I recently asked my friends about their biggest struggle as a newly minted professional. One of their answers that they didn’t really understand credit. What makes up your credit score? What is a good credit score and how do you improve yours? It seems like in our high school and college curriculum we were never taught or given help about understanding credit.
Let me know in the comments and I’ll write a post about it.
Millennials are Afraid of Credit Card Debt
As it turns out, most millennials like us don’t completely understand credit, so we choose to stay away. It’s a natural reaction but, apparently, it’s a trend. Federal Reserve data says that the percentage of millennials who hold credit card debt has fallen to its lowest level since 1989 (when I was born).
So why aren’t we comfortable with credit card debt?
One reason, is that we grew up during the Great Recession. Therefore, we know the consequences of not being financially stable and how things can turn for the worst. We don’t have much trust in the financial market.
Our generation, millennials, are also more educated than we have ever been and, therefore, more financially responsible! We understand what we can and cannot afford to live irresponsibly and are extremely hesitant (with good reason) to use credit cards to live beyond our means. Huge no-no!
With this extra education we have, comes student loans. We are already in debt! Why would we want to add more debt to that? The average American millennial now has $17,200 in student loan debt. And that really sucks. But we must live with it.
Seems like our generation is being very financially responsible. How can this be a disadvantage?
Well, maybe you want to buy a car or a house…
We Need to Build Credit
Without a substantial credit history, it is much harder to take out a home mortgage. I know right. Clearly, since we haven’t fallen into the trap of living beyond our means with credits cards, we wouldn’t be irresponsible when buying a house!
Unfortunately, it doesn’t work that way. You need to show evidence of handling debt to be trusted with more.
I’ve mentioned Dave Ramsey’s book, Total Money Makeover, before and I think it’s great. But there is one point that he makes that I disagree with. Dave suggests eliminating debt completely out of our lives by paying cash for everything. This just isn’t realistic for those of us just starting out in the real world. If we waited to save enough to purchase a house with cash, we would waste 10s of years still renting while we save up! That’s money that we will never get back.
If I saved half of my paycheck to purchase a $200,000 house in cash, I would be saving for over 8 years. That’s over $100,000 wasted in rent.
Long story short, we need to build some credit.
My Credit History
I got my first credit card in grad school and after 5 years of using my card responsibly, I racked up some pretty good credit. As of a couple weeks ago, my FICO credit score is in the high 700s and inching closer and closer to 800! (That’s my goal since watching Blackish season 2, episode 13.)
With my awesome credit score, I was able to lease my new car at a very low interest rate! It is beyond affordable! I’m basically driving the car for free…ok not really. But almost.
This can be all of us if we use credit responsibly. But first, we need to understand how it works. So let’s get to it! Let’s learn more about credit!
Your credit score is just a number that represents your credit worthiness. It measures how likely you are to pay your debts. But what is FICO? The FICO credit score is just a fancy name for the model used by most banks and credit grantors. It’s based on your credit files from the 3 national credit bureaus: Experian, Equifax, ad Trans Union.
Your FICO score is determined by many different pieces of credit data in your credit report from those bureaus above. All of this info is grouped into 5 categories: payment history, debt burden, length of credit history, types of credit used, and recent searches for credit.
The following varies for different people, but here’s the gist of how much they contribute to your overall credit score:
35% Payment History: This category is determined by the presence or lack of poor debt management.
30% Debt Burden: This includes your debt-to-limit ratio, number of accounts with balances, amount owed across different accounts, and amount paid down on installments loans.
15% Length of Credit History: Info for this category comes from the average age of the accounts in your report and the age of the oldest account.
10% Types of Credit Used: This one is pretty self-explanatory. Different types of credit include credit cards, car loans, mortgage loans, student loans, etc.
10% Recent Searches for Credit: This includes when you apply for some type of loan. But don’t worry, multiple inquiries with 14 or 45 days of each other is seen as one. So it’s ok to shop around for something like a car loan.
How Credit Cards Work
When you use your credit card, your company or bank loans you the money for the purchase. Then your card company gives you a grace period (usually between 20-30 days) where you can repay the amount before interest accrues.
The grace period is where you NEED to live!
If you pay your account balance before your grace period is over, then you will pay 0% interest. The grace period ends on your card payment due date.
People get into trouble when they don’t pay back the money before the grace period is over. This is when the interest starts to build. It gets higher and higher each month that you have an unpaid balance.
Credit cards typically charge between 10-20% of the total balance for interest. Suppose your card has an interest rate of 15% APR (annual percentage rate). If you charge $300 to your card that you don’t pay off in a year, you’ll end up paying $45 in interest. Which doesn’t sound so bad.
However, this isn’t usually the case. When people have credit card debt, they are carrying a much higher balance. Suppose you owe $3,000. That’s $450 in interest each year! It can be so easy to fall into this trap. Credit card companies only require you to pay a minimum payment each month (about 2-5% of the total balance).
If you find yourself in credit card debt, you can transfer your balance to a new credit card that has a 0% APR for the first few months.
I highly recommend the Chase Slate card. I actually have this card. It has 0% APR for the first 15 months of ownership. It costs $0 to transfer a balance within the first 60 days. Plus it gives your FICO score each month so that you can keep track of how you are doing.
Related Post: Understanding Your Expenses
We will discuss this in more depth next week along with techniques for handling credit responsibly and improving your credit score in part two of The Millennial’s Guide to Understanding Credit. Make sure you don’t miss out! To be notified about my new posts, join the Minted and Printed Newsletter. You will also get access to freebies and other awesome resources!
I hope that you enjoyed this post. Let me know in the comments if this helped you to better understand credit. Also, tell me what struggles you have had as a new adult navigating the real world. I’ll write a post about it and help others with the same struggles. Until next time,
P.S. I would love it if you shared this post and pinned this image!