Expert OpinionJean Helwege
Ph.D., Professor of Finance, Philip L. Boyd Chair in Finance - School of Business Administration, University of California Riverside
UCR School of Business Professor of Finance Jean Helwege was asked to provide expert insights on building credit card credit for an article recently published on WalletHub.
Americans are big spenders, often spending more than they can handle. So it is not hard for ordinary people to fall behind on their payments and end up with less than pristine credit. This might not matter much early in life, but if you are looking to buy a condo or a house, or a new car, a good credit score can make a huge difference in the amount of interest you pay. In the extreme, having bad credit can shut you out of the housing market altogether. A bad credit score is clearly something to avoid but does that mean you should avoid all debt? It turns out that no credit score can also cause problems. Therefore, the ideal strategy is to have a good credit history.
Creating a good credit history requires borrowing through some form or another: credit cards, auto loans, home mortgages, student loans or some sort of installment debt by a company that reports it to one of the three consumer credit agencies. Experian, TransUnion and Equifax collect information on your payment history and outstanding balances, which is information used by Fair Isaac to calculate your FICO score. A perfect FICO score is 850 but any score of 800 or higher is considered exceptional. Most lenders will offer a reasonable interest rate to borrowers with FICO scores over 660. Fair Isaac provides considerable information on how to improve your credit score. The make the point that someone with no credit cards tends to be a higher risk than someone who has managed credit cards responsibly. Therefore, building a good credit history should start early.
If you have not borrowed before, you can't know how you will react to having a large pot of money available. Will you pay for an expensive vacation with a credit card and take years to pay it off or will you only use a credit card to pay for gasoline? If your first loan is a car loan, the large initial amount of debt might get you into trouble. Buying a car could easily turn out badly - an accident or buying a lemon with large repairs could turn your high monthly payments into a nightmare. Building credit by buying a house is even riskier - repairs and property taxes can overwhelm you, Or your job situation might force you to move, causing you to incur large transaction costs shortly after moving in. In contrast, a credit card has the advantage of allowing a new borrower to build credit slowly by starting with a very low credit limit. You might also consider a secured card where the amount you can spend is not only quite limited, but the money on the card came from you, rather than a bank.
Credit cards vary in their benefits, so consider the annual fees associated with them. If you are just trying to build credit, you shouldn't choose a card that offers airline travel rewards. For the perks of a travel reward card to cover the annual fee you need to make purchases of several thousand dollars. Ideally, find a card with no annual fee. A low interest rate should not be a major factor because the goal is to pay off the balance in full every month. If you cannot pay it off in any given month, stop using the card until you have your spending under control, but don't close the account (it will lower your credit score). If you are able to pay off the card each month but are forgetful, set up your checking account to send the minimum balance each month. Being late on even one payment is terrible for your credit score, so make bill-paying a high priority. Making a budget, or at least listing all your likely expenses, will help you forecast how much you can spend on your card and comfortably pay it off every month. Just because you only pay for car maintenance once a year does not mean you should not consider it part of your monthly expenses. Likewise, it would be foolish to think that you can go year after year without encountering any unexpected big expenses, so don't go so far into debt that you cannot handle one of them. Keeping an emergency savings account will make it more likely that you can always pay off your card in full.
You can check on your progress for free by visiting one of the credit reporting agencies. Besides offering guidance on how to improve your scores, these companies are also helpful in protecting you against fraud. To ensure that no one fraudulently opens an account in your name, you can put a freeze on your account. A freeze also has the advantage of making you think twice before you apply for more credit. It would be a shame to build up good credit and then tear it down by taking on too many credit cards, so be cautious in expanding your credit lines and accounts.