To say I had humble beginnings would be an understatement. Fortunately, I wasn’t ever homeless and never went hungry! But after my dad died from cancer, my mom really struggled financially. There’s no doubt we lived below the poverty line.
I distinctly remember that her lack of access to credit resulted in our cable and other services getting disconnected repeatedly. I also remember the times I’d be with her at a department store to buy a few things for the holidays, and invariably the cashier would entice her into applying for a credit card with the hope she’d get 20% off her purchase.
Time after time, she’d be rejected, and we’d leave dejected.
A few years later, when my older brother went to college, I remember him calling home to ask my mom if she could co-sign a lease so that he could live off-campus with a few of his friends. Ultimately, she didn’t qualify, and my older brother had to ask a friend’s parents to help in a pinch.
I remember how embarrassed he was to ask them. And that was the day I decided I needed to understand what this credit stuff was all about, so that a similar thing wouldn’t happen to me.
I was 14 years old.
Two decades later, I have bulletproof credit and rock-solid finances. In many ways, those experiences ended up being extremely fortuitous and played a large role in the prosperity I’ve had as an adult.
I want to share a few steps that young people can take to start their credit building journey. But first, I think it’s super important to understand why credit matters in the first place.
Why Credit Matters
There are a few personal finance “gurus” out there who say that people should avoid credit altogether. Few are as well known as Dave Ramsey.
Are you looking to buy a house? They recommend that you wait until you have enough money saved up to pay for it in cash.
However, we all know that very few people have a few hundred thousand dollars burning a hole in their pocket. And if you were able to save that much money, you likely wouldn’t be well served by spending it all on a single purchase.
A more likely scenario would be that you’d follow that no-credit advice for a few years, recognize that you need a mortgage to realize your home ownership dream, and then end up paying insane interest rates.
Hold up; interest rates? Yes, interest rates. When you borrow money for any type of loan, your credit score is typically the key factor that determines your interest rate.
And when you’re talking about a massive purchase like a home, that could mean tens of thousands of dollars in extra costs.
If you’re in college or just starting your career, you might be thinking that buying a house is still far away. But that’s precisely why I’m talking about it now; because building strong credit is a marathon rather than a sprint.
How Credit Scores Affect Student Loan Borrowers
Let’s move on from houses and focus on something that might hit a little closer to home for you: student loans.
Did you know that the price of a college education has increased eight times faster than wages over the last 30 years? That means young adults are graduating with more student loan debt than ever.
The majority of students end up with federal student loans, which have interest rates set by legislation.
However, as interest rates drop and debt balances rise to new heights, refinancing student loans can end up saving some grads a lot of money in interest if they can qualify for a lower interest rate.
My twin brother left grad school with over $125,000 in student loans, and that’s becoming more common. So if you plan on getting an expensive education, having a high credit score is critically important.
And finally, if you remember the anecdote about my older brother needing a co-signer, use it as a cautionary tale and as motivation for building credit and not needing to rely on anyone else to rent a home or negotiate a car lease.
Editor’s Note: Refinancing your student loans can often lead to significant savings. But be aware that refinancing federal loans to a private lender means you’ll no longer be eligible for valuable government programs like income-based repayment plans and their associated student debt forgiveness rules, which allow you to write off your remaining balance after a certain number of on-time payments.
How Credit Scores Are Calculated
The first step to establishing solid credit is understanding how credit scores are calculated.
Five major pieces of data are used to calculate a credit score.
- Payment history (35% of your score)
- Amounts owed (30%)
- Length of history (15%)
- Credit mix (10%)
- New credit (10%)
Payment history refers to your record of paying your bills on time. If you have a past-due account, it will hurt your score. This tells lenders whether you’re likely to repay a new loan on time.
Amounts owed reflects your credit utilization. If you’re using a lot of the credit that’s available to you, it’ll hurt your score because it may signal that you’re overextended and may be unable to pay your bills.
Longer credit histories are rewarded with higher scores. Length of history looks at how old your accounts are and how long it’s been since you’ve used them.
Credit mix refers to the different types of accounts that you have — credit cards, student loans, car loans, etc.
Finally, new credit refers to the fact that opening multiple accounts in a short time period can signal risky behavior.
How to Establish Credit
Once I understood how credit scores were calculated, it was a lot easier for me to understand what I needed to do to establish and build strong credit.
The first step was to open a credit card, since it would be the easiest way for me to establish a credit history. This was important, since a strong “length of history” and “payment history” require a longer track record.
I recommend that anyone apply for their first credit card as soon as they turn 18 years old. Look for cards targeted to students or young adults, since you likely won’t qualify for the more sought-after rewards cards. If you apply and are rejected, don’t despair.
Secured Cards Can Help New Borrowers Establish a Credit History
If you can’t get approved for a regular credit card, you can look into opening a secured credit card. This is a credit card designed to help individuals build credit responsibly.
If you’re approved for this type of card, you’ll provide money as collateral in exchange for the line of credit. This helps the lender lower the risk, because if you don’t pay your bills they can keep your deposit.
Once you’ve had a secured card for a while, and have a consistent history of on-time payments, you can try to apply for a traditional or unsecured credit card. I was lucky to be approved for a standard credit card on my first try as an 18-year-old.
It’s also worth noting that credit cards can be hazardous if not used responsibly! This is because they have insanely high interest rates.
When I first got a credit card, I was super afraid of ruining my credit. This led to me hardly ever using it. I held jobs throughout most of high school and college, so I would only use it for the occasional lunch to keep the account active.
Note: Credit card companies reserve the right to close inactive accounts.
At one point in high school I worked at a Sunglass Hut kiosk in a major department store. I was incentivized to have clients sign up for the store’s credit card. Everything came full circle and I understood why clerks were always so eager to offer them to my mom.
One other thing that you can do — if you’re just starting out or aren’t yet 18 years old — is to be added to a parent’s card as an authorized user. When this happens, the account will show up on your credit report as if it were your own.
Just make sure that they have strong credit themselves, because any negative marks they cause will correspondingly harm your own credit score!
Avoid Costly Mistakes
Finally, it’s critically important not to make reckless decisions. Having strong credit can help you save money by qualifying for better interest rates, but saving money on interest will pale compared to the interest you’d have to pay on a credit card if you don’t pay the card off in full each month.
It’s also helpful to understand that a few pervasive myths related to credit can end up being expensive.
For one, you never need to carry a credit card balance to build credit. I’ve had people ask me that for years.
In other words, it’s OK (and likely a great idea) to always pay your statement balance in full. If you only pay the minimum balance, you’ll keep your account in good standing, but you’ll be charged interest.
The problem with paying credit card interest is that the rates are so high that the balance can quickly balloon and spiral out of control.
Another thing that you need to be on the lookout for is having friends and family ask you to co-sign a debt for them. Growing up in a low-income environment, I’ve been asked countless times to co-sign for friends and family.
I’ve only done it once, and that was for my mother’s car. I helped her make the payments on the account to make sure it was always paid on time. I needed to be 100% sure that a missed payment wouldn’t be reflected on my report.
In general, co-signing is extremely risky, and doing a friend a favor is usually not worth the huge downside risk.
In closing, there are really only a few things you’ll need to remember to slowly but surely build excellent credit.
They are: start early, never miss a payment, and avoid credit card interest.