There’s a great debate going on amongst personal finance experts across the world. It’s an important debate to us, but then again we think all of our debates are important. We’re kinda a self-important bunch. The question that launches the debate: Should anyone ever have a credit card? There are the the extremists among us that say any use of credit is evil, unnecessary, and avoidable. You’ve actually heard this debate before, but it had nothing to do with credit. It’s the abstinence vs. “safety” conversation. The personal finance debate is incredibly similar to the “aggressive hugging” debate. And just like in the “aggressive hugging” abstinence debate, both sides are strong in their convictions. The “no debt ever” movement is a compelling one, but it makes some processes unacceptably hard.
I believe that credit cards are unnecessary, once credit history is established. I believe regular credit card use induces superfluous spending. Points, cash back, and other reward programs wouldn’t exist if they didn’t increase bank revenue via increased consumerism. This is exactly why I personally don’t use a credit card, and why I urge other established individuals to avoid using them too. However, I do believe that a credit card is incredibly necessary to establish credit for those individuals that have no credit.
There are two groups of people who want their credit score to go up: people with damaged credit and people with no credit. Today’s focus will be on the no credit people. We’ve tackled the damaged credit people in the past, and will address them again in the near future. When you have no credit, life can get incredibly difficult and frustrating. A person with no credit simply hasn’t borrowed money that is reflected on his credit report. This leads to the denial of new credit, increased renting costs, and the requirement of a co-signer. Which brings us to possibly the most frustrating question in personal finance. “How in the world am I supposed to establish credit if people keep denying me because I don’t have any established credit?”
The answer to this question is shockingly simple that your head will spin. You need to get a credit card. I know, you’ve already tried that. But you did it wrong. Before we go much further, I need to draw a line in the sand. While I don’t believe people with established credit should use a credit card, I do believe people with no credit should use a credit card to establish credit. I realize you might think I’m splitting hairs to make a point, but I assure you I’m not. Think of it this way, you needed training wheels when you first learned to ride your bike, yet you don’t use them now. You could use them. There are still advantages to using them, but you don’t use them. This is exactly what you need to do with a credit card. You just need the right type of credit card.
You need a secured credit card. A secured credit card is a credit card that is secured by a cash deposit. Specifically, you send the credit card company a check or money order for $200-$1000 to secure the credit line. The credit card company doesn’t have to trust that you will pay your credit card bill because they already have your money. Think of it like a refillable gift card that reports to the credit agencies. When you make a purchase, you create a debt on the card. To establish a credit history, make a payment on that debt to bring your security deposit back to its original amount. For instance, if you start with a $200 security deposit, spend $50 on shoes, then at the end of the month send $50 to the credit card company to take your balance back $200 deposited, then they will report this credit activity to the credit agencies. This establishes credit in a safe way. And did I mention that you get your deposit back when you are done? No, of course I didn’t mention that, until now.
The point of this exercise isn’t to buy things that you can’t afford. The point is to buy things you can afford, and then demonstrate your ability to pay back your debts on schedule.
There are some other considerations. You shouldn’t leave a balance on the card greater than 50% of the entire credit line. For example, if you have $200 deposited, you shouldn’t build up debts over $99. If you do, you will have a high credit utilization ratio, and this can affect your score negatively. Additionally, you will need/want to continue putting small purchases on this card for about 12 months, in order to establish credit. You can always deposit more cash into the security deposit to increase your credit line, but don’t get too carried away. The point of this exercise is to establish your credit for a few very important reasons. Oh, and don’t you dare miss a payment. You will go from having no credit to having damaged credit. And that’s a transition you don’t want to make.
When you have no credit, your auto insurance, renters insurance, and homeowners insurance costs can be higher than they otherwise would be. If you have no credit, you may have trouble renting a home or apartment. And if you have no credit, it will be very difficult to get a mortgage, no matter how great the rest of your financial life is. There are financial institutions that do something called manual underwriting. This is a loan evaluation process in which your non-credit factors are weighed differently than a conventional underwriting process. I’ve been able to walk individuals through this process in the past, and it’s no sure thing.
Establishing credit will also let you do all other sorts of things. However, many of these things aren’t so great. Established credit will allow you to get store credit cards, car loans, and unsecured credit cards. I find all three of these uses of credit to be unnecessary. You used your training wheels to learn to ride a bike, now take off the training wheels.
Peter Dunn a.k.a. Pete the Planner® is an award-winning financial mind and a former comedian. He’s a USA TODAY columnist, author of ten books, and is the host of the popular radio show and podcast, The Pete the Planner Show. Pete is considered one of the foremost experts on financial wellness in the world, but he’s just as likely to talk your ear off about bass fishing.