the tradeoff of lower credit limits and higher interest rates. In contrast to secured cards, some student credit cards will even offer incentives such as cash back on purchases, and guaranteed limit increases after a predetermined amount of on-time payments. An additional benefit of these cards is the ability to grow with the individual, contributing to the length of credit history, a key element in the FICO scoring system’s weighing. These cards may be more readily available to students whose parents co-sign, but remember that this could result in negative side effects on the parent’s score. The incentives, no security deposit, and generally lower fees may make this a more attractive alternative to secured credit cards.
Finally, you can add your child as an authorized user of one of your existing credit card accounts. In this case, within a few months most credit card issuers will add the full account history to the authorized user’s credit report, and will be considered in the FICO scoring system. However, both the good and the bad will be added to the authorized user’s record, so it is most beneficial to use an old account (length of credit history), with a history of on-time payments and a low balance relative to its limit. The exact FICO scoring system is largely a “black box”, but experts generally agree that this method provides the slowest benefit as the child is only marginally responsible for credit usage and repayment. Before pursuing this technique, be sure to verify with the card issuer that they do in fact add account history to authorized user’s credit report.
There are several great options to begin building a credit record for your child, but to keep moving in the right direction it is ultimately up to the borrower to use credit responsibly, and make their payments on time. In addition to making on time payments, it is important to pay off most or all of the balance each month to avoid the excessive interest rates charged by some of these cards, as well as to keep their credit utilization ratio low (30% of your score). Use www.bankrate.com for a good comparison of these cards, including interest rates, annual fees, and other features. These options are not mutually exclusive, and the best strategy may include utilizing several options to establish multiple lines of consistent payment history.
At AEPG®, we love helping the next generation start off on the right foot, develop positive financial habits and pave the way to a successful future. To help the young adult you care about gain financial independence and get started on a secure financial footing, please feel free to contact me.