Between coursework, internships, and everything else life may be throwing your way, worrying about your credit score is likely not a priority right now. What you should know though, is that this score is a critical component to securing financing for large purchases; it’s the primary indicator that lets lenders know how risky it is to loan you money.
So, when you’ve finished school and are ready to take that big financial next step—like buying a home or car, starting a small business, or just getting a credit card for everyday use—your credit score will determine interest rates you will receive for these loans. It’s the primary indicator that lets lenders know how risky it is to loan you money.
So, whether you want to take out a mortgage, start a small business, buy a car or even get a credit card for everyday use, your credit score will determine interest rates you will receive for these loans.
Why You Need a Good Credit Score
If you have a good credit score, lenders will give you more favorable interest rates because they’ll know you are more likely to pay back the loan. A bad credit score will do the opposite: lenders will charge you more for the loan, or in some cases, refuse to loan you money at all. That’s why it’s critical to get your credit score to be the best it can be.
Bankrate provides a simple example of this principle: If you were looking to get a mortgage, a credit score of over 720 would get you some of the best interest rates available. A score of about 620, on the other hand, would lead to an interest rate almost a full percentage point higher. That doesn’t sound like much, but the difference can be quite large.
Say you had a 30-year fixed mortgage of $200,000; the 4 percent rate that someone with a good credit score would pay would be $954.83 per month for the principal and interest on the loan. A person with a bad credit score might get an interest rate of 5 percent for the same loan, bringing the monthly payment to $1,073.64. That’s about $120 more per month for the same loan.
So what exactly goes into your credit score? FICO, the producer of the most widely-used credit score, breaks it down according to the following proportions:
- 35% – Payment History
- 30% – Amount Owed
- 15% – Length of Credit History
- 10% – Credit Mix
- 10% – New Credit
Of course, as a student, you likely haven’t had many opportunities to strengthen your credit history. That’s OK; there are still a few fairly easy ways to build credit:
1. Apply for a Credit Card and Pay Your Balance on Time
One common misconception is that you can maintain a good credit score if you don’t open any credit cards. After all, you can’t have bad credit if you don’t use credit in the first place, right?
Not exactly. Your credit score is essentially a way for lenders to determine how likely you are to pay off a loan. If you have no credit history, lenders have no way of knowing how credit-worthy you are and they’ll consider you a risk. Paying off a credit card each month is a great way to build up your payment history, which makes up 35 percent of your credit score.
By opening a credit card, using it to make purchases and paying off the balance on time and in full each month, you’ll develop a solid history of on-time payments that will improve your overall credit score. Paying your balance in full is very important because it will help you develop some great habits, such as limiting your spending only to what you can pay off each month and avoiding high interest rates.
If you don’t have any credit or income yet, you may need a co-signor (see #4 below) or you may need to wait until you’ve secured a job post-graduation and consider the next option instead.
2. Start Off with a Secured Credit Card
If you have no credit or bad credit, it may be difficult to open a credit card with favorable rates. If this is the boat you’re in, consider opening a secured credit card, which requires you to make a cash deposit that acts as the collateral for your line of credit.
For example, if you put $400 in your account, you can charge up to $400 on your secured card, and pay it back monthly just as you would with any other credit card. This helps you build credit because the bank will report your on-time payments to the three major credit bureaus.
There are usually additional terms and fees that could affect the usefulness of a secured credit card. Just like with a standard credit card, it helps to research all your options before opening a secured line of credit.
3. Check Your Credit Report (for Free) Often
Federal law requires each of the three major credit bureaus to provide you with your credit report once every 12 months for free at www.annualcreditreport.com. There are other sites that will show you your credit report and claim to be free, but most of them actually require a subscription—Annual Credit Report is a good option that is actually free.
Checking your credit report regularly will help you detect things like identity theft, credit card fraud, or even just mistakes from creditors, all of which can lead to lasting damage to your credit score if they aren’t detected and remedied quickly.
4. Get Some Help from a Credit-Worthy Family Member
Just as an introduction from a mutual friend can make meeting new people less stressful, getting a loan or credit card becomes much easier when you can have someone—like a parent or other family member—with established credit who can vouch for you.
As an example, if you’re taking out a loan, you can have someone with a good credit score act as a co-signer who will be responsible for the payment of the loan. Another way to piggyback off someone else who has good credit is to become a joint owner on his or her credit card. You’ll both be responsible for paying off the balance each month, so as long as the two of you continue to pay off the balance for your shared account on time and in full, you’ll develop a credit history even if you rarely use the card.
You should, however, use caution when bringing on a co-signer for a loan or becoming a joint owner on someone else’s credit card. If you fail to pay off your loan, your co-signer will be on the hook for it. Additionally, if the person responsible for paying off the shared credit card balance fails to do so, your own credit score will be negatively affected.
5. Apply for a Mix of Credit Types
There are two major types of credit: open-end/revolving lines of credit and closed-end/installment loans.
A credit card is the most common example of an open-end line of credit; you borrow against it and pay back as much or as little (at least the required minimum) as you want at a time. (As we mentioned, it’s best to pay the full amount due to avoid paying the extra interest and potentially affecting your credit score if the balance gets too high.) A closed-end line of credit is generally a loan you pay off at regular intervals with a fixed end date, such as an auto loan.
Having both types of credit is critical: As FICO explains, 10% of your credit score comes from your credit mix. That is, having a strong history with both open- and closed-end credit lines. This means that paying off your student and auto loans on time, while maintaining good spending habits with your credit card, will be critical to building good credit after graduation.
Your post-grad years—the years when you’ll most likely look to buy a car, get married, buy a home and make other big life decisions—will be made much easier if you can build good credit and get good interest rates on all of these expenses and investments. Start planting the seeds of good credit now, and you’ll be able to reap the harvest later.