Credit Risk
Illustration: freepik.com

When someone mentions credit cards, do you envision mountains of debt incurred during Confessions of a Shopaholic-style purchasing sprees? If so, know that the reality of these flashy pieces of plastic includes more than the risk of debt. Credit cards are one of the best ways for university students to build and maintain a high credit score. Without a strong score, you’ll have trouble securing loans, renting a flat, and more.

The Basics

First, what is credit? A typical example is a student borrowing £1,000 from the bank to pay for a car. The student will be expected to pay back the original amount borrowed, as well as accrued interest, within a given time span. He might, therefore, end up spending £1,200 total on the car rather than the £1,000 he would have paid if he’d had the money from the outset.

The principles described above also apply to credit cards. Unlike debit cards, which withdraw money already in your bank account, credit cards rely on borrowed funds. Your bank extends you a line of credit, such as £1,000 per month. Every time you swipe your credit card, you use a portion of this credit. By the end of the month, you might spend £300 of your limit. You can either pay back this amount in full or make a minimum payment. Be warned, however, that only paying a portion of your credit card bill can lead to higher interest rates and dent your credit score.

Credit Scores

For college students and 20-somethings, credit cards are one of the best ways to build and maintain a high credit score. Before you build a credit score, however, you need a credit report. A credit report aggregates information about your credit record, including the number and kinds of accounts you have, whether you make payments on time and how much of your credit you use.

An individual with a house, a job, and savings will likely have a strong credit report because there is evidence of their ability to control debt and loans. Students are seen as more of a risk, as they only have short, insubstantial credit histories. This means that graduates looking for funds to buy their first flat are less likely to receive a loan than a wealthy family looking to buy a second home.

Your short payment history puts you at a disadvantage, but as your report becomes populated with student loans, car loans, and credit cards, proper management will leave you with a strong score right from the start.

The habits you initially use to build a strong core are the same ones you’ll use throughout your lifetime.

Since you can’t control the age of your credit history, look at other factors that influence a score. To ensure you have a strong payment history, pay off your monthly credit card balances on time and in full. If you’re forgetful, set an automatic alert each time your bill is due, or use the auto-pay option offered by your lender or bank. If you follow these key steps — make on-time payments covering all of your balances, maintain a reasonable amount of card debt, and apply for credit only when absolutely necessary — you will be on track to have good credit habits for the rest of your life.

The Pitfalls of Credit

At the same time, it is important to acknowledge the downsides of credit cards (especially in the hands of young adults).

One of the greatest pitfalls of credit is the interest that racks up on monthly payments.

If you borrowed £100 with 10 percent interest every year and didn’t spend or add to it, it may seem as if the £100 would double in 10 years. In fact, the amount owed would double after just over seven years.

Thanks to the principles of compound interest, the original £100 debt would increase to £110 after one year and £121 after two. In year two, the interest rate of 10 percent applies to the new one-year total of £110 rather than the original £100. Before long, your debt can spiral out of control.

It might seem like a good idea to spend £399 and go into overdraft to pay for a plasma TV in time for the FA Cup Final, but in a year’s time when the price of the TV has dropped and you have only been able to pay the minimum monthly payment (meaning the interest is still growing), you will realise it was a mistake. Missteps like these can send students into further financial trouble.

The Benefits of Credit

In the end, it is important to stress that both good and bad credit exist. An example of good credit is a young couple with two children borrowing £20,000 to build another bedroom. This couple will likely be able to pay back the loan in a reasonable time period, and when the time comes to sell the house, the extra bedroom may bump up its selling price by £40,000. Even after you add in the interest on the original loan, the couple may make money through their investment.

Once you have your first credit card and know how to ensure a strong score for years to come, you’ll realise that having a card doesn’t always equate to mountains of debt. Although credit cards can be dangerous in the hands of students who don’t understand how they work, they offer many benefits.

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