For young people, the idea of establishing credit can be a little frightening. Even so, young adults should know that without credit it will be very tough to buy a car, a house, or to qualify for a decent credit card.
In order to have a credit score, you need to have at least one account that's been open for six months or more and has reported to the credit bureaus in that time period. Once you have an account set up, how you use it can make or break your credit score. Here are three great ways to get your credit history started on the right foot.
A secured credit card builds credit, but keeps you honest
Without an established credit history, you may still be able to qualify for a traditional credit card, but that doesn't make it a good idea. This is especially true if you're in college, where credit card companies will literally beg you on the street to apply for their cards, hoping to profit on careless usage.
The problem with this is not only the danger of getting in over your head in credit card debt, but the fact that student credit cards and other products designed for people with no credit history don't usually have great interest rates and fees.
Instead, I always suggest a secured credit card for a borrower's first credit card. There are plenty to choose from, and I recommend picking one from a reputable, national bank, like this one from Capital One.
Basically, a secured credit card requires you to deposit some money in a bank account, sometimes as low as $200, and the bank will then issue you a card with a credit limit equal to your deposit. The credit card will then function like a normal credit card, requiring monthly payments on your balance and reporting to the three major credit bureaus.
Also, don't worry about the "secured" title; this won't appear on your credit report. A secured card is indistinguishable from a traditional credit card in the way it's reported.
Finally, a secured card can prevent you from spending money that you don't have. Since your credit limit is equal to your initial deposit, you can only spend money that you already have earned and deposited. And when you eventually decide to close the account, your deposit will be refunded to you.
Check out your local credit union
Many credit unions have a loan product called a "credit builder" loan, or something similar.
Basically, the bank gives you a loan for a small amount, generally less than $1,000. Unlike a traditional loan, the funds are not released to the borrower, but are instead placed in an interest-bearing account at the credit union.
The borrower then makes loan payments for a period of a year or two, and once the balance is paid in full, the funds are released to the borrower.
Interest rates on this type of loan are usually pretty low, since the bank is holding onto the money and not taking too much risk. However, the interest you pay on the loan is likely to be higher than the interest you collect. So, it is important to note that this will end up costing you some money in interest.
So, for a small cost, you can end up with a pretty good payment history on your credit report. Just check with the bank to make sure they will actually report the loan payments to all three major credit bureaus.
Borrow for things you can afford to buy anyway
Now, generally it's not the best idea to get credit cards from department stores. They typically carry rather high interest rates and have relatively low credit limits.
However, they tend to be a little easier to qualify for, especially for borrowers with limited credit histories. So, if you are going to buy something that you already have the money to pay for, it may be a good idea to open a store card and charge the purchase, only to pay it back right away.
According to a Bankrate.com article, even though department store cards have high interest rates, they are generally better deals than borrowers with limited or no credit can find through traditional credit cards. Plus, these cards tend to offer some pretty impressive rewards, even when compared to the best traditional credit cards.
Plus, many stores have interest-free financing deals for a certain length of time. So, you might be able to establish credit and take your time paying off your purchase at no cost to you. Just to be clear, this should not be a tool for buying high-ticket items you can't afford. But, if done correctly, buying an item within your budget and paying it off in installments can help your credit.
For example, if you were going to purchase an iPad from Best Buy, you can get interest-free financing for up to 18 months. As long as you pay it off during that time period, it won't cost you a dime in interest charges, and in the meantime your payments (and eventually a "paid in full" account) will be reported to the credit bureaus.
Just to be clear, I'm not advocating department store credit cards for everyday use. However, when used correctly, they can be an excellent tool for establishing credit. Just be careful not to spend more than you normally would without the card, and these can be an excellent tool to build credit.
The sooner the better
The best thing to do when establishing credit is to get started as soon as possible. It doesn't take too long to build up "good" credit, but getting "great" credit can take time.
One big factor in the FICO credit scoring formula (the most commonly used by lenders) is the length of your credit history and the average age of your accounts. So, the sooner you start, the sooner you'll have a long, respectable credit history.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool owns shares of Capital One Financial.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.