Credit Scores
April is Financial Literacy month, so I'm going to write about some broader topics that might be helpful to you and your student. Starting with credit scores: what are they, how do you get one, why do you care?
My friend Jennifer, who's also a financial advisor, says that a credit score is the adult version of an SAT score. There are a lot of similarities: it's semi-opaque, has a big impact on your future-- especially the cost of your future-- and can be improved if you put some effort into understanding it.
Credit scores are used by lenders to predict a borrower's creditworthiness, or likelihood of repaying a debt. Scores range from about 300 to about 850, with 740 and above considered "very good" or "excellent." There are multiple credit scoring systems out there, but FICO (from the Fair Isaac Corporation) and VantageScore (from the three credit reporting agencies) are the most common. Those with scores above 740 typically get the best rates and terms when borrowing, whether for credit cards, mortgages, cars, or even setting up utilities for their residence. A good credit score will save you tens or even hundreds of thousands of dollars in interest over your lifetime.
What goes into your credit score? There are five components:
Payment history. This is the largest element of your score, accounting for 35%. Want to improve your credit score? Set up automatic payments so that you don't inadvertently make a late payment, and pay off credit cards in full every month. Payment history includes both revolving credit, like credit cards where you spend and pay on an ongoing basis, and installment credit, like mortgages and car payments where you purchase an item and make consistent payments until the debt is paid off. Installment credit has a higher impact on your credit score.
Credit utilization. This is both how much you owe and how much credit is available to you. Credit utilization accounts for 30% of your score. Generally speaking, "good" credit utilization is 30% or less. That means that if your credit card limit is $10,000, your credit score will be better if you keep your balance below $3,000. Higher credit utilization indicates that a borrower is spending a higher portion of their income on debt retirement. Even if you pay your card off in full every month, spending up to the card's limit will have a negative impact on your credit score. If that's you, consider making a mid-month payment on the card to lower the balance, or ask for a higher credit limit (but don't use that as an excuse to charge more).
Length of credit history. This accounts for 15% of your score, but can factor more heavily for individuals with very short credit histories. Because of this, it can be a good idea to get a credit card as soon as you're able. Student loans can help young people establish credit history, but only once they're in repayment.
Credit mix. Credit comes in two types, secured and unsecured. Secured credit is debt that has collateral-- a loan made to purchase a specific item such as a mortgage or car loan. If you don't make your payment on a secured credit account, the lender can repossess the collateral. Unsecured credit is things like credit cards or student loans, where there is no collateral and the lender makes assumptions about the borrower's ability to repay the debt based on their creditworthiness. Credit mix accounts for 10% of the formula; it's fairly insignificant except when the borrower has limited other credit data.
New credit. The last 10% of your credit score is determined by how much of your credit is new. Lenders assume that when people apply for credit frequently, it's probably a sign of financial strain. Every time your credit score is checked, it shows up on your credit history. Credit inquiries can remain on your score for two years, although FICO only includes checks in the last 12 months.
Parents with good credit who want to help their students establish credit can do a few things:
Add the student as an authorized user on an existing credit account. You don't even have to give them a card, but you should request that the lender report the card's usage to their credit report as well.
Monitor your student's credit history at annualcreditreport.com. This includes both checking that any cards on which they're an authorized user are reporting to their credit file and making sure no one else is opening unauthorized accounts in their name.
When your student is in college, help them set up automatic bill pay for any utilities or other bills they're responsible for, and get cc'ed on any bills they get so you can follow up and confirm they're being paid.
