The Dangers of Avoiding Credit

Young people with little debt experience can run into trouble when they want to take out a loan.

By + More

My 25-year-old coworker thought she had done everything right when it came to protecting her credit. She paid off her student loans early. When she does use a credit card, she pays it off in full each month. And she’s never been late on a monthly bill. Her credit score was over 750, which is considered excellent.

Despite that stellar record, multiple lenders turned her down for a mortgage earlier this year. The reason, they told her, was that her credit record was simply too light. Since she had paid off her student loans and didn’t use much credit elsewhere, they had no way of knowing whether or not she would be responsible with a mortgage. In other words, she was being penalized for living a relatively debt-free life. To make matters worse, one of the lenders told her that because she was shopping around so much for a loan, the multiple inquires into her credit report were starting to negatively impact her score.

[In Pictures: 12 Money Mistakes Almost Everyone Makes]

Her experience gets at one of the great weaknesses of our credit reporting system: In order to borrow money, you have to have already borrowed money. That’s the only way you can demonstrate that you are “credit-worthy,” as the credit reporting bureaus put it. To get to the bottom of this conundrum, I spoke with Rod Griffin, public education director for Experian, one of the big credit reporting bureaus. Here are two truths and four myths about credit reports:

Truth: Having little experience with credit can make it hard to take on a mortgage.

The first thing lenders look for when assessing whether or not they want to give someone a mortgage is their credit history, says Griffin. That means you need to have open, active credit accounts in your name in order to demonstrate that you can handle credit.

Truth: Comparison shopping can hurt your credit score (a little).

For large purchases such as mortgages or auto loans, lenders expect consumers to shop around, so credit bureaus lump inquires that happen within a certain time period (usually 14 to 30 days) together. That means they have only a minimally negative impact on your credit report, says Griffin, so consumers don’t need to worry about shopping around, and in fact, it’s probably a good idea to do so.

But when someone—such as my young coworker—has a limited credit history to begin with, that minimally negative impact can make a bigger difference. And in fact, on her credit report, it says she’s been dinged for having “too many inquiries in the last 12 months.”

So what can someone in that situation do? The only solution is to wait it out, says Griffin. “You need to demonstrate over time that you handle your debts well, and that will be reflected in positive credit scores.”

Myth: Paying off your loans early hurts your credit report.

When you pay off a loan, your credit history is updated to reflect that, but it is still considered useful information and, because it’s positive, typically stays on your credit report for 10 years, says Griffin. (Negative information, such as a delinquency, only stays on your report for 7 years.)

But lenders have their own criteria, which is the problem my coworker likely ran into. Her lenders required her to have at least three open, active accounts for 24 months or longer, and her student loans didn’t count since they were paid off.

Myth: Your credit accounts need to be in your name only to strengthen your history.

You can build up your credit history with your parents’ help if they are willing to share a credit card with you, for example, or add you as an authorized user onto their accounts. “That’s a good starting point,” says Griffin. You can also put utility bills and other accounts in your name, even if your parents are the ones footing the bill.

[In pictures: 10 Ways to Improve Your Finances in 2011.]

Myth: College students should take out lots of credit cards to build up their credit report.

While college is a good time to wade into the credit waters and learn how to use a credit card responsibly, there’s no need to take on multiple cards, and in fact, taking on too much debt and failing to make payments will hurt your credit report. Limited and responsible use is probably best. That’s why Griffin and others in the credit industry are worried that the new Credit Card Act, which places restrictions on college students’ access to credit cards, could ultimately hurt young people’s ability to build their credit histories.

Myth: You need to take on debt in order to take out more debt.

It’s not a history of debt that you need, but a history of credit. That subtle distinction makes a big difference, because it means you don’t need to rack up credit card bills, you just need to use a credit card and pay it off each month, for example. “Credit and debt aren’t the same thing,” explains Griffin.

My coworker’s story has a happy ending. She was able to eventually buy a condo in the building she liked, but only with her parents’ help. Because of her limited credit record, lenders required a 20 percent down payment from her. It took her extra time (and her parents’ support) to save that much, but eventually she did, and now she’s a homeowner—with a beefed up credit record.

Kimberly Palmer is the author of the new book Generation Earn: The Young Professional’s Guide to Spending, Investing, and Giving Back.