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This article is part of In Session: The Teen Vogue Lesson Plan. Find the full lesson plan here.
Chances are you’ve heard the terms “credit score,” “good credit,” and “bad credit” thrown around here and there. But, while they all may be very familiar phrases, they can also be very confusing ones. After all, you don’t actually encounter your credit score on a daily basis, and your “good” or “bad” credit isn’t presented to you on a graded paper like a math test. They exist somewhere in the virtual world and may not come into play in your daily life. But credit — the root of it all — is actually a pretty important thing, particularly as you make increasingly more independent purchases in your life. It’s a good idea to get a handle on what it is and how it affects you (now and in the future), which is we sought out some expert help to break it down.
What is credit and what is it used for?
Credit is essentially borrowed money that you can use to buy everything from groceries, to a car, to a new home, and the agreement that you’ll pay the lender back at a later date, usually with an added fee. In short, it’s “how you make purchases in life when you don’t have the cash to buy something outright,” Shannah Compton Game, a certified financial planner (CFP) and host of the podcast Millennial Money tells Teen Vogue. “You’re leveraging someone else’s money, i.e. the bank or credit card company, to make purchases.”
And you’ll need to build a credit history, or a track record of borrowing and paying back credit, to make increasingly larger purchases. “It’s so important to build credit [history] because credit will help you buy stuff in life — whether you want to buy a car, rent an apartment, buy a house, or score that cool rewards credit card, you’re going to need credit [history] to do so.
How do you build credit?
Here’s where it gets a bit confusing. If you need a credit history to get a loan, but you can’t establish a credit history without already having some loans, how does it work? While yes, you’ll likely need a credit score to get a car loan or certain credit cards, there are ways to build credit from scratch. According to Student Loan Hero, there are certain types of student loans you can get (like federal student loans) without having a credit history, and paying back those loans helps you build credit history. That said, if you wouldn't have taken out a student loan otherwise, it's not the best idea to do so just for the express purpose of building credit. There are other ways to do so.
You can also start out with a secured credit card, which requires you to put down an initial cash deposit (usually at least $200, according to NerdWallet) to open the card. But unlike debit cards, secured credit cards aren't funded by that deposit. You'll still be borrowing money from the bank (your credit limit will likely be anywhere from 50 to 100% of the deposit), and you'll still have to pay the monthly bills with money separate from the deposit, but the deposit serves as sort of an insurance policy for the bank. As myFICO explains, if you don't pay your balance for a long time (becoming "delinquent") or close the card without paying, the bank can use the money you already paid up-front to cover your debt. If you're payed in full when you close the card or upgrade to an unsecured credit card with the same bank, however, you'll get that deposit back. Essentially, aside from the initial deposit, a secured card “works just like any other credit card reporting regularly to the credit bureaus.” Game says. You can get a secured credit card from most major banks; just make sure you understand the required minimum deposit and any additional fees before you open one.
And, per NerdWallet you can build credit history by linking up with someone who already has it. For example, you can co-sign an apartment lease with a parent or become an authorized user on their credit card. The landlord or bank will have the security of knowing someone with an established credit history is on the hook for payment, and you’ll start establishing your own history as the rent or credit card bill gets paid because your name is on it, too.
What is a credit score and how is it used?
Your credit score is a three-digit number (between 300-850) that’s linked to your social security number, determined by your credit activity, and referenced in all sorts of circumstances. “It’s not just about buying big purchases like cars and houses,” Game says. “Your credit score is also used for any type of loan you apply for, credit cards, your cell phone contract, utility bills, private student loans, renting an apartment, and even some jobs are looking at credit score as a factor of your potential as an employee.”
A low credit score could mean you’ll get denied a loan you apply for, Game says, because “your credit score is a measure of your credit worthiness.” And even in instances when your score doesn’t keep you from getting something you apply for, it can affect the actual agreement you enter into. “A low credit score won’t necessarily get you denied an apartment lease, [for example],” Game says. “[But] it might mean that you will have to put down more of a security deposit.”
In terms of credit cards and car and mortgage loans, for example, your credit score impacts the interest rate, or the amount you pay the bank or lender for borrowing money. (With credit cards, this is referred to as annual percentage rate (APR), but you only pay that if you don't pay your statement balance in full every month.) “The lower your credit score, the higher the interest rate,” Game says. “The higher the interest rate, the more you’ll end up spending to pay off that debt. [...] Sometimes the difference between an average credit score and an excellent one can mean hundreds, if not thousands, of dollars in what you’ll end up paying overall.”
What impacts your credit score?
“There are five main factors to your credit score,” Game explains. “Do you pay your bills on time, what amount of available credit are you using, the length of your credit history, the mix of your types of credit, and how many credit inquiries you’ve had over time.”
According to Wells Fargo, your payment history and current debts (how much money you are currently borrowing that you haven’t paid back) are the two biggest factors; but the other three still have an impact. For example, as Game noted, your credit mix can improve your score. “Think of it like going to the yogurt shop and adding all your favorite toppings,” she says. “The more ‘toppings’ or different types of credit you have, the better your score. Think things like student loans, car payment, bank credit cards, retail cards, gas credit cards, and any other loans.”
But, she notes, there are two main things you really need to focus on if you want to maintain a solid credit score: “paying your bills on time and not using all the available credit you have.” As a good rule of thumb, aim to use 30% or less of your available credit. For example, you may have a credit card that gives you $1,000, but that doesn’t mean you should use (read: spend) all of that. Rather, try to spend no more than 30% ($300 in this case) between payments.
How do credit cards impact your credit score?
While other loans and agreements play a part in your credit score, Game says that credit cards are usually the “main culprits” in bringing down credit scores, noting that the national credit debt in 2017 was a whopping $931 billion. “[That] means we put a lot on our credit cards that we can’t pay off each month,” she says.
And the amount of debt you have on your credit card isn’t the only thing that impacts your credit score. “Paying your bills late can drag your credit score down super-fast,” Game says. There’s also the number of credit cards you have, though that doesn’t necessarily mean having a lot is a bad thing. Game explains, “One of the main factors of your credit score is the amount of credit you’re using – for instance, let’s say you have a credit card with $1,000 available credit and you are using $800 of that available credit. Your score might be lower than someone who has two credit cards each with $1,000 available credit and they’re using $400 on each card – the same balance, but now the amount of available credit is larger and the amount used is smaller on each card than if you had just one credit card.” Think back to that 30% figure: Having two credit cards instead of one can help you use 30% or less of your available credit because you’re dividing your spending between the two. That said, “you’ve got to know yourself,” Game says. “If you’re bad with credit cards, it’s best not to tempt yourself with more of them. Just work to pay off the one you’ve got and get in a better money mindset around credit.”
But if you find you’ve opened more credit cards than you actually want, Game advises against actually closing any of them (versus simply not using them). “Depending on the amount of available credit you have, closing a credit card with a high credit limit could damage your score,” she says. “Also, if you close your very first credit card, you could risk resetting one of the main factors of your score — the length of your credit history.” But if you do ultimately want to close one card, she says paying off the others you have open can help offset any negative impact on your score.
How do you know your credit score, and what qualifies as a “good” one?
There are a few ways to find out where you stand with your credit. You’re legally entitled to a free credit report from each of the three main credit bureaus (TransUnion, Equifax, and Experian) by going to AnnualCreditReport.com. You can get additional free reports if you were denied a credit or loan based on your report (as long as you request it within 60 days of the notice of denial), you believe you’ve been subjected to fraud, you’re unemployed and planning to apply for a job within 60 days of your request, you receive public welfare assistance, or your state law provides it. But, while those reports include detailed information about your credit history, they don’t actually include your credit score.
There are lots of websites and apps that offer “free credit scores,” but make sure you read the fine print before you complete your request; as some of those offers may require you to enroll in a “free trial” of a paid service. If you don’t cancel the free trial in time, you’ll be charged for that service. Game recommends sites like Credit Sesame, Credit Karma, and NerdWallet. According to the Consumer Financial Protection Bureau (CFPB), you can also purchase your score from credit reporting companies like FICO. But you may not even need to go that route. Game also points out that many credit card companies include credit scores on the monthly statements.
While Game says it’s generally fine to check your credit score frequently, if you’re applying for loans or credit cards that lead to more than three credit inquiries by the lenders (known as "hard inquiries" in a 45-day time span, that could hurt your score.
As for the score itself, the number can land anywhere in the range of 300-850, and Game notes that scores in the range of 670-739 are typically considered “good credit.” 740 and above, she notes, will likely get you the best (aka lowest) interest rates. “But don’t panic if you’re not there yet,” she says. “You have plenty of time to [improve] your credit score.”
How can you improve your credit score?
So then, how do you actually do that? Applying for and using a secured credit card can help, “boost[ing] your score in a matter of months,” Game says.
But the best ways to increase your score are, again, paying your bills on time and using 30% or less of your available credit. “You have total control over your credit score though and can make positive changes to better your score in a short period,” Game says. “Focus on keeping track of where every penny is being spent each month, so you can make changes in your spending and work to pay your credit card bills on time and lower the amount of balance you have, which in turn will better your credit score.”
It’s key to have a solid understanding of and approach to credit before you even have any. “One of the most important things to consider before getting a credit card is your money mindset around credit,” Game says. “It’s important to not think about a credit card as a way to buy a bunch of cool stuff that you don’t have the money to pay for. Instead, think about using a credit card like a debit card." Don't spend money you don't have (or don't know you will have before your payment due date), and pay off your balance every month. If you absolutely can’t do that, make sure you at least make the minimum payment or, ideally, a few dollars more than that so you can chip away at your debt. If you find you’re a bit scatterbrained when it comes to remembering payments, “set reminders on your phone, pop ups on your computer, and whatever you need to do to pay your bill each month by the due date,” Game says.
If you can settle into those good credit habits and mindsets, Game says, you can "reap the upsides of having a credit card like a good credit score and bank all those awesome rewards and points that come with most credit cards.”
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