"I've heard that you have to get a credit card to build credit, but so many people build up credit card debt and I'm afraid to do it... "
I want to take a moment to talk about credit cards. The Good, The Bad, The Ugly, and The Not As Ugly As You Think Because You Aren't Thinking Of Them Right... Is that too long?
The Bad and Ugly
Why use a credit card at all? Here are some reasons:
- FRAUD: Your card is lost, someone uses it, you file a claim and the money is refunded. This takes 7-10 business days many times. It doesn't matter if the fraud was on a Credit Card, Debit Card, or Check... It's going to take a little while to refund. BUT on a credit card it's only tying up your "Available Credit" NOT your "Cash Balance" like fraud on a check or debit card would. Yes you'd get the money back either way, but the credit card makes that wait more comfortable.
- Purchase Protections: There are things SOME credit cards offer that debit cards typically don't.
- If you rent a car, the credit card may cover the insurance so you don't have to pay extra for that.
- If you pay your monthly cell phone bill through the credit card the card may cover the insurance on the phone so you don't have to pay for that.
- Certain items you purchase are guaranteed against loss or damage.
- GET PAID to spend your own money. With credit card rewards you can earn cash back, gift cards, and more for making purchases you were going to make anyway. This way your money is working for you more.
- Debit Cards used to offer this, and at most banks they don't anymore. But even when they did the rewards were less than the credit cards rewards were.
- Building Credit
- You CANNOT build a GREAT credit score without a credit card. You can't. There are idiot bloggers out there saying "You don't need a credit card, just do XYZ..." Here's the thing. You can build SOME credit without a credit card.
- You CAN build GOOD/DECENT credit without a credit card. You cannot build GREAT credit without a credit card... more on this in a moment.
- Again, despite the bloggers who love to misinform you, paying rent, utilities, insurance, cell phone bills, etc... does NOTHING for your credit. All of that positive info you are building helps with certain public profiles, but it does not help your credit reports or scores at all.
- NOT paying them may send you to collections which could ruin your credit, but the positive stuff doesn't help. You must pay on a "Credit Product" or "Trade Line" to build credit. These are Credit Cards, Loans, and Lines of Credit. That's pretty much it. Only these build credit.
The Things You Didn't Think About...
What do you mean by building GREAT credit?
FICO sees your credit score like this:
- Payment History (Making payments on credit products)
- Amounts Owed on credit products
- Length of Credit History ( how long credit products have been open)
- New Credit (when was the last time you applied for new credit)(this is where those "Inquiries" or "Hard Hits" affect you.
- Types of Credit used (They want to see experience with ALL credit types, including credit cards)
How does a credit card affect you?
- Payment History
- ANY time a credit product shows that something was due, and you paid at least what was due you get an "OK" stamp for that month. Whether you paid a $25 payment on a $300 card balance, or you had a balance of $1.50 and you paid the whole $1.50, either way you get an "OK" stamp for that month.
- Therefore the idea of getting a balance on a credit card and making payments could have some merit... BUT...
- "Usage" part of "Amounts Owed"
- Usage kills the idea of putting a $300 balance on a $300 limit card and making payments on it.
- Usage asks two questions. How much is available on the card? How much are they using?
- $300 credit limit (Available Credit)
- $300 balance on the card
- =100% Usage
- Grade F.
- FICO actually wants you to use LESS than 30% of your credit limits, less than 10% would be best.
- $300 credit limit
- $1.50 Balance
- = 0.5% Usage
- Grade A
- To figure out how much of your credit limit you can use and stay in good graces take the credit limit ($300) times 10% (0.10) [or 30% max (0.30)]. On a $300 credit limit you should not use more than $30-$90 during the whole month.
- $300 credit limit
- $30 balance ($90 balance)
- =10% Usage (30% Usage)
- Grade A
- If you pay the balance in full you will not pay interest. But the card, and credit report, will STILL show your balance as of the statement date so don't use more than 30% tops!
- Length of Credit History
- The older your credit history and average age of all your credit accounts, the better.
- Credit Cards (and some other credit lines) are the only products that stay open forever.
- Loans (Mortgages, Student Loans, Auto Loans, Etc) all eventually get paid off, refinanced, or closed/sold). Every time you close a loan it is removed from the average age of your open accounts. Every time you get a new loan it reduces the average age of your accounts.
- If you have 3 CC's. One is open 2 years and two are open 5 years. Your average age is 4 years. (2+5+5)/3=4.
- Close one of the 5 year old cards (2+5)/2=3.5 and you now have an average age of 3.5 years.
- Close the 2 year old card (5+5)/2= 5 and you now have an average age of 5 years.
- FICO prefers that you have 1-3 credit cards and no more. Department store cards like dillards, kohls, target and walmart count as credit cards. You should have no more than 3. Closing them may hurt you because of the above math.
- Because you don't want to open new cards or close old ones unless you have to, choose 2 great cards, keep them active, used regularly, and open forever. Never close a card unless you must or get a new one unless there is a significantly good reason to do so. If you already have 5 credit cards do more research before closing any.
- TYPES of credit used
- The more variety of good history you have the more secure your credit looks to be.
- Some people with high credit scores are still declined for auto loans because they've had no "loan" experience. Adding a credit card or two can balance out your experience.
BOTTOM LINE, My Advice:
Get 1 or 2 credit cards (NOT 3). Make sure these are cards you can use everywhere (Visa, Master, Discover, Amex logos) NOT a department store card or jewelry store card. These should be cards you can use frequently for small amounts. Walmart/Target may be OK, IF you shop at walmart/target frequently already.
Go out ONCE A MONTH and make a RIDICULOUSLY SMALL purchase. Go buy a $1.50 Dr Pepper, a $5 Cheeseburger, or $30 in gas. Put the card in the back of your wallet and don't touch it again. Wait for your statement, PAY IT IN FULL!
This way you'll NEVER pay interest on a credit card, you'll NEVER get into credit card debt, and you'll STILL build credit. In fact, because of usage scoring, your credit will be BETTER than the one who put the $300 balance on his card and made min payments for a year.
Do this every month, from here on and into the future. DO NOT put big purchases on your card. DO NOT use more than 30% of your available credit during the course of the month. DO NOT use more than 2 cards (3 if you must, no more). DO NOT EVER carry a balance over (paying less than the total statement balance).
It's not that hard. If you don't have the discipline to make one purchase and pay it off you shouldn't be even talking about credit. You should be building a habit of saving and budgeting first. Until you have a savings started, it's a waste of time to start building your credit. Once you have developed the habit of saving and NOT touching that savings, and you are working some form of a budget, THEN build credit. Don't touch credit until you have that down first.
The Total Money Makeover: A Proven Plan for Financial Fitness
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