I am a military member looking to build up credit for a house, so I would like any info you have on the differences in credit cards and prepaid cards. Any additional tips you might have for someone who does not know what they are looking at would help me a lot. – Rachel
I would like you to serve yourself as you're serving our country: Open a credit card account so you can start acquiring the kind of credit score that will help you get a terrific mortgage and into a wonderful home.
I say a credit card and not a prepaid card because there is a very important difference between the two. The former will — with excellent use — help you establish a credit rating that lenders will assess. The latter will not. Prepaid cards are nothing more than debit cards that you fill up with your own cash. While they provide the convenience of plastic, you're not borrowing money, so there is no record on your credit report of how or where you're using them. In other words, although prepaid cards won't hurt your credit, they won't help it either.
Credit cards, on the other hand, will help you establish a credit history that allows you to prove your creditworthiness to lenders. When you obtain a credit card, the bank that issued it will let you draw from a fixed sum of money, called a credit line. Whatever you charge, you are under contractual obligation to repay. You don't have to send all the money at once, however. The credit issuer will send you a bill, asking you to send at least a minimum amount based on the balance. For example, if you charge $700 in July, you'll receive a bill in August asking for a certain percentage of that, which will be determined by your interest rate. Those payments (and whether you make them on time) will become part of your credit history.
Pay by the due date and you'll keep the account in good standing. In fact, your credit card payment history is the most crucial factor in your FICO score, which is derived from the information provided by lenders in your credit reports — and is the scoring model most commonly used by lenders.
Don't charge up to the limit and then keep the balance up there, though. Not only will you compromise your score (the amount you owe is the second-most weighty category in a FICO score), but finance fees will be added and you'll accumulate a debt that could be very hard to pay off quickly. Additionally, a mortgage lender will not want to see that you already owe a substantial amount of money. It would show that too much of your income is already promised to others, making the new loan unaffordable.
Eventually, you'll want to gradually add other types of credit (without applying for more than you can handle) to the mix (such as a car loan, for example). FICO scores range from 300 to 850, and to get a mortgage with preferable terms, yours should be in the mid-700s.
Because it looks like you're just beginning (you didn't mention any cards or loans), you probably have a thin credit history. So I recommend starting with a secured credit card. These products are perfect for people who have not yet established a positive credit rating. I'm an unabashed fan of these types of accounts because they are fairly easy to qualify for because you are required to put down a deposit to secure a modest credit line. Most people make a mistake or two in the beginning, so why not limit those errors with a short credit leash?
Just get one card to begin with, and use it for a year. Charge small sums that you can easily afford to repay in 30 days. Send the payment well before the due date to get into the habit. If you feel anxiety over how much you've spent and gasp, “Wow, that's a big bill — how will I pay it all right now?” consider it a sign to pull back on charging. You should always feel good about what you've charged and never feel stressed about sending the total balance due.
This is basic training, Rachel, and everyone who wants to create the type of credit rating that a mortgage lender will accept will have to go through it.
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