As your teen launches into adulthood they are going to begin to make bigger financial purchases and decisions that are going to be more complicated than just running to Target and grabbing that item they have been saving for. Their ability to rent an apartment, get a cell phone contract and buy a house will be determined by their FICO score. This is a number between 300 and 850 that tells lenders how likely a person is to pay their bills on time. To have a score, a person must have had at least one account for the last six months that was reported to the credit agencies. The higher the score, the less of a risk to the lender. For that reason, people with higher credit scores receive better interest rates on mortgages and loans.
A credit score is determined by the following factors: payment history (35%), amounts owed (30%), length of credit history (15%), credit mix (10%), and new credit (10%). When just starting out, either because of age or lack of credit history, your teen must be even more diligent with their credit. The report averages all credit accounts. If a person only has one or two accounts, those accounts are going to count for more. An older adult may have several credit cards, a mortgage, and a student loan. If that person paid late on one of those bills months ago, it won’t be as detrimental because there are more accounts and more history to average.
The most important factor is payment history. It has the greatest affect on the credit score. This is determined by whether you pay your bills on time. The goal is to build up a history of consistent, on time payments. You must pay your bills and pay them on time!
The next most important factor is amount owed. It is also called the credit utilization ratio. Lenders want to know how much available credit is being used. Using all available credit, even if the bill is paid off every month, makes a person look like a higher risk. You don’t want to appear like you are living above your means to repay. The goal is to owe less than thirty percent of your available credit.
For example, if your teen has one credit card with a $1,000 limit, she needs to keep the balance below $300. The amount is calculated by looking at all available credit. For example, if a person had three cards with a total available credit of $5,000, they should not let the total of all the balances exceed $1,500.
The third factor is length of credit history. The longer the credit history, the better it looks. Since your teen is just starting out, there really is no getting around it. Their credit history just won’t be very long. We already discussed one thing you can do. If you have good credit, you can put your teen on one of your cards as an authorized user, and that will favorably influence their credit report and score. Make sure your card issuer reports authorized users to the credit agencies.
The next factor is credit mix. This shows the lenders what types of accounts (installment or revolving) and how many of them you have. Installment accounts are accounts like mortgages and car loans where a person pays a fixed amount monthly. Revolving accounts are credit accounts that let you borrow money and pay it back over time. Lenders want to see that a person can maintain good credit across different types of debt. This factor is not that important, so I wouldn’t focus too much on getting more credit.
The final factor is new credit. This component considers any new credit just received as well as new credit applications. A person should be careful not to apply for a bunch of loans or credit cards at the same time. Doing this makes someone appear like they are preparing to take on a bunch of debt. I know all those stores in the mall are offering 10 percent off for applying; just because you can doesn’t mean you should!
Many lenders look at both the credit report and credit score to determine if they will extend a loan and how much interest will be charged. Excellent credit scores will get a better interest rate. This could potentially save thousands of dollars over the life of the loan.
There is another credit score that is becoming more popular called the VantageScore. The VantageScore was created by the three major credit bureaus (Equifax, Experian, and TransUnion) as an alternative to the FICO. Lenders for many years have mainly used the FICO, but they are beginning to pay more attention to the VantageScore. This is great news because people who had trouble getting a score in the past because of limited credit history, such as young adults, find it easier to get a VantageScore. With a FICO score you need at least six months of credit history compared to only a month or two with VantageScore.
The two scoring agencies use much of the same data to calculate your score, but calculate the numbers a little differently. It doesn’t really matter which one you use, they both are reporting your credit history and worthiness. One will not report a low score, while the other reports a high score. Just pick one. Many credit cards offer free credit score reporting. With some cards, such as Capital One and Discover, you do not even have to be a customer. You can also obtain a free score through personal financial sites like CreditKarma and NerdWallet.
This blog post is an excerpt from my book I Am Not Your ATM: A Practical Plan For Teaching Your Teen to Manage Money. If you want a step by step guide on how to gradually teach your teen how to handle money, check it ou