Building Credit From Scratch – Are Young Adults Doomed for Financial Failure?

Young Adults: Doomed for financial failure?

Young adults are faced with a unique set of challenges that cause many to struggle with credit. Inexperience, school loans, social pressures, and financial optimism all lead down the path of least resistance – a really bad credit score.  However, it’s important to remember that there are long-term consequences of bad credit, and restraint today can pay off big time down the road.

1. Inexperience

A renowned Harvard Professor in behavioral finance, David Laibson, conducted a study showing that there is a learning curve involved with “gotcha” fees – it’s mostly newer cardholders that get slammed with unpleasant surprises at the end of the month.  This group of customers consists of a significant number of young adults who end up effectively subsidizing the freebies that a lot of more experienced cardholders enjoy.

2. Student loans

Peter Thiel, a co-founder of PayPal and a successful hedge fund manager, recently created a fund offering $100,000 for 20 students to drop out of school and launch companies.  He believes that in many cases, education is a bad investment, a theme that may resound with a growing population of early 20 some-things who are struggling financially.

“University administrators are the equivalent of subprime mortgage brokers,” he says, “selling you a story that you should go into debt massively, that it’s not a consumption decision, it’s an investment decision.  Actually, no, it’s a bad consumption decision.  Most colleges are four-year parties.” – Wall Street Journal interview

It takes decades for the average American salary to pay back a $100,000 college tuition loan, factoring in the cost of living expenses, taxes, and such.  To make matter worse, this crippling debt is un-escapable even in most bankruptcy filings.

3. Social pressures and financial optimism

Young adults are especially susceptible to social pressures, largely by virtue of being single and un-established from a social and career perspective.  This leads to a predisposition towards irresponsible spending on automobiles, entertainment, and clothing.

A psychology today survey shows that the deficit spending of Gen-Y may be encouraged by their financial optimism – 85% believe that their financial situation will improve over the next year, which is in stark contrast to 35%, for those over 65.

This confluence of factors drives a “buy now, work later” attitude that can cause years of heartache down the road.

Your credit is important.

Students and young adults who start out with limited credit histories need to realize that their credit will come under scrutiny near-term and in the futures.  If they focus on establishing good credit, it will serve them well, whether they are applying for an apartment rental, or signing up for a post-paid cell phone plan.  Down the road, they will also need good credit to buy a home or a car.  Poor decisions, like the credit card-enabled impromptu vacation to Europe, can haunt them for years down the line.

Building good credit is entirely within our control.  Using credit cards regularly, yet responsibly and within our limits, will help keep our finances in shape and allow us to establish a credit history.   With some history established, home loans and auto loans can also be used to help maximize our credit scores, as long as we are responsible with our spending and our payments.

“The easiest time to get a credit card is when you’re a college student,” said Gerri Detweiler, author of The Ultimate Credit Card Handbook.  If you are a college student and can’t get a regular credit card, you can apply for a secured credit card where your credit limit is what you deposit with a lender.  After 12 to 18 months of on-time payments, your secured card can often be converted to a regular one.

If you’re already starting to get in trouble with a credit card balance, try getting the best balance transfer card possible – you can get somewhere in the ballpark of a 3% rate over 2 years, providing some breathing room, with the right introductory 0% APR deal.  Just make sure you take that time to pay the balance off, rather than using it as an excuse to accumulate more.

While Gen Y may be optimistic about their financial future, credit missteps can echo for years. Tread carefully, and next time you see a friend buying something they can’t afford, try to remember the benefit your restraint will bring you years down the road, rather than envying her consumption.

Tim Chen is founder and CEO of NerdWallet.com, a website that helps young adults to compare student credit cards.  Tim also educates consumers about credit cards and debt management at the Forbes Moneybuilder Blog, the Huffington Post, and the Christian Science Monitor