Credit. There sure are a lot of opinions and misconceptions about it!
If you don’t know what your credit score means –
If you have a low credit score or limited/nonexistent credit history –
If you think you’re better off avoiding credit altogether –
…read on (:
Benefits of good credit
Your credit history is what tells lenders, landlords, and even potential employers what they might be able to expect from you based on your credit history.
If you have a high score, then lenders can expect that you will repay your loan on time and as agreed. They will reward you by approving requests for more and better credit. A good credit score could qualify you for a better car insurance rate, for example, or a lower interest rate on a car/home loan, credit card, etc. (allowing you to pay less money to the lender).
When it comes to credit cards, a high credit score will often mean that you qualify for a higher spending limit and more impressive perks. You can use websites like Nerdwallet to compare credit cards – and view the credit score range that they recommend you fall within if you are considering applying for each card.
Drawbacks of bad or limited credit
If you have a low score, then lenders will be more nervous to lend you money. You might have a history of maxing out credit cards without paying them off, defaulting on your student loans, etc. Or you may just be inexperienced, so there is no way for lenders to know whether they can trust you. It will be harder to secure new credit and you will probably be offered higher (worse) interest rates.
A bad or limited credit history could also be an obstacle in getting an apartment. It can mean that you need a co-signer on your lease (or on a loan for that matter). In some cases, it can even make employers think twice about hiring you (although they need your permission to pull your credit history).
Credit score break-down
Your credit score is a number between 300-850.
The exact ranges and determining factors vary. You might be able to see a version of your credit score through your credit card company, and you can access your full credit report with each of the three major credit bureaus: Experian, Equifax, and TransUnion. You are eligible for one free copy of your report from each bureau every 12 months through AnnualCreditReport.com, so many people suggest spacing them out throughout the year. You could check Experian in January, Equifax in May, and TransUnion in September, for example.
Wherever you look, you’ll generally see a breakdown of credit score ranges similar to these:
Excellent: 800 to 850
Very Good: 740 to 799
Good: 670 to 739
Fair: 580 to 669
Poor: 300 to 579
Where your score falls on this scale is determined based on the factors outlined below.
Payment History (35%)
This is the single most important component of your credit history, accounting for more than 1/3 of your score, and is influenced by the percentage of on-time payments you have made. The higher your percentage on on-time payments, the better. Consistently making on-time payments shows accountability, which is something that anyone checking your credit will value.
Takeaway: Try to make on-time payments every time, even if you can only pay the minimum due.
Total Amount Owed (30%)
Nearly as important as payment history is your total amount owed – or more specifically, the percentage of your total credit that you are currently using. It’s not really about the amount of money you owe; it’s about showing restraint with lots of credit available and comparatively low utilization. For example, having $1,000 on a credit card with a $10,000 limit (10% utilization) is better than having $500 on a credit card with a $1,000 limit (50% utilization).
Takeaway: Spend less than 30% of the total credit that you have access to at any given time.
Length of Credit History (15%)
This factor is determined by the age of your oldest open account. Sometimes you will also see the average age of your accounts taken into consideration. Either way, older is better because it shows experience. For this reason I will likely never cancel the Discover* credit card that I got during college, even though I tend to favor other cards now.
Takeaway: Keep your oldest accounts open if it makes sense. (I wouldn’t avoid paying off a loan for this reason, though!)
Types of Credit (10%)
Your score will be higher if you have a variety of installment and revolving credit. Loans are classified as installment credit; credit cards are revolving credit. Managing multiple types of credit shows responsibility. So, if you only have a car loan you might want to consider applying for a credit card, too (as long as you’ll qualify for it).
Takeaway: Diversity is good. But don’t reverse my suggestion and go buy a car just to have another type of credit.
New Credit (10%)
Your score will be lower if you have a lot of new accounts and/or recent credit inquiries. “Credit inquiries” refers to the number of times your credit report has been pulled for things like an apartment rental application, mortgage pre-approval, a new credit card (all “hard” inquiries, which will show up on your report for 2 years), or pulling a copy of your own credit (a “soft” inquiry, which is only on your report for 6 months). Fewer new accounts/inquiries indicates a stable financial situation.
Takeaway: Be strategic about when applying for things that require a credit pull – and only apply when you know you will qualify.
Do you believe these credit myths?
You should carry a balance on your credit card.
I know several people who thought that they should pay less than their full credit card bill to improve their credit. This is a good way to pay more than you need to, because it means that you’ll be paying interest on whatever you didn’t pay off. It is also a good way to damage your credit score if you are leaving a high balance on your card (see “Total Amount Owed” section above). It will not increase your credit score.
You should pay off your credit card before the statement posts.
Not if you want your reward points! In my experience, you only receive points/miles/cash back based on the spending reflected on your credit card statement. If you don’t wait for the statement before paying off the card, then you won’t get the rewards. I did this a few times with my first credit card during college, wanting to make sure the payment was taken care of before I forgot about it. I stopped once I realized that my reward points weren’t accumulating!
You can’t access credit if you don’t have a credit history.
It’s harder, but we all start somewhere! “Beginner” credit cards usually have high interest rates and limited perks. That’s fine as long as you pay off your balance in full every month so that you don’t have to pay any interest. A secured credit card is also an option for beginners – you’ll have to make a refundable security deposit in exchange for the credit line. A family member (or friend) can add you as an “authorized user” of their credit card. If the credit card company reports activity to authorized users’ credit files, you will benefit from their responsible credit management. Be careful, though! It is risky to tie yourself to someone else’s credit.
Loans (student, car, etc.) build credit, too. To take out a loan without a credit history you will likely need a cosigner with good credit who agrees to pay off the debt if you don’t make the payments.
Where to go from here
If you want a good credit score (and why wouldn’t you??), you’ll want to keep these key takeaways in mind:
- Try to make on-time payments every time, even if you can only pay the minimum due.
- Spend less than 30% of the total credit that you have access to at any given time.
- Keep your oldest accounts open (if it makes sense).
- Diversity is good.
- Be strategic about when applying for things that require a credit pull – and only apply when you know you will qualify.
Looking for a new (or first) credit card?
I mentioned above that my first card was with Discover*; this is a great option, especially if you’re just starting out. If you have a higher credit score you may want to consider something with more perks and/or a generous spending bonus like the Chase Sapphire Preferred* card. You can find a full list of the credit cards that I use in this post.
Ready to branch out?
If you want to learn more about responsible money management, check out this post or browse tags such as money, spending, and credit card.
Thanks, Investopedia and Credit.com, for helping to inform this post!
Note: Links with “*” at the end are affiliate links, meaning that we might receive a financial reward if you click the link and sign up for something. This is done at no extra cost to you, and I have only included products that I have used myself!