By Stephen Fournier, President, Central New York Market, KeyBank
The purpose of building credit is to demonstrate financial responsibility to potential lenders. Unfortunately, credit is a bit of a catch-22. If you have it, you probably have a decreased need for it. If you need it and don’t have it, it’s often hard to get…but not impossible.
Building credit is about making strategically sound financial decisions. It’s about taking on debt and managing it responsibly so that one day, when you’re ready to finance a house, car or a college education, lenders will look at you and say, “this person has a track record of honoring their commitments and is worthy of a large loan.”
The dangers of accumulating debt
Establishing credit is not risk free. According to the Journal of Consumer Research, people who use credit and borrow to make purchases spend more money on their purchases than they would have had they used cash. In fact, one ill-advised purchase can start the snowball rolling down the hill.
Once you do have access to a little bit of credit, avoid the tendency to feel a false sense of prosperity. The reality is, credit may give you borrowing power, but it is not a license to spend. If you cannot afford whatever it is you may want to buy today, it’s generally a good bet you will not be able to afford the payments tomorrow.
The worst thing you can do to yourself if you are trying to build credit is to accumulate debt. Accumulating debt affects your ability to qualify for certain loans or financing. In addition, debt limits your ability to save money or invest in your future.
Also, banks, lenders, car dealerships and other financial institutions will look at your credit report to determine whether or not you qualify for a loan or repayment option. Those with bad credit or a high debt-to-income ratio may not qualify for certain loans or receive extremely high interest rates.
In addition to preventing you from purchasing a new car or home, or even financing your child’s education, bad debt damages your credit and can leave a lasting mark—up to 10 years in the case of bankruptcy.
How to build credit responsibly
While having bad credit can make financing the important things in your life extremely difficult, having zero credit can be equally disadvantageous.
Many lenders refuse people with little or no credit history because they have no information to evaluate, which ultimately makes them a potential bad risk for investment. This is why it is imperative to establish credit as early as possible.
The American Bankers Associations recommends following a five-step credit road map. To summarize:
- Start with a credit card. Credit cards are relatively easy to obtain, even if you do not have a credit history. If you have a negative credit history, you can get a secured credit card that you guarantee by making a deposit. The important thing is to use credit cards for small purchases that you are able to pay off on a monthly basis.
- Move on to an auto loan. Try to limit the amount you borrow by saving enough to make a sizable down payment. This will keep your monthly debt obligations low while taking your credit score to the next level.
- Settle in with a home loan. First, determine how much home you can afford. Between your mortgage and all other monthly payments (car, credit cards, student loans, taxes, insurance, etc.), you do not want to exceed 40 percent of your monthly income.
- Teach your kids about money and credit. You are their primary financial role model. The smarter your kids are with their financial decisions, the quicker they will become creditworthy themselves and the less likely you will be stuck repaying debts on any loans they may have you co-sign.
- Kick your feet up and relax. There is a reward for building strong credit early in life…and it’s that you won’t be saddled with debt later in life, will have more money saved and have the financial freedom to do the things you want to do—because you will have been in the position to plan and budget for them.
Remember, establishing good credit means much more than securing approval for credit cards and loans. It is also about building financial wellness and creating a path to financial independence.
Credit cards are the most common way to build credit, but they are not the only way. Car payments, mortgages or personal loans are also ways to establish credit without ever opening a line of credit. Anything that demonstrates stability and economic responsibility is a great way to establish good credit.
The important thing is to be responsible in your decisions and actions, because securing access to credit should be about the big picture—establishing a stable financial footing that will help you build a better life for yourself and those you love.
About the author: Stephen Fournier is president of KeyBank’s Central New York Market. He may be reached at either 315-470-5096 or [email protected].
Maintaining your credit demonstrates financial responsibility
The best way to maintain good credit is by demonstrating you are a financially responsible borrower. Here are some things you can do to help manage your credit cards and debt effectively while keeping your credit in good standing:
- Seek cards with low interest rates. One advantage of having a good credit score is being eligible for the lowest interest rates available. However, it’s not always easy to find a card with great rates. So look for the card with the lowest rates and best rewards for your lifestyle.
- Pay bills on time. Always pay your credit card bills on time. Late payments will have a negative effect on your credit score. If you forget to pay bills on time, consider setting up automatic withdrawal from your checking account. KeyBank’s online and mobile banking tools can also help you schedule timely payments. If you have overdue bills, plan to take care of them immediately.
- Make more than the minimum payment. If you only make the minimum payment to your credit card balance, costly interest payments will be added each month. If you can’t pay your credit card balance monthly, the next best solution is to pay more than your minimum monthly payment and stop borrowing.
- Avoid cash advances. Never say never, as emergency situations can call for resorting to any measure, but try to avoid cash advances. Interest rates on cash advances are often higher than the rate on purchases, and you can easily dig yourself into a deeper financial hole.
- Use credit cards wisely. You should only use your credit card under two conditions. One, you can afford to and will make full payment on all purchases at the end of each month. Two, for emergencies. If neither of these conditions apply, keep your credit card in your wallet.
- Keep accounts open. Surprisingly, closing a credit card can actually hurt your credit score because your credit score measures available credit versus credit balance. So the more credit you have available that you don’t use the better your score will be. So feel free to shred unused credit cards, just don’t cancel the account.
Remember, credit isn’t a bad thing. It allows us to make important purchases, such as cars and homes, we otherwise couldn’t afford. It can also help individuals launch and grow businesses. The key is to maintain a healthy relationship with it so it’s there when you need it.
