One of the worst financial mistakes you can possibly make is to destroy your credit. Unfortunately, more than two-thirds of Americans do just that by making a major credit-damaging error before their 30th birthday. Most end up rebuilding it eventually, but the best move is to take care of your credit from the start. Here's what gets young people into trouble, and some smart ways to take the opposite road and maximize your credit score while you're getting started.
The data is alarming
According to a survey by Credit Karma, 68% of Americans will make a major credit mistake before the age of 30. These mistakes include, but are not limited to:
- Overspending on credit cards. This can happen at any age, but it's most common for first-timers. The Credit CARD Act has stopped credit card companies preying on college students who don't have an income, but this is still a major issue for twentysomethings.
- Defaulting on a loan. The average college graduate with loans graduates with about $30,000 in student loan debt, and defaults aren't uncommon. The job market for recent grads isn't great, so defaults on other loans, like auto loans, are also more common for twentysomethings.
- Collections accounts. If a credit card or other debt account is sent into collections, it can have a serious impact on your credit score.
Any of these can do serious damage to your credit, and this damage can linger for quite some time. Most negative information stays on a credit report for seven years, and some can remain for up to a decade. A single late credit card payment can initially drop your credit score by up to 110 points, according to Equifax, and can have a significant impact for years to come.
One of the biggest problems is that younger people often don't realize just how delicate their credit is, or how credit scoring works at all. In fact, 72% of respondents to the survey said they had no education about personal finance before college.
How to build your credit in your 20s
First, you need a basic knowledge of how your credit score works. The FICO scoring model is by far the most commonly used, and ranges from 300 to 850. While the specific FICO formula is a closely guarded secret, we do know the general composition:
- 35% of your FICO score comes from your payment history. Self-explanatory. Pay your bills on time, as agreed, and this category will take care of itself.
- 30% comes from "amounts owed," which refers to how much of your credit limits you're using and your loan balances relative to the original amounts, and not as much to the actual dollar amounts.
- 15% comes from the length of your credit history. Included in this are the age of your oldest account, the average age of all of your accounts, and the age of individual accounts.
- 10% comes from new credit. This category takes into account how many of your accounts were recently opened, as well as how many times you've applied for credit.
- 10% comes from the types of credit you're using. Lenders want to see a healthy mix of credit accounts (credit card, auto loan, student loan, mortgage, etc.). So, if you only have one type of credit account, it could hurt your score.
One smart way to build credit while avoiding the potential pitfalls discussed earlier is with a secured credit card. Secured cards work just like standard credit cards, look the same, and are reported to the credit bureaus in the same way, but with one major difference. In order to obtain the card, you need to make a security deposit that's typically equal to your credit limit ($300 or $500 seem to be popular starting amounts).
Secured cards generally offer competitive interest rates and reasonable fees, and will prevent you from spending money you don't have, while helping you build a strong payment history. Most major banks have secured card products, so shop around.
In addition, some other suggestions if you're just trying to get your credit history established:
- Only apply for credit when you need it. One or two credit applications won't have a huge impact on your score, but a lot of inquiries in a short time can really hurt.
- Try to keep your credit balances low, relative to your limits. Experts generally suggest using no more than 30% of your available credit at any time, and lower is better. For scoring purposes, it can actually be better to owe $1,000 on a credit card with a $10,000 limit than it is to owe $200 on a card with a $1,000 limit.
- Let your accounts age. When you're just starting to establish credit, don't open and close accounts frequently. It may be tempting to close your "starter" credit cards when your score starts to improve, but keep in mind that these are older, established accounts, and could be helping your score.
- Finally, keep an eye on your credit. Many credit cards now offer free FICO scores to customers, but many have other scoring versions. If you want your FICO scores from all three credit bureaus or if you don't have access to a free score, you'll have to pay for it, but this can be well worth the $20 a month or so it costs to actively monitor your credit.
Why it's so important
The late 20s and early 30s are the time when many adults need to take on debt to buy a house or car, and are the last group of people who need the additional expense of a high interest rate.
According to MyFICO.com, the national average APR for a 30-year mortgage borrower with a 760 FICO score (considered to be "excellent") or above is 3.366% as of this writing. With a score in the 620-639 range (considered to be "fair" credit), the borrower can expect a rate of 4.955%.
On a $250,000 mortgage, this is the difference between monthly principal and interest payments of $1,104 and $1,335. From a long-term point of view, the lower payment translates to more than $83,000 in interest savings over the life of the loan.
Today's twenty- and thirtysomethings with record levels of student loan debt and a so-so job market don't need to be burdened with tens of thousands in unnecessary interest charges. That's why it's so important to take care of your credit while you're young.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.