By NATHAN GARDNER
Establishing credit, apart from being the most fun way to spend a weekend, is one of the most important financial steps a college student can take. For many, college will be the time when they transition away from being dependent on their parents and start taking charge of their own finances. Good credit is a crucial aspect of financial independence and there are a few important steps to take and things to know.
Establish Credit: This process is much easier than many people realize, though it can often take several years, so it is better to start the process as early as possible. There are three easy steps to take to get started.
- Get a credit card
- Get a loan
- Set up automatic bill pay
The importance here is to have multiple forms of credit – revolving (credit card) and installment (loan) – and to ensure all bills are paid on time, every time. This is the surest way to establish and maintain good credit. This is, of course, an oversimplification, so it is important to understand some basics.
Credit Score: This is the number that banks and other financial institutions will use to determine creditworthiness. What a “good” credit score is varies by lender, but is generally around 700-720. Good credit means easier-to-obtain loans and credit cards, low annual percentage rates (APRs), and higher credit limits. Bad credit (or failure to establish credit) means moving into your parents’ garage (your old room is a fetish crafts area now), driving a ‘98 Civic, and probably owning too many cats.
Creditkarma.com is a free site that provides credit scores from Equifax and TransUnion (there is a third credit bureau, Experian, that Credit Karma doesn’t list). The site also has several helpful tools, such as: recommendations of steps that can be taken to improve credit, a credit score simulator which allows users to play around with different scenarios that could affect their credit, and loan calculators which help users determine what they can afford. Credit Karma also lists six main areas that affect credit scores:
- Open credit card utilization: This number is the percentage of total available credit that is being used. As a quick rule, credit card holders should never surpass a 50 percent utilization rate. For example, if a credit card has a $500 limit, the cardholder should never charge more than $250.
- Percent of on-time payments: Even one or two late payments can have a negative impact on a person’s credit score. Most banks have online and/or automatic payments, so paying bills on time has never been easier.
- Number of derogatory marks: These are the worst case scenarios for too many missed payments and can include “accounts in collections, bankruptcies, foreclosures, and liens,” according to the site. All of these things have a huge negative impact on credit and will stay on an individual’s credit report for 10 years!
- Average age of open credit lines: A great reason to establish credit while still in college — having mature accounts shows lenders a history of being financially responsible and improves a credit score.
- Total number of accounts: Having multiple lines of credit open improves a credit score because it shows lenders that the borrower handles credit responsibly, with the added benefit that it often results in lower total credit utilization.
- Total hard credit inquiries: Hard inquiries are made when an individual asks a lender to check their credit in order to secure a loan or credit card. Trying to open several accounts at once, however, can have a negative impact on credit, so it is wise to spread hard inquiries out by applying for no more than one account every two to three months.
Credit cards: Credit cards are a great way to establish credit, but they can also do a lot of harm. After a few drinks, it may seem like a good idea to whip that card out and pick up everyone’s tab, but it is sobering when you get the bill. Credit cards are tools to establish and maintain good credit (or as emergency funds) and need to be treated responsibly. There are a few good things to know before applying for a first credit card.
- Secured vs. unsecured: A credit card is secured by a deposit that is made with the issuing institution for the credit limit amount. This deposit is used to ensure payment which limits the institutions risk. Secured cards generally have low credit limits – $100 to $200 so most college students can afford the deposit. Typically, the card will stay secured for one year, after which it becomes unsecured and the deposit is refunded. It is important to thoroughly read and understand any changes that are made to the credit agreement when this happens. I know someone whose annual percentage rate (APR) jumped from 15 to 64 percent!
- Use regularly, pay off monthly: If credit cards are not used regularly, issuing companies can deem them inactive or even cancel the line of credit. Use credit cards every month to ensure they stay active, but take care to not go over 50 percent of the limit. A credit balance does not need to be carried over month-to-month to reap credit score benefits, and interest will not be charged if the balance is paid in full before the last day of the billing cycle.
- Annual percentage rate (APR): This is the interest rate paid for using a credit card. Credit cards often have higher APRs than other forms of credit so it is important to monitor their use. “Annual percentage rate” makes it seem easy to calculate, but it is actually much more complex than many people imagine.
Banks calculate credit card interest by taking the APR (assume 15 percent) and dividing it by the number of days in a year (assume 365, though some banks use 360) to get a daily percentage rate (DPR, .04 percent in this example). That number is then multiplied by the average credit balance and the number of days in the month.
Average credit balance is calculated by multiplying each balance held during the course of that month by the number of days it was held, adding up those totals, then dividing by the number of days in the month. If there is a balance of $250 for the first 15 days of a month and then a charge is made and the balance increases to $500 for the next 15 days. The average is calculated as follows:
($250 x 15) + ($500 x 15) = $11,250 ÷ 30 days = $375 average credit balance.
So, the calculation to determine the monthly interest charge would look like this:
0.0004 (DPR) x $375 (average credit balance) x 30 days = $4.50
That doesn’t seem like a lot of money, but the example is relatively small considering the average American household had $15,355 in credit card debt in 2015, according to nerdwallet.com. Using that amount, the average interest payment for American households is $184.26, or about $2,211 per year.
If for no other reason than how boring this all is, let’s just agree that that it’s definitely better to pay in full every month and avoid the topic of interest altogether.
Loans: For credit purposes, loans operate similarly to credit cards, but there are a few unique things to keep in mind:
- Good debt vs. bad debt: The idea that any debt can be considered good is debatable, as there is always a measure of risk involved. If used properly, though, debt can be a financial benefit. Generally speaking, “good” debt is used to obtain an appreciating asset (like a house or a business degree), and “bad” debt is used to obtain a depreciating asset (like a car or a liberal arts degree). In other words, good debt has the potential to indirectly make money, whereas bad debt only increases the amount of money being spent.
- Loan term: This is the amount of time the borrower has to pay back a loan and can last from as little as 30 days for a personal loan to 30 years or more for a mortgage. Paying over a longer term can drastically increase the total cost of a loan because interest is calculated yearly. For example, a 30 year, $200,000 mortgage with a 4.5 percent APR would be charged $165,000 in interest over the term of the loan. If that term is reduced to 15 years, the amount decreases to $75,000. Reducing the term can increase the monthly payment, however, so finding a balance here is key. Luckily, there are online loan calculators which allow users to play around with numbers and come up with a scenario that works best for them. Dinkytown.net is a great option because of its simple design and vast library of calculators.
Cosigners: A cosigner is accepting responsibility for the loan which reduces a lender’s perceived risk and can increase the chances of being approved, lower the interest rate, and increase the loan amount. Obviously, this all hinges on whether or not the cosigner has good credit, so this should only be attempted with someone who is financially savvy.