Knowing a few key strategies and the fundamentals of credit and banking services can help you make better-informed decisions about your financial future.
The high costs of being “unbanked"
The millions of Americans who do not have a bank account are known as “unbanked." There are various reasons why someone might choose to forgo a bank account, but in doing so they're opening themselves up to added risks, costs and fees.
For example, many unbanked people who do not have credit find themselves looking to pawn shops, check cashing outlets, cash advance services, and other alternative finance options that tend to charge high fees and ruinous interest rates. Check-deferral services (“cash advance" services) can have annual fees as high as $900 for a simple $200 check cashing service.
It's almost always better to have a bank or credit union account and be counted as part of the mainstream financial services system, rather than relying upon expensive, risky, and poorly regulated financial services.
Opening a checking account
Opening a checking account is the first step toward building credit and being part of the banking system. Start by finding a bank or credit union with a convenient location to where you live. Read the fine print on any fees associated with the checking account – for example, is there a monthly fee, a fee per check, balance inquiry fees, overdraft fees, or ATM fees? Some banks offer packages of services where you can get a free checking account if you set up a direct deposit, or if you sign up for other products and services such as a savings account or credit card.
Also, pay attention to any restrictions on the account. Does it require you to hold a minimum balance (a minimum amount of money in the account)? Is there a holding period for deposited checks (a length of time that must pass before you can get your money)?
Look for the right combination of special features as well. Make sure it's easy to direct deposit your paycheck into your account (this can help you save time and avoid the risk of delayed or lost paychecks). Find out what options are available for automatic payments, online banking, or online bill pay – this can make it convenient to schedule and pay bills each month. Also, ask for options on overdraft protection to avoid getting charged painful overdraft fees in case your checking account balance drops to zero; many banks will offer options to connect your checking account to a savings account or credit card to help avoid these fees.
Most checking accounts will let you access your money via a checkbook (paper checks), online bill pay (checks that you can send via online tools), automatic payments (withdrawn automatically each month to pay bills such as rent/mortgage, utilities, cell phone, etc.) or debit card (the special piece of plastic in your wallet that can be used at ATMs or any point of sale that accepts credit cards).
Having a checking account is a crucial step in building credit. But it's just the beginning.
The three "Cs" of credit
When people talk about “good credit," what do they mean? Generally, as a consumer, a credit score determines your ability to borrow money. Consumers who have a good credit score are rated by the financial system as being a good risk, who are likely to repay their debts on time. Consumers with “bad credit" are rated as being less likely to repay their debts.
In general, there are two ways for people to buy things: in cash or with credit. Buying with credit lets you buy the items today, in exchange for paying back the debt in the future.
Your credit score is determined by “The Three Cs:" Character, capital, and capacity.
- Character: Based on your credit history, are you a trustworthy character who can honestly and reliably repay your debts? Have you used credit before; do you have a history of paying your bills on time?
- Capital: What if you don't repay the debt? Do you have other financial assets such as real estate or a car that can be used to repay the debt? (This is also known as collateral.)
- Capacity: Do you have the productive abilities and earning potential to repay the debt? Do you have a steady job, and how long have you worked there? How many other loan payments do you have? What are your current living expenses? Can this new debt fit into your overall financial life, or not?
By evaluating these various aspects of your financial life, credit bureaus assign you a credit score and lenders evaluate your ability to repay a loan. People with good credit scores tend to qualify for lower interest rates and more favorable loan terms; people with no credit or bad credit scores tend to get denied loans or offered less favorable loans (higher interest, bigger down payments, etc.).
Building a credit history
What if you are just getting started as an independent adult who is establishing a credit history and living within a budget for the first time, or if you have gone through a bankruptcy and need to rebuild your credit? There are a few key strategies to keep in mind:
- Establish a steady work record. Gaps on your resume and job losses can also hurt your credit rating.
- Pay bills promptly – rent, utilities, car payments, credit card payments, and more. Set up automatic payments or online notifications from your bank, if possible, to remind you to make payments on time.
- Build up a savings account with regular deposits.
- Get a local store credit card and use it – and make regular monthly payments. This will show other credit card issuers that you can be trusted with credit.
- Apply for a small loan (use your savings account as collateral, if needed) and pay it back.
- Get a co-signer on a loan (such as for a car) and pay back the loan yourself. (Co-signers are taking a risk on you, so make sure it's someone you trust – if you fail to repay the loan, your co-signer is required to repay it themselves.)
How much debt is too much?
One risk of credit is that you might borrow too much money. Credit card debt is a leading factor in personal bankruptcies; many consumers get overextended financially and their debt gets out of control. One of the rules of thumb for how much debt is too much is the “20-10 Rule" — never borrow more than 20% of your yearly net income (after-tax income), not including housing debt.
For example, if your monthly earnings after taxes are $4,000 per month, then your yearly net income is $48,000. So 20% of your annual net income is $9,600.
This means you should never have more than $9,600 of non-housing debt (including credit cards, student loans, and car payments) outstanding at any time. Exceeding the 20-10 Rule threshold could be a sign of financial stress, putting you at higher risk for bankruptcy.