What Teens Should Know About Credit

What Teens Need to Know About Building Credit: A Quick Guide

 

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Too often, young adults face a rude awakening as they enter into their late teens and early 20s. Suddenly they are out on their own, looking to secure their first credit card, private student loan, or car financing, only to discover that they have no credit history on file with any of the major credit bureaus.

 

It's a shock to find out that, even though you’ve never defaulted on any debt or bills, you aren’t able to secure some of the most basic types of credit. To avoid this, teens and their parents should start thinking about building credit well before the young adult’s 18th birthday.

 

How Credit Works

Truth be told, adults barely understand how credit scores work, let alone teenagers. However, credit isn’t as mysterious as some make it out to be.

To start, there are three leading credit bureaus in the United States including Experian, Equifax, and TransUnion that will determine your credit score. They each use five different factors, all weighted differently, to determine your final score which can range from 300 (the worst) to 850 (the best).

The below items are listed from greatest to least influence over credit score:

  1. Payment History (35%): Do you have a history of making on-time and full payments on major bills, including utilities, cell phones, and loans? Your payment history is used to predict future payments. If you were late in the past, will you be late going forward.
  2.  Credit Utilization (30%): If you have a credit card with a $5,000 limit, are you using all $5,000? Even if you have access to thousands of dollars of potential credit, the percentage of that credit you have actually used influences your credit score. Try to keep your credit utilization below 30 percent to make sure your utilization helps your score and doesn’t hurt it.
  3. Credit History (15%): One of the main reasons why parents should help their teens secure credit early is because the length of credit history does influence a credit score. While decades of history isn’t necessary, the earlier you get started, the better.
  4. Credit Mix (10%): Having a reasonable mix of different types of credit plays a small but important role in your score. Having two to three different types of credit, including student loans, credit cards, and more, will help.
  5. New Credit (10%): Each time you apply for or open a new line of credit, a lender may perform a “hard credit pull” which will reduce your score slightly. Over time the effect dissolves, but if you have new credit on your history, this will slightly decrease your overall rating.

 

Why Credit Is Important

Credit is how lenders, banks, and - even in some cases - landlords, determine if you are likely to default on your financial obligation. If you have a history of late payments on your credit card, will you also continue to make late payments on your student loan?

Your credit score is a picture of your financial past which influences a lender’s decision to offer you credit and the appropriate terms for the credit. The lower risk they deem you to be, the better interest rates you may qualify for. If the banks assess you as too risky, it will be challenging to source any credit at all.

How Teens Can Start Building Credit

Even for teens who still live at home and are financially dependent on their parents, there are ways to develop credit history early on.

For example, some credit cards allow for secondary authorized users, with no age limits. Bank of America, Chase, and Capital One are some examples. Before setting up your teen as an authorized user, speak with the issuer to confirm they report (at the very minimum) the credit history of authorized users to a credit reporting agency. This will help to build the basis of a credit history for your teen

Another option for teens who have moved out from their parent's house is to work with one of the new organizations which report on-time rental payments to a credit reporting agency. Until recently, credit scores were unaffected by on-time rent payments. However, there are many new organizations now developing ways for renters to make their monthly rent payments count.

Credit Mistakes/Traps to Avoid

An easy mistake for first-time credit holders is to get in over their heads. After all, if you’ve never had a credit card before, it's easy to spend much more than you can pay off each month. Make sure to keep track of how much you have spent on your credit card and never spend more than you can pay off before your due date.

Also, be wary of any credit card offers that seem too good to be true. Whether that be an amazing bonus offer, a super low interest rate (below 15% or so), or something else, chances are they are looking to prey on newbie credit holders and may have some hidden fees or fine print that will cost you in the long run.

Another mistake is to avoid looking at your credit card statements or bills before paying them. Yes, it’s time consuming to review monthly bills, but you never know what errors you could find. Did a restaurant overcharge your credit card? Did your phone company miss one of your payments? Reviewing bills can save you money and save your credit score over the long run.

Another easy mistake to make when you are trying to build credit is to sign up to absolutely every offer that comes your way. Just because part of your credit score is based on a credit mix, doesn’t mean you should go crazy accepting every credit option put in front of you. Only apply for what you truly need and can manage.

Final Thoughts

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The idea of building a credit score can be overwhelming for teens with little personal finance knowledge. Though it can be stressful, it’s not overly complicated. Know the details of your credit cards and loans and make sure to understand how they affect your credit score before you take them out. Spend smartly with your credit and don’t bite off more than you can chew. If you can do these things – along with understanding how credit generally works – then you will be well on your way to building that perfect score of 850.

Dave Rathmanner is the VP of Content for LendEDU – a site dedicated to helping consumers with their personal finances. In his free-time, you can find Dave working out, playing lacrosse, or dreaming about his next dog.

Amanda SterkComment