Typically there are two schools of thought with regards to debt. One school believes that it is best to not have any debt at all. The other believes that having some debt is best. There are reasons for and against both of these viewpoints (and both have been written about extensively) but we’re going to go rogue and suggest that there is a third option that is better than the other two: it’s good to use your credit but mind your balances.
Finding Credit: Factors to Consider
Now we don’t mean that you should immediately apply for a dozen cards and loans. On the contrary! If you are new to credit or are trying to rebuild your credit, you should take this process slowly and do your research. Look for low interest cards and reasonable loan terms. Don’t accept whatever comes your way because factors like interest rates and loan terms will affect how much you pay per month and overall.
Be wary of “alternative” loans and credit offered that isn’t FDIC insured or backed by a legitimate banking institution. Yes, micro loans and peer to peer loans are great but they don’t really affect your credit the same way a traditional credit card or loan does. And do not take out too many cards at once, especially if you’re trying to rebuild your credit. Start with one card and grow from there.
What To Put On Credit
Once you’ve found a good card with a good balance, you might be tempted to go right out and buy that flat screen you’ve been eyeing or book that five star getaway. Resist the urge to immediately max out your card. Why? Because the ratio of credit used to credit available factors heavily into your credit score. Being near your limit can drop your score significantly.
Instead, for at least the first six months you have your card, use it only for small purchases that you know you will be able to pay off right away. This helps you build a good payment history and increase your credit score. It also gets you into the habit of monitoring and managing your balance.
Great items to put on that credit card include media subscriptions (like Netflix, Hulu, etc), groceries, gas, etc. These are all expenditures you’d be paying for out of pocket anyway so you’ll know that you have the funds to cover them. If your creditor processes payments quickly you can pay them off right away. But whatever you do, do not let them begin to accrue interest because interest rates can grow quickly.
Do NOT take out cash on your credit card. Cash advances are charged a higher interest rate than regular purchases. They are also the last purchases to be paid off, regardless of when you took out the advance. This allows the creditor to bilk you for a lot more interest over the lifetime of your credit.
Carrying A Balance
Once you’re in the habit of paying off your card regularly, you can graduate to larger purchases. A good rule of thumb is to limit these purchases to items you know you will be able to pay off within three months even if you have a financial emergency. Holiday shopping expenses are a good example of this. A new gaming system or small kitchen appliance (think stand mixer, not refrigerator) is another. Pay off one purchase before you make another to keep your interest rate low and the balance on your card manageable. Do this for at least six months while continuing to use your card for every day purchases that you pay off immediately.
Carrying a Long Term Balance
Remember: the amount of money you charge is just as important as the credit afforded to you. This is why you spend a year keeping the balance as low as possible. After a year of this, you can apply for a second card (remember to look for good rates, etc) or a small loan to make a bigger purchase that you pay off over the course of a year or so. This will show that you can handle credit and pay down larger balances responsibly, without using up all of your credit at once.
Once you’ve paid off that larger purchase you should have built up a pretty amazing credit score (even if you have some older blemishes still being reported). Now is when you can use that credit you’ve built up to qualify for an auto loan or maybe even a mortgage.
Ideally we would all live debt free and never use credit at all. In reality, however, our credit is a major factor in almost every aspect of our lives–including employment! Hopefully these tips will allow you to use credit to your advantage.