As a demographic group, Millennials are the most credit-adverse of any group since the Great Depression. Millennials tend to be one of the most saving-conscious demographic groups. Yet Millennials, collectively, have the worst credit scores than other demographic groups.
Not a problem because you always pay your bills on time, you glibly reply? Think again. Credit scores are important for getting financing for major purchases – everything from appliances to a car to a home. But did you know credit scores are also used to screen rental and job applicants? They are used to set insurance rates. And utility companies use credit reports to determine if you need to provide a deposit and how big that deposit will be.
Basically, your credit score serves two purposes.
The first is to verify that you really do, in fact, exist as a part of the transaction society in which your parents and grandparents lived. It’s not enough to hand someone your birth certificate while engaging in a conversation…. You need to do financial transactions if you really want to be counted. The second, and arguably the more important, provides an objective measure of the risk.
Seeing the credit score as a measure of your riskiness – or trustworthiness – may seem to be a cold and impersonal way to evaluate your personal character, and it is just that. But that’s the point. Financial transactions are typically evaluated “at arm’s length,” not considering whatever strong bond may exist between two life-long buddies. Credit scores provide the person who does not know you a summary of how trustworthy you have been with your past financial transactions. That’s why more than just lending institutions use them.
And that’s why they’re so important to your future success!
Your credit score is calculated on five different aspects of your credit usage. The largest component, 35%, is your payment history. Obviously, you want to make your payments in full and on time – for whatever the prices and to whomever the costs go. If you can’t make a full payment, make a partial payment. Better to timely make some payment than none at all. It is important to note that while your payment history is the largest component of your credit score, it is not the majority of it. Staying on top of your student loan payment does help build your credit score, but it does not automatically put you in a higher credit score category.
The second-largest component at 30% of the total score considers your total outstanding balance relative to the amount of credit available. This part of the credit score is more complicated, making it more often overlooked or disregarded. First, this component considers how much is still outstanding on your student loan or other installment-type loans (s). The more you’ve paid the loan down, the better. Second, this component looks at how you use your revolving credit sources. A low or zero balances on a couple of cards will positively impact your score. Many credit cards that are nearly “maxed out” will drag your score down, even if you are responsible for your payments.
The third-largest component involves the length of your credit history. Thankfully it only accounts for 15% of your score since it is largely outside of an individual’s control. A long history of responsible credit usage reflects a higher credit score.
Your credit score’s smallest factors are credit mix in use and new credit (10% each). While you want to have significant amounts available, opening several new lines in a relatively short time may indicate that you are a credit-risk because you may be facing imminent financial troubles. This will lower your score. The responsible way to build your score is to slowly open new credit lines, only as it makes financial sense. The mix of your credit usage is also part of your score. Having the only experience with installment-type debt, such as a student loan, does not fare well in calculating your score, showing that you are responsible for several types of credit.
Many Millennials avoid using credit because of the possibility of fees, penalties, and other “unadvertised” costs. If credit is used irresponsibly, it is possible to rack up more than $6,000 in credit-related expenses in just four years, even with a credit card that only carries a $500 limit.
However, the real cost of credit card fees and penalties is seen compared to what $6,000 could have done if invested properly. If those funds were invested in the stock market rather than on fees (or beer and pizza), assuming an annualized, inflation-adjusted average return of 9.64%, by the time you retire, you would have a tidy nest egg of nearly $350,000!
Irresponsible credit usage drives down your credit score. Not using credit never allows you to increase your credit score. For the person sitting “at arm’s length” looking to evaluate if you are a good risk for a job or a lease agreement, the difference is negligible. From some perspectives, it may even be fair to say that. in our society, not using credit is a sign of fiscal irresponsibility.
Beyond just the basics of avoiding fees and having something to sock away for retirement, a good credit score opens many other opportunities to save money.
A good credit score indicates that you have demonstrated that you are trustworthy and responsible. That allows others – who are considering you “at arm’s length” – the opportunity to feel more comfortable in doing business with you. That is true for creditors when you want to make a major purchase. It is true of employers when you can get that dream job. And it is true of landlords when you finally find that great apartment in the good part of town. But most importantly, being a low-risk person means you have choices regarding where you spend your hard-earned cash. Those who want to sell you their products and services will work extra hard to make their offering more attractive – which typically means you get a deal where others pay through the nose. That is the difference between purchasing a brand new car with a $200 monthly payment and a used car for $330 per month.
Having good credit means more cash in your pocket. For example, if you buy a house, the cash savings in interest rates alone between a person with a credit score of 760 and 630 is approximately $100,000 over the mortgage life. And, according to the IRS, the average home mortgage-related deduction claimed in 2013 (latest data available) was a whopping $8,900. Perhaps it is irresponsible not to establish good credit and forego such cash-saving opportunities.
The most important factor in building an excellent credit score is to make your payments on time and for at least the prescribed amount. This is true whether you’re making payments on a student loan, a car loan, credit cards, or even paying your Mom. Late payments and payments for less than the minimum amount will adversely affect the largest part of your FICO score quickly and decisively. If you cannot make timely payment for some reason, you should call the creditor as soon as possible to explain your situation and make temporary hardship arrangements.
The second and third steps to build excellent credit is only to take out new credit as you have, as opposed to taking out as much credit as you can to see if you can get it. Then, get the balances paid off as quickly as you can. You want to have a high available credit relative to your outstanding balance. Still, opening many lines of credit in a short period may indicate that you are in financial trouble with the digital algorithms that calculate your score.
Finally, take out and use a credit card. Granted, many millennials are already paying student loans and may even have a car loan. But these are considered installment loans. On the other hand, credit cards are considered revolving lines of credit – they’re different from your installment loans. Using multiple types of credit instruments, you demonstrate that you are responsible and trustworthy in various situations.
Whether you like it or not, our society’s financial aspect is greased by credit scores. Having and maintaining a high score makes your financial world so much easier, opens doors of opportunity closed to others, and allows you to save significant amounts of your hard-earned cash. Is your credit score important to you? It certainly is to everyone else.