A woman who was turned down for a loan recently came to me for advice to find out why she was rejected. Sitting at my desk, she said she had perfect credit. When I asked her why she thought her credit was perfect, she replied that she should have perfect credit because she had no problem paying her bills. I asked to see her credit report and there was nothing on it.
It’s a common misconception that we start out with perfect credit and it gets worse with every loan or credit card we obtain. As a result, people avoid taking out loans and they cut-up or cancel credit cards they no longer use.
Unfortunately, this well-meaning advice is incorrect.
I’ll illustrate it this way: If you were going to loan your car to someone, would you rather loan it to someone who had never driven before or to someone who had a perfect driving record with years of experience?
Obviously the answer is that you would feel better about lending your car to someone with years of great driving experience. And the same is true for money lenders: They prefer to lend to someone who has proven in the past that they would pay back the money they owed.
Therefore, our credit scores grow when we borrow money and pay it back on time and in full, and decline when we don’t borrow money or when we don’t pay it back on time.
So one of the best skills you can learn (and you should teach to your children) is how to get and manage debt in order to build your credit score. Here are some tips to help you:
- You need a variety of loans. You should have a couple of revolving loans (like credit cards and lines of credit) and a couple of installment loans (like a mortgage or car financing). Lenders want to see both types!
- Inactive accounts won’t help you. Credit cards that remain dormant on your credit report don’t give you a better score. Use them regularly to take them out of hibernation, or the lender may close the account due to inactivity. (Remember: Always be responsible and only spend when you have the money to pay your credit card back).
- Pay back your loans on time. This is huge. Lenders are more likely to lend you money if they feel like you will pay them back when you say you will.
Lenders want to see a history of responsible borrowing to help them decide whether they should lend to you. Use that line of credit from time to time and make sure you rotate through all of your credit cards on a regular basis to keep them active. When building new credit, try for store credit cards or secured credit cards.
So, if you want that mortgage or that big loan in the future, the best thing you can do right now is start (responsibly) spending money with credit.
Image: Amy the Nurse, via Flickr