Our oldest son, who will be 22 years old in a few months, will be graduating in June of 2017. This has led him to begin planning the transition of becoming financially independent from his father and I. While he takes care of many of his own expenses, he is fully aware he will be incurring a substantial amount of financial responsibility when he moves out next year; rent, utilities, and food.
One of our priorities is that he can sign for an apartment lease without his father and I being co-signers. Making this a reality will mean he needs to show he can handle credit. How does he accomplish this without incurring a continuous flow of debt? There is a way, but it requires frugality and discipline.
He will be applying for a credit card. Yup, a credit card, but keep reading because it’s not necessarily a careless decision. You may be wondering, “How will he qualify for a credit card without a credit history and a co-signer?” He will be applying for a secure, or pledged, credit card. A secured, or what is sometimes called a pledged, credit card is when the borrower puts up collateral in the form of cash to secure the credit card. Simply, our son will put $500 into an account that cannot be withdrawn or used. That $500 will secure a $500 credit card. Then he will use the credit card for purchases he already makes…gas for his car…and nothing else. This is where he will learn to be both frugal and disciplined.
Each month he will pay off the credit card in full. This will keep him from incurring any interest charges, while allowing him to learn and show he can handle credit and has a willingness to payback what he has borrowed. One important factor to using credit in this manner is the percentage of how much credit is used to how much is available. In order to build a high credit score, this percentage should be at 30% or lower. In this case, assuming he pays off his credit card each month, he cannot charge more than $150 in a given month.
If he loses his job, or cannot pay the credit card anymore for some unforeseen reason, he can close the card and have the $500 he pledged as collateral applied against the card to pay off the balance. If he stops paying on the card and doesn’t close it out, it would hurt his credit; however, at some point the financial institution would close the account and apply the $500 toward the balance.
Could he ever owe more than $500? Yes. If he were to max (charge up to the $500 limit) out his credit card and not make any payments, the interest incurred from the recurring monthly balance would cause the balance on the card to go over $500. Allowing this to happen usually triggers a higher interest rate and additional fees such as “over-the-limit” fees.
Opening a credit card, even with cash collateral, is not advised if a person is not committed “and” able to pay off the incurred charges each month. This method is one way to build credit for a person who has no credit or has a poor credit history, but it requires a great deal of determination to be both frugal and disciplined.