Life After Graduation: Understanding Credit

In Part 2 of our Life After Graduation Series, we’ll take a closer look at credit. What is it, why is it important to maintain a good credit record, and how do you build credit?

What is Credit?

When we speak about credit, we are likely discussing one of two things:

• An agreement to borrow money from a lender and pay it back over time

• The creditworthiness of an individual. Creditworthiness can be determined by the amount of debt a person holds and their record of paying it back on time. When discussing a person’s credit, we are really talking about their overall credit history.

For our purposes, we will focus on credit as an individual’s credit history and why good credit is essential to your overall financial wellness.

Why Does Credit Matter?

Your credit history influences your ability to receive a loan, such as a mortgage or auto loan, the interest rates you receive, and whether or not you can get a credit card. In some cases, potential employers may even check a person’s credit before extending a job offer, meaning maintaining good credit can benefit you now and help you secure a better financial future.

Types of Credit

You will encounter a couple of different types of credit:

• Installment credit is a loan for a set amount of money you pay over time, usually with a fixed interest rate. Examples include mortgages and car loans.

• Revolving credit allows you to borrow up to a certain amount of money. You must make minimum monthly payments and pay interest on any balance you carry. If you pay in full each payment period, you will not pay interest, but if you carry a balance, you will pay interest. Interest rates are often variable, meaning they may change over time. Credit cards are an example of revolving credit.

What is a Credit Report?

A credit report is a document that contains information about your credit history, including any credit cards you have, student loans, mortgage loans, and any other debts. It documents whether you have paid your lenders on time. The information in your credit report influences your credit score.

You can request a free credit report from AnnualCreditReport.com to see how your credit history is listed and check for errors. 

What is a Credit Score?

A credit score is a number between 300 and 850, like a grade for your financial history. The higher the number, the better your grade. This number is important—it may be requested by lenders, potential landlords, utility companies, and potential employers to determine whether they will do business with you.

There are many different credit scores, but the main ones you will come across are the FICO score and the VantageScore. According to Experian, 90% of top lenders use the FICO score to evaluate a customer’s creditworthiness. A score close to 300 is considered poor credit, while a score close to 850 is considered exceptional. According to FICO, the average American consumer will have a credit score between 670 and 739. 

While the FICO score has historically been more commonly used, according to NerdWallet, VantageScores are beginning to get more attention, so it is good to have an idea of both your FICO score and your VantageScore score.

Often, your credit report will not include your credit score, but many banks and credit card companies have programs that allow free access to credit scores for account holders. If you do not have an account that offers access to your credit score, you can get it through the three major credit bureaus (Experian, Equifax, and TransUnion).

How is My Credit Score Calculated?

FICO Score

According to FICO, your score is calculated based on information from your credit report. FICO offers a general breakdown of how scores are calculated, but they give the caveat that the levels of importance they list are for the “general population and may be different for different credit profiles.” Here is what they say the general breakdown is:

• Payment History: 35%
  Have you paid your credit accounts on time? How much of a risk is the lender taking by offering you credit?

• Amounts Owed: 30%
  How much of your available credit are you using? If you use most or all of your available credit, lenders may determine that you are overextended and decide it is too risky to lend you money.

• Length of Credit History: 15%
  A longer credit history is generally considered a good thing, but it’s not an absolute necessity for a good credit score. The score generally looks at how long you’ve held your accounts and how long it has been since you used them.

• Credit Mix: 10%
  What types of credit accounts do you hold?

• New Credit: 10%
  Lenders may consider you a risk if you have opened multiple new credit accounts in a short time. This could include hard inquiries on your credit report, so it is best not to apply for credit you don’t need.

VantageScore

According to NerdWallet, establishing a VantageScore can take less time than establishing a FICO score—a month or two versus six months of credit history. The widely used VantageScore 3.0 model rates credit factors by how “influential” they are:

• Payment History (Extremely Influential): 40%

• Amounts Owed (Highly Influential): 34%

• Includes utilization, balances, and available credit

• Depth of Credit (Moderately Influential): 21%

• Credit age and mix

• Recent Credit Behavior (Less Influential): 5%

Yikes! My Credit Score is Terrible! What Do I Do?

Take a deep breath, and don’t panic. A bad credit score is fixable over time. First, get a copy of your credit report and check it for mistakes. You can dispute inaccurate information on your credit report. If that information is found to be incorrect, it will be removed from your report and can improve your score.

Be sure to make your payments on time for all loans. If you are carrying credit card debt, make a plan to pay it down and pay it off. Even if you need to make the minimum payments on credit card debt, making the minimum payment is better than making no payment at all. As you are able, increase what you are paying to pay down your debt as quickly as you can. There are a few ways to do this on your own:

• Snowball method: With the Snowball Method, you focus on your smallest debt first, meaning that you pay minimum balances on all of your debts and then throw as much extra money as you can at paying down your smallest balance first. Once you pay down your smallest debt, you focus on the next smallest debt. Again, I cannot emphasize this enough: you are always paying at least the minimum payment on all of your other debts and paying your regular bills so that you do not become delinquent; you are just focusing on putting extra money towards those smaller debts to get them paid off more quickly.

• Avalanche Method: With the Avalanche Method, you focus on your highest-interest debt. You pay the minimum balances on all your debts but then throw as much extra money as possible to pay down your highest-interest debt first. Once that is paid off, you focus on your next highest-interest debt.

• Lowering Your Credit Utilization: This tactic, as explained by NerdWallet, involves focusing on the credit card with the highest credit utilization rate or the highest amount of credit being used. By lowering your credit utilization rate, you can improve your credit score.

Try to automate your payments as much as possible to ensure that your bills are paid on time. Only do this if you know you will have the money in your account to pay your bills so that you don’t risk over-drafting your account and paying fees.

I’m Not Borrowing Money. Why Do I Need to Build Credit?

Your credit score isn’t used just for borrowing money. Potential landlords may check your credit to assess your risk. Poor credit may mean you must pay a higher security deposit, find a cosigner on your lease, or disqualify you altogether from renting some places.

Your credit can also influence your insurance rates and whether utility companies require you to put down a deposit before they provide service to you. And it could impact insurance rates in some states. Additionally, in states that allow it, potential employers may view your credit history in their background checks.

So, even if you are not planning on borrowing money anytime soon, building and maintaining good credit is highly influential in other areas of your life.

Ok, How Do I Build Credit?

If you are starting without any credit, it can be hard to obtain credit. If you have no credit history or if you have a low score, you may need to find credit products that are geared toward building your credit score:

• Secured Credit Cards: These cards require a security deposit as a part of the application process. The deposit protects the credit card companies if you fail to pay your bill. However, it should not be considered a “down payment” on your credit. Instead, you will pay your credit card bill every month. Once you build your credit and either upgrade your secured card to an unsecured card (or close your account), you will get your security deposit back (minus any fees or outstanding balances).

• Credit–Builder Loan: These loans are meant to build credit for people without a credit history. It acts like a loan in reverse - the lender holds the money throughout the loan, and you make monthly payments, which the lender reports to credit bureaus to build your history of on-time payments. Once the loan is paid in full, you receive the money. If make your payments on time throughout the loan, you build a good credit history.

Some may also advocate becoming an authorized user on somebody else’s card to build credit, though I would say take this advice with caution. If you go this route, you need to know that the person who is on the card has a good credit history and pays their bill on time each month. If you are an authorized user on somebody else’s card and they make a late payment, it will negatively affect your credit, even if you never made a purchase on that card. So, being an authorized user can be a way to build credit, but it can also destroy your credit if you hitch yourself to the wrong wagon.

How Do I Maintain Good Credit?

These habits can help you build and maintain good credit:

• Always pay on time. If practical for your situation, set up automatic payments to ensure timely payment.

• Manage your credit utilization. Try to keep your revolving credit (credit card) usage under 30%. 

• Only apply for credit when you need it. Too many applications in a short time can lower your credit score. 

• Check your credit report regularly. Go to AnnualCreditReport.com and make sure there are no errors. 

• Keep old accounts open. Closing old accounts can shorten your credit history, lowering your score.

You Can Do This

Especially when you are starting out or starting over, it can feel like a herculean task to build or repair your credit. Taking time to understand your situation and plan your strategy will make a world of difference. Watching your credit score increase as you build your credit will be immensely rewarding and a positive step in your financial wellness journey. You’ve got this!

Are you starting out or starting over? Do you need some help moving through the overwhelm?

I’d love to help! Schedule a free consultation with Gentle Fearless Coaching and Consulting to see if a Confidence Coaching Package is right for you!

*This article is for informational purposes only. It shall not be construed as specific advice or a substitute for professional advice from a qualified financial professional. I am not an accountant or financial advisor, and information on this site is not a substitute for information provided by a professional familiar with your situation or unique needs.