by Carla Lake | September 25, 2013 11:16 am
For many young adults (including myself), credit cards are confusing. Yes, having a good credit history is important if you want to buy a car or a house.
But what if you don’t? And why bother with having to pay off credit card debt and interest if a debit card basically lets you do the same things a credit card does?
A credit card offers you a “line of credit” — money you can borrow from your credit card issuer to pay for things. Most credit cards offer a “revolving” line of credit, which means you can make a minimum payment on the total amount you have spent with your card each month, and the unpaid balance will revolve, or carry over, to the next month — plus interest.
If you pay off what you owe within a certain amount of time, you can avoid paying interest on it — and with current average rates at 13% for fixed-rate credit cards and 15% for variable-rate cards, you want to avoid paying interest.
Payment history accounts for 35% of your FICO credit score, the rating that credit reporting agencies provide to lenders to tell them how likely you are to repay a loan. So if you don’t have any previous history of paying rent, bills or loans, a credit card is a good way to show lenders — as well as potential landlords, and even employers — that you’re in good financial standing.
Credit cards also can offer rewards like cash back, extended return policies and airline miles.
So say you’ve found out what your credit score is from one of the three major credit bureaus — Equifax, TransUnion or Experian (or all three) at AnnualCreditReport.com. Perhaps your score is on the low end of the 300-850 range. What can you do to improve it, and thus improve your chances of getting a good rate on a car loan or mortgage?
Since your previous payment activity has such an outsized effect on your score, it’s one of the first places to start.
This piece of advice will sound simple, but it’s essential — don’t spend more than you have. Keep the amount you owe as low as possible (MSN Money says keeping balances below 30% of your credit limit is best), or better yet, pay off your debt in full each month.
You also should avoid certain behaviors to keep your score high: opening up several credit cards in a short amount of time, moving debt around and — this one surprises most people — closing out old, unused credit cards. It’s better to have a longer history of credit, so your old account can actually help that aspect of the score.
Keep in mind, though, that credit cards aren’t the only way to build up your score. It just has a larger effect on your score than some of the other ways, like applying for loans.
The difference is subtle, especially as more debit cards offer rewards like credit cards, and some even have a line of credit in the form of overdraft protection. But when you pay for something with a credit card, technically the bank is loaning you the money, even if you pay it back in full the same day. With a debit card, there is no loan — the money comes straight from your account, so it doesn’t count toward your credit score.
If you’re concerned that a line of credit is too much temptation to spend freely, a debit card might be a safer option. But it will not help you build credit.
If you can pay off what you owe, a credit card (and the resulting good credit score) is a great way to show lenders, landlords and even potential employers you’re reliable. If you can’t, a credit card can be a liability.
It’s important to remember that when you use your credit card, you are incurring debt. Credit cards aren’t magical pieces of plastic that let you spend money you don’t have, and worse, if you don’t pay them off each month, they make you pay more than you otherwise would (in interest).
Still, using credit cards to build credit can make it easier to purchase big-ticket items like a car or home down the road, and they can teach you important financial habits, to boot.
As of this writing, Carla Lake did not hold a position in any of the aforementioned securities.
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