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By Ashley Finke

Listen Up, Millennials: Credit > Debit Part Two

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July 31, 2015
   
   

Millennials Credit v Debit Header2

Part 1Part 2Part 5

If you’re reading this then you probably are one of the following:

  • A Milken Institute Currency of Ideas fanatic who read part one
  • A millennial wanting to learn how to improve your credit
  • My mom

Yesterday I gave an overview of millennials’ misunderstanding of the importance of credit. In today’s part, I’ll share some basic but vital information about credit – things I myself didn’t know until two weeks ago. Yay for blogging about personal finance education! Let’s get down to it.

1. What is credit? And why does it matter?
The word “credit” describes ones’ ability to obtain goods or services based on the assumption that one will pay for such things in the future. Credit is a critical factor in mortgage lenders’ decision-making processes, because the strength of your credit or my credit will determine how much lenders will be willing to loan to us, and it will also influence the interest rate at which such loans are made. If our credit scores are not strong, we may be faced with interest rates and down payments that we millennials can’t afford, and thus we will be unable to enter the housing market. (See part one about why owning real estate is a good idea for a vast number of people.)

2. What’s the difference between a credit report and a credit score?
There are three major credit bureaus in the U.S. (Experian, TransUnion, and Equifax), and each of these issues a separate credit report to individuals. Credit bureaus collect information from banks, credit unions, credit card issuers, retailers, mortgage lenders, collection agencies, and public court records. They use this information to compile a distinct credit report that consists of personal identification information, trade lines (information about your credit accounts), credit inquiries, and public records/records of default to collection agencies. Anyone can access their credit reports for free at such sites as FreeCreditReport.com or CreditKarma.com.

Credit scores are three-digit numbers, calculated using the information obtained from a credit report. Credit scores give potential lenders a sense of the risk they might be taking by lending to you. The two most popular scores are Fair Isaac Corporation (FICO) scores and VantageScores; both are scored on a scale from 300-850, with 300 being the worst score, reflecting a poor ability to make payments, and 850 being the best, indicating a great record for paying off debts. Because each of the three credit bureaus produces a distinct credit report, and a different credit score is determined based on each report, you might have three different credit scores.

3. What factors determine my credit score?
Though FICO and VantageScore don’t reveal the exact calculations they use to come up with our credit scores, we do know approximately how much each of the following factors affects their numbers:

FICO
VantageScore

35% Payment History

32% Payment History

30% Total Debt

23% Utilization

15% Length of Credit History

15% Balances

10% New Credit History

13% Depth of Credit

10% Types of Credit Used

10% Recent Credit

 

7% Available Credit

4. Who looks at my credit score?
If you’re attempting to secure a mortgage loan from a bank or some other lender, they will definitely look at your credit score, even if you have a co-signer, such as a parent, on your mortgage application. Whether it’s a FICO score or VantageScore, lenders want to gauge how well you have managed credit in the past. They view this history as a good indication of the risk that you might default on your mortgage payments. A “poor” or “bad” credit score (anything below 600) indicates a greater risk of default than would a score above 600. Scores between 600 and 660 are considered “fair,” while anything above 660 is “good” or “excellent”. The better your score, the better your ability to negotiate favorable interest rates and the easier time you will have obtaining a loan.

5. How are credit scores keeping millennials from entering the housing market?
The most important point I want to make is that our credit scores are one of the most critical factors in determining whether we can obtain a mortgage and what interest rate we can negotiate. Lower interest rates ultimately mean less money out of our pockets (if you don’t know about the effect of compound interest, you must learn about it).

I’m not suggesting that everyone in our generation open six credit card accounts and run up a pile of debt just to demonstrate that we can pay off their cards on time. All I’m saying is we would do well to be more aware of our current personal credit history and of the impact our bill-paying habits have on our score.

I logged onto CreditKarma.com and checked my credit score (this is not a plug for this particular service; I simply remembered its name because it’s cool and, you know, because alliteration appeals. Props to its marketing team). Checking my score told me my payment history is great, but my lack of multiple accounts is “very poor” and is hurting my credit score. My utilization (the percentage of my credit limits that I’m using) is at 22 percent, creeping up on the recommended max of 30 percent. I should probably consider opening another credit card to spread out my charges, and thus lower my utilization rate on my main card.

I learned all of this in less than five minutes, and it was completely free.

When it comes to credit, millennials are the absolute worst, right? Wrong! There is hope even for the hopeless. Look here for help on building your credit from scratch. And here or here for how to repair or improve your scores.

6. But why can’t I just keep using my debit card?
Our generation’s proclivity for the fast and easy hasn’t gone unnoticed. Newer models of FICO scores are trying to give consumers credit (pun intended) for paying utility and telephone bills on time. VantageScore’s 3.0 model gives a break to people who have paid their collections accounts in full. These kinds of consistent updates to competitive models might soon yield provisions for debit-only users.

Even so, a major challenge to millennials still exists because Fannie and Freddie, the biggest sources of mortgage financing in the U.S., are two old geezers who hate change.

Don’t know enough about who Fannie and Freddie are? Still concerned about what all of this means for our generation? See part three on Monday.

 

Ashley Finke was a summer intern for the Milken Institute Center for Financial Markets in 2015.


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