Money and You: Course Notes

In this section, we’ll go through the main contributors to your credit report and scores in order of how big of an impact they have.

- Payment History. (Very high impact.) The most important factor in your credit is your history of making payments on loans and certain bills. Missing even one payment can wreck havoc on your credit score. While not as bad, late payments also can drastically impact your credit. Note that a payment is not counted as “late” until it is 30 days past due. So, if you have a credit card payment due on July 1st, as long as you pay it by July 31st, the payment is not considered “late” in terms of impacting your credit.

When you pay certain bills, the lender or company will report to the credit bureaus that you have made a payment on time. If you are late with a payment or miss a payment, they will likewise report so. It takes dozens of reported on-time payments to build your credit up, but it only takes one bad month to lower your score. Now all bill payments are reported to credit bureaus. All loan payments, such as mortgages, auto loans, equity loans, and personal loans are reported to credit bureaus each month. Rent can be reported, but that is up to your landlord to do so. Generally, rent payments are not reported unless you miss payments. Similarly, utilities, phone, TV, and insurance bills can be reported, but are usually not. If you do miss payments, these companies are more likely to sell your debt to a collections agency, which absolutely will report your missing bill payments. Fines and tickets are not reported in Massachusetts.

Medical debt is tricky. It only takes one small thing to happen for medical debt to pile up. If you have an emergency medical procedure that your insurance doesn’t cover, you could be looking at hundreds of thousands of medical bills. A common false belief is that missed payments on medical debt can’t be reported for Massachusetts residents. This is false. It absolutely can. Many medical providers choose not to report themselves, but collections agencies absolutely will. However, since medical debt is seen as involuntary debt (choosing to take out an auto loan is never life-or-death), there is some leniency. First, medical debt of less than $500 will never hurt your credit. This is because it is really common to have to fight with your medical insurance company over co-pay amounts and whatnot, which takes time. Second, once your unpaid medical payments are reported to a credit bureau, the bureau cannot legally affect your credit report for 365 days from the day they are told about your missed payments. Paid medical debt is no longer report as well, meaning once you pay medical debt that went to collections, it is removed from your report. Further, some credit score models do not take into account unpaid medical debt. There are talks about eliminating all medical debt from credit reports, but that is looking less likely under the proposed goals of the new administration and legislature.

- Amount Owed. (Very high impact.) In general, the more you owe, the more risky it is to let you borrow more money. Even you you have a very high income and can afford a large mortgage or auto loan, large loan amounts will hurt your credit.

Percentage of credit utilization also affects your score. Owing $10,000 in credit card debt is much worse if your credit limit is $15,000 versus $50,000. (66.7%credit utilization versus 20%.) Ideally, you want to keep your credit utilization below 10%of your total “revolving-credit” accounts. (Revolving credit is a type of open-ended loan in which you can borrow up to a pre-approved amount. Credit cards and home-equity loans are examples of these.)

- Length of Credit History. (Moderate impact.) This is one you don’t have much control over. Lenders, employers, etc. would prefer to see you have 25 years of good credit history versus one year of credit history. Credit history is usually determined to be either the age of your oldest account or the average age of all your accounts. For example, if you opened your first credit card five years ago and opened a second credit card one year ago and no other types of accounts, your “credit age” could be either 5 years or 3 years (average of 1 and 5), depending on the reporter’s model. I didn’t pull 25 years out of thin air. That is usually the credit age needed for the best positive impact to your score. Again, don’t stress over credit age. Once you have an account open, you just have to wait.

There are some nuances to this. If you pay off a loan, that account is called “closed.” Closed accounts stay on your credit report for up to ten years and continue to contribute to the “age” of your credit. After 10 years, closed accounts disappear, suddenly changing your “credit age.” Also, not using available credit can be seen negatively. Some credit card companies close your credit cards if you do not use them for some period of time (often a year). So, it is in your best interest, if you can, to keep your oldest account open.

- Credit Mix. (Lower impact.) Lenders like to see that you are capable of paying a variety of types of bills. Having one credit card and no other types of accounts or loans makes it look like you have too narrow of credit history. So, most credit reporting models favor having kinds of both installment debt (mortgage, student loans, etc.) and revolving accounts (credit cards and equity loans). Even though have a broader mix of credit types helps your credit score, the impact is not worth taking out new loans or opening more credit cards just to improve your credit score. Be smart about loans and credit cards.

- Credit Inquiries and New Accounts (Lower impact.) Statistically, if you take on more debt, you are more likely to miss a payment on older debt. So, opening new accounts tends to lower your credit rating.

First, when a company or person needs to check your credit report, they “pull you credit report” or “run an inquiry.” When you apply for a home loan, the bank will pull your credit report to determine if they are willing to give you a loan and what rate they are willing to give you. Even if you do not actually take out the loan, this credit check will hurt your credit rating a bit. There are two types of credit checks. A soft credit check is a check companies do to find out who they would like to offer you something. Credit card companies are the biggest users of soft inquiries in that they look for people with scores in certain ranges to market particular credit cards. Since you do not authorize these checks, soft credit inquiries do not affect your credit at all. A hard credit check is one that a lender will do when you apply for a loan or credit card. These do lower your credit rating.

The decrease in credit ratings from hard credit inquiries is usually small and very temporary, assuming you make payments on all your bills on time. Further, if you “rate-shop” and apply for loans at a few places in a short time-frame, those multiple checks are often counted as only one “credit inquiry.”

We all start out as ghosts. My generation (millennial) had a saying when we were hitting the job market. “To get a job, you need experience. To get experience, you need a job.” A similar adage is true for credit. “To build credit, you need credit.” That is, in order to show someone that you can be trusted with their money, you have to have already shown that you can be trusted with money.” Some people decide they want to start building credit, but find they are rejected due to having no credit history. This section is about starting your credit journey.

The first option comes with a huge disclaimer. Promise me you won’t make any decisions until you complete understand how credit cards work and their dangers. Promise? Good. Opening your first credit card account is a quick way to start building a credit history. If you can demonstrate that you can use a credit card responsibly, and make all payments on time, you’ll see a strong start in your credit. However, credit cards have the potential for enormous debt that is easy to fall into. Never open a credit card unless you are 100%sure you can use it responsibly. We will go over credit cards in the the next section. If you are determined to open a credit card but do not trust yourself not to overspend, you ask your parents/guardians to hold onto it for you and only use it to buy one small thing a month, like a pack of gum or a coffee.

If you do not trust yourself with a credit card or cannot get a credit card, a secured credit card may be an option. When a financial instrument is “secured,” it means its tied to a relatively safe asset. A secured card is tied to a bank account, making it function much like a debit card. To open a secured credit card, you usually deposit money into a bank account, called a “security deposit.” You are issued a credit card with a limit equal to what you put into the account. You cannot spend the money from your security deposit. Each month, you pay your credit card bill from your (different) regular account. If you miss a payment, the bank used the money in your security deposit account. A secured card is a way to build credit with less risk of falling to credit card debt. So, it can also help with anxiety around credit cards. Secured credit cards are meant to be temporary. Once you’ve built some credit and feel less anxious about credit cards, it may be time to move onto a regular credit card. There is one caveat. Not all secured cards report to the credit bureaus, which makes them pointless for building credit. Make sure the one you want is from a bank that will report to at least one of the three reporting bureaus.

This one takes a lot of communication and trust. You can build some credit history by becoming an “authorized user” on someone else’s credit card account. Most commonly, parents or spouses add someone as an authorized user. The benefit is that all reports from the credit card company regarding on-time payments now goes to your report as well. However, being an authorized user means that you essentially have access to whatever credit the primary user has. For example, if your parents have a credit card with a $20,000 limit (much higher than the usual $500 limit for a first credit card), you have access to the spending power of that $20,000, but your parents are responsible for the payments. It takes a great deal of open communication, planning, and trust for this arrangement to work. One option some of my friends’ families did when we were young adults was to make their child an authorized user but did not actually give them the credit card or any of the information. The idea was to help their kids build credit without the risks of a teenager doing something foolish with a high-limit credit card. A few (emphasis on few) credit cards allows primary users to set separate spending limits for authorized users.

Some small banks and credit unions offer “credit-builder loans.” These loans don’t make much sense on the surface, but they are effective at building credit. With a credit builder loan, you apply for the loan but do not get the funds right away. They are held in an account. You then make payments for this loan (with interest) as you would for a normal loan. Once the loan is paid off, you get the loan amount you actually applied for. For example, suppose you take out a credit builder loan of $1,000 at 7%interest for one year. You do not get that $1,000 right away as you would with a traditional loan. Instead, you would make monthly payments of about $86.53 per month. Notice that you would pay \(86.43 \times 12 = \$1,038.36\) in total. At the end of the year and after you made all you payments, you would get that $1,000. Yes, you lose money, but that is because it is a loan. You have to pay interest. Think of it as paying $38 to start building your credit. Because credit builder loans are small (usually about $1,000), big banks don’t deal with them. Some online banks do, but they are usually predatory and trick you into a really high interest rate. If you go this route, go with a local credit union.

In general, it takes about six months of on-time payments to establish a credit history. This in no way means you’ll have a great credit score in six months, but you will have some history, and you will have access to better credit cards, loans, more apartments, etc.

Once you’ve established some credit, you want to maintain your credit and continue to build it overtime. We’ll go over a few things that will help you stay on top of your credit.

- The first is more of a general philosophy. I’m going to give you a rule. It’s overly-simplistic and requires some caveats, but it is a solid rule for maintaining your financial health, particularly with respect to credit.

That requires some explanation. Some debt is okay and often unavoidable. A reasonable mortgage or car loan are examples of okay debt, but those are predictable and expenses you would likely have no matter what (housing and transportation). The above rule is directed at things like credit card debt, home equity, personal loans, payday loans, etc. A more apt rule might be, “never take on debt you can’t afford,” but that doesn’t stick with you as much as “never go into debt.” Make whatever changes are necessary to avoid falling into debt. The debt will become a burden.

- In a similar vein, the second recommendation is to never buy something with a credit card that you don’t have the cash to pay for. If you don’t have the full cost of a TV saved up and able to be used without draining your savings, then do not buy the TV with a credit card. It is easy to amass well over $10,000 in credit card debt with minimum payments that grow and grow. If you only purchase what you know you can afford, you can go through life without paying a penny in credit card interest and never amass debt. A good mindset is to think of your credit cards as a debit card in which each swipe/tap directly withdraws from your cash account. They aren’t, but having that mindset can help control spending.

- Set up automatic payments for bills. It is easy to get a bill in the mail and forget about it for a while until it’s late. Automatic payment eliminates that scenario. If you can, set your credit card payments to automatically pay your full balance each month. This way, you’ll never pay any interest and won’t amass any debt. (Only do this once you have a solid budget and are comfortable enough with your spending that you won’t have money you need for rent or some other necessity automatically withdrawn.)

- Check your credit reports regularly. By law, the credit bureaus have to give you free access to your credit reports once each year. Make use of that. Most credit cards these days have a benefit that allows you to access a pared-down version of your report whenever you want. If you have access to that benefit, do so at least one a month. You want to look out for irregularities. Mistakes happen sometimes. One small billing error may make your auto loan bank mistakenly report you as missing a payment. Maybe something went to collections, and you didn’t know. Maybe someone committed identity fraud and opened an account in your name. It is important to keep a lookout for irregularities on your credit reports and contest anything that is incorrect.

- Put a “credit freeze” on your accounts. A credit freeze is when you tell the reporting bureaus not to allow anyone to access your credit report. This prevents anyone from taking out any loan in your name or applying for credit cards in your name. It also significantly reduces the amount of junk mail you get since companies can’t access your report to target you for advertising. However, by “anyone,” I mean everyone, including you. So, if you need to apply for anything that requires a credit check, you actively need to remove the freeze or do a temporary removal (called a “thaw”).

- If you become comfortable with your own responsible credit card spending habits, every now and then ask for a credit limit increase. Having a higher credit limit lowers your overall credit utilization, which is seen positively by lenders. Of course, never request a spending limit increase if you are building credit card debt; the last thing you want in that situation is more room to amass more debt.

-If you go “rate-shopping,” try do so in a short time span (about two weeks). Shopping around for the best interest rate with hard credit checks needed for each will be treated as one inquiry if they are all made around the same time. If they’re spread out over a couple months, you can hurt your credit a fair amount.

-Have an emergency or rainy-day fund that can pay about three months of your required payments. If you find yourself out of work, on disability, parental leave, etc., your bills don’t stop. Have a fund to help you make it through until you can find employment again.

Now that we’ve discussed how to start building credit, it’s time for you to make a plan. In a paragraph, explain what you would like to do to start building credit. If you are already building credit, explain how you are doing so and what you are doing to maintain your credit.