After reading last week's article, you may be left thinking “I don’t ever want to touch a credit card, one misstep and it’ll ruin my life!!” As such, in this article, I’ll be discussing three general rules you should follow when handling credit to ensure you have a healthy relationship with credit and don't suffer any of the effects I discussed in the previous article.
Before I discuss the actual rules, let me repeat a couple important ideas about credit. The first is that building credit is not quick, although it can be relatively simple as long as you are aware of a few key ideas (which I’ll be discussing today) and you remain responsible. Building a strong credit score and credit history requires time - many months at the very least, and often years. Implementing these rules will not get you an 800 credit score right away, but it may very well get you there in a couple years. Remember, building credit is a marathon, not a sprint.
If you want a detailed description of what credit is and how your credit score is calculated, check out this article and this article.
With that said, the first “rule” of handling credit is utilizing at most, 30% of your available funds. This means if you have $100 available through your credit card (a credit limit of $100) you should use around $30 at most. Credit utilization, or the amount of credit you use compared to the amount of credit you have available, is a big portion of your credit score. Around 30% of your FICO score is based on “amounts owed”, so using most of the money available to you through credit can be harmful.
Why do creditors want to see lower utilization rates? Well, the higher your credit utilization rate, the more relative debt you have, which makes you more of a risk to the institution that is lending you money. Simply put, if you have less debt, the chances you pay it back on time are higher, if you have more debt, the chances you pay it back on time and in full are lower. In short, try to keep the amount of credit you use low compared to the total amount available to you.
While credit utilization makes up 30% of your FICO score, your payment history, which shows if you've paid off any debt on time in the past, makes up 35% of your credit score. This is the single biggest factor when it comes to your credit score, so knowing exactly what it means is extremely beneficial.
This leads us to the second “rule” when handling credit: only take on loans/borrow money you can afford to pay back, and always… always make payments on time. Now, this may seem self-explanatory and basic, but it's important to always keep it at the back of your mind when you're dealing with credit of any kind. When I refer to credit, in this context, I mean a loan of any kind, student loans, car loans, mortgages, credit cards, and so on. Now this “rule” has two elements, so let me elaborate on each part.
The first part is only taking on what you can afford to pay back. This means being aware of your financial situation; knowing how much money you have available in cash (checking and saving accounts), your income, and your expenses. Once you're aware of your financial situation, decide how much credit you can afford to use; if you’re making $1,000 per month, it's probably not wise to spend $1000 using your credit card. Make sure you take a close look at all the money you spend and earn within a month before making any major purchases using a credit card or taking on a loan.
Now that you know how much you can afford to take on, it's important to pay back any debt on time. The easiest way to do this is to set your bank account to automatically withdraw money anytime a debt needs to be paid. As long as you’re only spending what you can afford to pay back, and know how much money you have coming in and out of your account, this shouldn’t lead to an overdraft (when you withdraw more than you have), and will also save you the time of manually having to go and pay off your credit card and any loans individually. This also helps prevent missed payments in the case you forget to make a payment. If you don't want to set up automatic payments, make a note in a calendar or set a reminder to make payments on any debt a couple days before the payment is due.
The final “rule” for using credit is that you should remain patient, and continuously utilize it. This means that you should use some form of credit every month, even if it’s only for a few dollars, and start as soon as possible. If you don't use credit, your credit score and credit history won't build-up, and 15% of your FICO score is based on the length of your credit history, so starting early is beneficial.
Furthermore, make sure to keep your first-ever credit card, because as long as you’ve continued making on-time payments, it is extremely beneficial to your credit score to have accounts (credit cards, loans, etc) that are old because it shows that you have responsibly handled credit for many years, making you a “good” borrower in the eyes of lenders, meaning it's easier for you to get more favorable interest rates on loans and gain access to more credit through higher limits.
Because these three elements make up nearly 80% of your credit score, and play an important role in your credit history, as long as you keep these ideas in mind when you use credit, you should be well on your way to an excellent credit score. Thanks for reading, feel free to leave any questions below or email us at financeforteens.org@gmail.com, and I’ll catch you in the next one!