This article was co-authored by Nathan Digmann, Associate Advisor at Wipfli Hewins Investment Advisors, based in Milwaukee, WI.
We’ve all seen the television commercials: the young man sporting a goofy outfit, while singing a corny song about the importance of good credit. You probably don’t need a television ad to know how important a good credit score is to your future financial success — but what about your children or grandchildren? Do they understand the concept of credit? Do you know if they’re taking the necessary steps to establish a good credit history?
At this point in your life, maintaining a strong credit score may seem like an easy feat.
But do you remember when you applied for your first credit card? What about the moment you signed for your first car loan? Did you know how to navigate the process? Those days may seem far off in the past, but they’re in the near future for your young family members — particularly for those who are just entering adulthood and are starting college, a career or some other life path. Many people fail to remember just how difficult it can be for inexperienced spenders to establish credit, which is why it’s important to be proactive in introducing the basics early on.
Below are a few key strategies you can share with your young family members as they start to build credit and forge the path to financial independence.
Lay the building blocks
We always hear that a good credit score is imperative — but why?
First, let’s take a look at how a credit score is defined.
When someone attempts to set up a credit card or apply for a loan, the bank checks his or her credit history, which helps determine the likelihood that they’ll be able to pay the money back. Your credit score (also known as your “FICO® Score”) is determined based on the following categories:
— Payment History: Have you been paying your bills on time?
— Amounts Owed: How much debt do you currently owe? What percentage of your total credit line are you using on a regular basis?
— Length of Your Credit History: How long have you been using credit?
— Credit Mix: What types of credit do you have? How many credit accounts do you have?
— New Credit: Have you applied for multiple different types of credit recently?
Given these parameters, it can be particularly difficult for young adults to build and maintain a strong credit score. As you can see from the chart above, “Length of Credit History” makes up 15 percent of a person’s credit score, which can be a setback for someone who has never used credit before. This negative impact often builds upon itself, because the inability to get credit can also contribute to how much a person owes.
In other words, an individual may need to use a greater percentage of their available credit, compared to someone that has a higher limit; this can be a detriment to that person’s credit score.
While it can be a challenge for young people to build solid credit, it’s certainly doable — and most importantly, it’s crucial to their ability to finance most life milestones.
Whether it’s buying a house, purchasing a car or simply applying for a credit card, good credit is a key to long-term financial success. If your family members can’t build credit for one reason or another, they might need to take on less favorable terms or may be denied their request for a loan altogether.
To avoid this, there are several ways in which your family members can build and maintain credit from an early age.
1. Get a credit card as soon as possible
Time is the biggest factor working against young adults who are trying to build their credit score. In many cases, they simply haven’t had the time to prove to creditors that they will be reliable and responsible borrowers. To counter this, it is important for young people to apply for a credit card as soon as they are able.
While credit card debt can come with risks, payment methods like debit cards or checks aren’t always the best options. Take the time to teach your children or grandchildren about the importance of spending within their means, paying down their credit card balance and approaching debt with a sense of responsibility and caution.
Young individuals should be proactive in proving to creditors that they will make payments sooner rather than later, which can help them build their score for when they actually need the credit.
Keep in mind that short credit histories may prevent individuals from being approved for regular credit cards. In these cases, there are several different types of cards that can act as alternatives:
If your family member is under age 21, you may want to consider making him or her an authorized user on your credit card account. An authorized user is issued a credit card that is directly linked to the authorizer’s account (i.e., a parent or another family member). This option can provide a young person with the ability to develop a credit history, even though the account isn’t in their name. You may choose to go this route until your family member has the necessary credit to apply and be approved for a card of his or her own.
If your family member is old enough for his or her own card, but doesn’t have enough credit for a card with regular terms, you might consider setting up a secured credit card. Though this type of card requires a cash deposit, it can be an excellent tool for young people with little or no credit. Secured cards provide people with the opportunity to use credit, make payments on time and boost their credit histories, so they will be ready to acquire a typical card later on.
If a secured card isn’t the right fit for your family member, consider a joint card or a retail card.
A joint credit card is similar to an authorized-user card, but it is issued directly to both parties (the card owner and the user) instead of being linked to an existing credit line. This is just another way for you to help a younger family member acquire credit. However, it’s important to note that when applying for a joint card, both parties’ credit histories are considered; both people are also legally responsible for the debt.
Be sure to keep this mind when deciding whether this option is right for you and your family member.
A retail card is another option you might want to consider. Many retail stores offer their own credit cards with low credit limits, and in some cases, a credit check is not necessary to approve them. These cards can be effective tools for building credit when other options are unavailable; plus, they can act as supplements to other cards.
2. Build credit responsibly
Acquiring credit is just the first step to developing a stable credit history. If managed well, credit can be a huge benefit to your financial life — but it can also get out of control very quickly if you fall off track. Here are some tips that everyone — at any age and stage of life — can use to manage credit sensibly and improve their credit score:
Make all of your payments on time
There isn’t much that looks worse to a potential lender than someone who can’t make payments or has been late with payments in the past. Remember, your credit is an opportunity to prove to lenders that you are a worthy debtor — don’t give them any reason to think otherwise.
Don’t use up your credit
Even though it’s tempting, try to avoid tapping into your existing credit; your credit rating will benefit if you only use a small portion of your limit. A good rule of thumb is to avoid spending more than 30 percent of your credit limit per month. This can be a difficult feat for people who are new to credit cards (like your children or grandchildren), because they’re often held to a lower credit limit. In that case, new cardholders may consider opening an additional credit card and splitting spending over two credit lines, granted that option is available to them (a retail card could also be an option here).
Be consistent and diligent
It isn’t enough to only follow the two rules we’ve outlined above; your credit score accounts for every mistake that you make, even if it’s only a small slip-up. Though it’s possible to make up for a late payment or a month in which you use your entire credit limit, it’s much better for your credit score if you are as consistent as possible.
3. Contact an advisor
Building and maintaining credit isn’t exactly the simplest undertaking, so you may consider utilizing the expertise of an independent financial advisor. He or she can help you navigate the options that are available and find the right fit for your situation.