This is part of our series A Guide to Jumpstarting Your Life Goals.
Before making your first major purchase with financing (aka a loan), make sure you have the following in order:
- You have built up a credit history with a credit card
- You know your credit score—and how to improve it, if necessary
- You understand interest rates and their relation to your credit score (lower rates for higher credit scores)
- You have saved money for a down payment, to reduce the size of the loan
If you’re going to finance a major purchase, start saving in advance if you can. If you know you’ll need a car in 12 months when you move for grad school or that furnishing a future apartment will cost a few thousand dollars, try to give yourself a long runway to start socking away a down payment or mini nest egg. Ditto for home buying, although the sticker price will obviously be much higher.
Most major purchases, however, require that you finance—aka, borrow—to make the purchase. If you’re going this route, you’ll need to know your credit score, a number from 350-850 tracked by three ratings agencies (TransUnion, Equifax, and Experian) and also known as a “FICO” score. You can order a copy of your credit report from each agency for free once a year, and many credit cards and banks now let you access your credit score for free as well.
Read more: Where is the best place to stash your cash?
In order to have a credit score, you need to manage a credit card account, or other types of debt (such as a student loan you’re now repaying). Some landlords now report your on-time rent to credit agencies, too, which can help young adults build credit histories faster than in yesteryear. If you haven’t used a credit card before, or are getting one mainly to establish a credit profile, you can typically secure one easily at a department store or general retailer. Make sure to pay the full balance off monthly—or at least exceed the minimum payment—to avoid hurting your credit score.
Most credit card companies now provide data on how long it’d take to pay off your balance making only minimum payments (and how much you’d pay in interest, typically a staggering amount of money) along with how much you could pay monthly to clear the debt in a shorter timeframe, such as 24 or 36 months.
Your credit score is influenced by several things: 1) what percentage of your borrowing capacity you’re using (in other words, if you’ve got credit lines for $10,000 and have spent $1,500, you’re using 15% of your credit), 2) your habits of making on-time payments (even paying 30 days late is bad), 3) how recently you opened the credit line, as well as other factors. If your score is over 720, it’s generally in B+ or better territory and you’ll get favorable rates. If it’s below that, you can let the passage of time or your spending behaviors (or both) improve the figure. For example, you can divert savings to reduce an outstanding balance.
Credit scores are the starting point for any loans you’ll need—and the size of loan you’re granted. The lower your score, the higher the interest rate you’ll pay. If you’re financing a $30,000 vehicle or a $275,000 mortgage, a 1% bump to your interest rate can really curb your borrowing power. Should your score fall into the “needs improvement” category, consider how much time it will take to repair it to access the most favorable rates—that is, if you can wait or if you can settle for less home or car.
Your next step: Review your credit reports, learn your credit score and make an action plan, whether that’s cleaning up anything negative or creating a strategy to improve the score—such as choosing to pay off a few cards. Play with a mortgage calculator or auto loan calculator, modeling your options based on your current credit score or ballpark credit quality against the financing options you might get with an improved score.