Why Do You Need A Credit Card?
We have all been told by our parents or grown ups that it is important to establish a credit history. “If you don’t have credit that is just as bad as having bad credit!” Probably heard something along the lines of that, right? So you know you need to establish a credit history but you unsure of where to begin. I know, I’ve been there. Establishing credit early on in your career is important. You do want to be able to buy a house and car, right? Establishing a credit history is important because it shows banks and lenders that you are responsible with handling your debts. Building a good credit score takes time so if you start early at 16 and are prudent in your spending habits you could have a good credit history within 2 years, maybe sooner. I will show you how to get a great credit score and everything you need to know to be on your way to a great financial future!
The Credit Score Breakdown
Now, before we begin on choosing the right credit card it is important to talk about how your credit score is calculated and how it is affected by your actions. The credit score is broken up into these categories:
- Payment History
- Credit Utilization
- Debt Load
- Account Age
- Account Diversity
- Hard Credit Inquires
- Collections Accounts & Public Records
The payment history category is one of the most important in determining credit scores because it makes up 35 percent of the total credit score. Therefore, it is imperative that when you have an outstanding balance on your credit you need to pay it off on time, every time. Even having just one late payment can send your credit score into free fall, particularly if you have yet to establish a track record. Always keep track of the due date to make sure you pay it on time. When you apply and get approved for a credit card the issuer will send you paperwork stating when payment is due. But i believe it is a good idea to just call the card issuer directly and find out exactly to avoid any mix ups that may occur.
The second part, credit utilization is equally as important as payment history. Credit utilization makes up 30 percent of your credit score. What exactly is credit utilization? Credit utilization is the percent of available credit that has been borrowed. As a rule of thumb, it is best not to go over 30 percent of available credit. Lets do some examples to get a better understanding. Lets say you have a credit card with a $1,000 credit limit. (Most cards start you off with $300 and you can ask for more later or get a secure card, more on that later). A 10 percent utilization rate is $100 dollars, 20 percent is $200 dollars, 30 percent $300, ect. A survey was done by Credit Karma to show the relationship between credit score and credit card utilization.
A credit utilization between 1-20 percent proved to be the best. Those with a utilization ratio of 10 percent had the best score with an average credit score of 753. People with a utilization ratio of 11-20 percent had a score of 715, beyond this ratio, your score drops more noticeably. The reason for this is because when the card issuer sends the report to the credit bureaus it looks bad when you use up most of you available credit. Your credit card balance must be paid back in full by the due date at the end of the month. Those with little to no credit history or bad credit typically spend more than those with good credit. Having a low balance shows that you are responsible with your debts. Another thing to note is that your payment history and credit utilization make up over a third of your entire credit score, so if you can properly manage your spending and pay on time your almost there!
Debt Load, Account Age and Diversity
The rest, such as debt load, account age and account diversity make up a much smaller portion of your credit score, usually 15-10 percent each. I won’t go into as much detail with these categories but a brief explanation is needed. Your debt load is basically the percentage of your gross pay that is currently used to pay off debt. Some loan applications will ask you how much of your income is used for debt before they will approve the loan to make sure you have the ability to pay it back. If you have a mortgage its best to have 40 percent or less of your income servicing on debt. If you rent, it should be below 30 percent. Account age reflects how long your credit accounts have been opened. Typically, the longer the better. A longer account history shows that financial institutions trust you and your business due to a long account history. The longer the account is open the better your credit score will be. It is because of this that you should think carefully about what kind of card to apply for. I prefer to get a card with no annual fee, otherwise you could end up paying $25 or $45 a ear just to keep the card active.
Account diversity is a measure of how many different accounts are opened in your name. Account diversity means you have several different types of credit or loans out. These accounts could be credit card accounts, mortgages, auto loans ect. The account diversity metric shows that different lenders are willing to extend you credit or loans meaning they trust you.
Hard Credit Inquiry
Hard credit inquiries are put on your credit report whenever someone, (bank, person,ect) runs your credit to see if you can obtain a new loan. Another type of hard credit inquiry is when you apply for a credit card. When an inquiry is placed on your report your credit score will take a hit and go down temporarily. It is usually short-lived and your credit score will go back up within a few months, assuming you have been using your credit responsibly. It is very important that when you apply for a credit card that you space out your applications. If you apply for too many loans or credit too soon your credit score will drop more severely and could prevent you from being able to buy a home, car or anything requiring a credit check.
While it is important for teens to build up credit what is equally as important is HOW you use the card. Remember, pay the balance due at the end of the month in order to avoid a late payment fee, interest charge on the balance due or a drop in your credit score. Just one late payment or missed payment can drastically mess up your credit, therefore it is important to not overspend on the card. Watch your credit utilization, keep it under 30 percent at all times, but preferably 10 percent will yield the best credit score. If you keep in mind and put into practice the information I have laid out here you will see your credit improve in a relatively short time frame.
Please stay tuned as I will continue to bring valuable information on all matters on finance and investing.