If you're a young adult getting ready to claim some financial independence, you've probably heard a cautionary tale or two from the older generation about avoiding debt, and were maybe even advised to steer clear of credit cards all together.
But, that may not be such a good idea.
“The idea that you shouldn't have credit or don't need it isn't really the best advice,” says Ornella Grosz, author of “Moneylicious: A Financial Clue for Generation Y.” The truth is, unless you plan to have cash to pay for everything from a car to a home, you'll have to learn how to leverage credit so you can qualify for loans a few years down the road, she adds.
So, what should be your first steps? Here are five ways to build a strong credit foundation from the get-go:
1. Don't finance a better lifestyle. If you're under 21, your credit card options are limited, unless you have proof of sufficient income. Once you're working, however, the credit offers start to come.
“Get one of your own,” encourages Scott Gamm, founder of HelpSaveMyDollars.com and author of “More Money Please: The Financial Secrets You Never Learned in School.” The key is to use it to make small purchases, and then pay the bill in full at the end of each month.
However: “If you start using the card to finance a better lifestyle, when the bill comes, it will be way too overwhelming to pay off, and that's how you can get into trouble,” he says. In other words, just because a creditor gives you a $500 line of credit, that doesn't mean you need to go charge a new iPad. Only make purchases that you can afford to pay back within the same month.
As for which card to choose, because you're just starting out, don't expect to get the best deals right away. “You're not necessarily looking for the best airline miles,” says Gamm. “You're looking to get your foot in the door.”
Credit issuers will start you off with a low amount of available credit, around $500, but may increase it as you continue to prove yourself.
2. Monitor all your accounts. It's easy to pay a bill without checking it closely. But that's one way to miss fraudulent charges or errors. Check your banking and credit card accounts carefully every week. Your financial institutions and sites such as Mint.com can help you track spending through email and text alerts. You can also use alerts as reminders to pay bills.
“If you pay a credit card bill late, the credit issuer could raise your interest rate,” says Gamm. And, even worse, that late payment gets reported to the credit bureaus, and your credit score takes a hit.
3. Become familiar with your credit reports and credit score. Most people don't become acquainted with their credit reports until right before they want to apply for a mortgage. That's a mistake.
The credit reports are generated by the three major credit bureaus, Experian, Equifax and TransUnion. They track whether you are paying on time, how much debt you have, how long you have had credit, the types of credit you have and any new credit.
You should check your reports every year for fraud and errors. Some experts advise that you check a different credit bureau report every four months. You can check each one for free once a year at annualcreditreport.com.
The information on the reports goes into your credit score calculation — another important item to keep on top of.
“Knowing your credit score is kind of like your grade in the financial world,” says Grosz. You can check your FICO score, the one most lenders use, at MyFICO.com for a small fee. The FICO score ranges from 300 to 850, with excellent credit beginning in the mid-700s.
4. Make student loans work for you. You may be dreading when you have to start paying back your student loans, but they actually serve an important purpose for your credit.
“In terms of credit score, student loans impact credit in a positive way because they are installment loans,” says Grosz. By showing that you can pay a set amount on time each month, it indicates to lenders that you know how to manage a debt. Lenders also like to see that you have a variety of types of credit.
The standard 10-year repayment plan is best, and paying extra on the principal is ideal. Some students make interest payments while they are in school, while others use any extra cash they have toward their monthly payments to shorten the life of the loan even more, decreasing the amount they'll ultimately pay.
If you're not able to afford the payment, the worst thing you can do is to stop making payments. Instead, you can opt for income-based repayment, or extended repayment, both of which offer short-term relief, but lengthen the life of the loan. The Student Aid website breaks down all of your options, but as Gamm explains, it's a matter of math. “Deferment and programs where you can postpone payments will start to creep up on you if you don't start tackling your debt as soon as possible,” he says.
5. Pay all your bills on time, all the time. “Paying your bills on time is 35 percent of your credit score,” says Gamm. That includes not only credit card bills, but your cell phone bill or any other accounts in your name. “If you don't pay on time, the creditor can send it to collections and that can be reported to the credit bureaus,” he explains. Add to that the fact that if you're assessed late fees, you're essentially throwing your money away.
Building a strong credit history is just like acing a course. Not showing up, failing exams and then pulling an all-nighter at the last minute to try to pass the final isn't a good strategy. The same is true for your credit. You need to start strong, be consistent and develop good habits that can serve you well for the rest of your financial life.