One of our goals is to equip our readers with resources and tools they need. In a previous article, we wrote about how to prepare your children for entrepreneurship. Today, we will be sharing an article we have found useful. The article focuses on how to teach your children about credit. The original article written by Trent Hamm of The Simple Dollar. So, if you are a parent, this is for you.
As a father of three children, I find it very important to support them in a variety of different ways. One of the most important subjects I feel my kids need to know, they might not learn in the classroom — either online or in person. Teaching my kids about credit and general financial education will help them make their own important financial decisions in the future, which is something that I didn’t have. Here’s why you should teach your kids about credit, what exactly it is and how to start those conversations early enough that they have the time to learn and ask more questions.
Why you need to teach your children about credit?
When I first became an adult, I really didn’t understand the impact that credit would have on my life. I didn’t understand the value of a good credit score or how to build it.
This led to some pretty poor choices on my part during my early adult years. I took out lots of loans to buy things like furniture, believing it would be easy to pay it back later. I got several credit cards and filled up those balances. When it came time to get a car loan, I didn’t really have the best credit, but I didn’t understand why the car lenders weren’t giving me a good interest rate. I chalked it up to my own status as a first-time car buyer.
Eventually, I came to a situation where I literally could not afford to pay my bills and I was being declined for credit limit increases. It was that financial situation that caused me to start The Simple Dollar, which began as an exploration of my own financial turnaround.
Here are a few key reasons why I’m teaching them:
- If I had made better financial choices early on, I would be in far better shape right now. Hindsight is 20/20, of course, but I made so many financial missteps along the way that gave me little benefit in the moment but had enormous cost over the long haul.
- I do not want my children to repeat the same mistakes I did. As I started to have children and have watched them grow up, I don’t want them to repeat my mistakes. I want them to walk into adulthood at least equipped with basic financial knowledge and an understanding that big financial missteps early reverberate throughout your life.
An understanding of credit is a very important part of all of this. Understanding what credit is all about, what a credit report is, how the things you do alter your credit report, and how a bad credit report and a good credit report can reverberate throughout your life for a long time to come are lessons I want to impart on them so that they’re at least better equipped to make good decisions when they’re flying on their own.
What to teach your kids about credit
1. What exactly is credit?
Credit simply refers to the ability to borrow money and to access goods and services with the understanding that you’ll be able to pay for it later. Any time you get something now without actually having to take cash out of your wallet or your bank account to pay for it immediately, you’re using credit. This is a lesson that I’ve imparted on my kids over and over again as they’ve grown up, probably to the point that they’re sick of it.
If I pay for something with a credit card, I make it a point to say that I’m not actually paying for it with my money. Rather, a credit card just says that it’s okay for me to borrow money for a while from a bank to pay for this. Eventually, I have to pay the bank back, and if I wait too long, like more than a month, I’ll have to pay them back extra. The same thing is true whenever you get goods or services now but you don’t have to pay until later. Whoever is giving you the goods and services now believes that you are trustworthy enough that you will pay them later. With a credit card, it’s the credit card issuer that believes you’re trustworthy enough that you’ll pay them back later.
2. “Why don’t you just pay now?”
Usually, at some point, my children figure out that I could instead just pay for those goods and services with my own money right now instead of paying later. Why don’t I just do that?
Obviously, the big reason is that sometimes I don’t have the money right now. If I don’t have the money to buy something right now, but I think I’ll have it later, I can use credit to borrow money and pay for that thing right now. I point out to them that whenever you do this, you’re putting yourself at risk of damaging that trust that’s being extended to you, and losing that trust has a lot of consequences. Another reason is that it can sometimes be convenient and can sometimes offer other benefits. With a credit card, it’s convenient to make several purchases throughout the month, then pay them all at once when I review them. There’s also the benefit of the purchase protections a credit card gives you, as well as the rewards program.
The catch, of course, is that if you don’t pay it back quickly, interest will quickly overwhelm those benefits. With most credit cards, you have roughly a month to pay back the money you borrowed with the card; if you let it go any longer than that, you begin to have to pay interest to the lender, and that interest is high. You want to avoid paying interest if at all possible because that’s just lost money.
Even worse, if you borrow too much and can’t pay the bills, you start to damage your credit. This means that, in the future, people won’t lend you money, and it can impact other things like your ability to get an apartment or even to get a job. That’s bad on its own, but those kinds of things alter the course of your life and not in a good way. It means lost opportunities, which guide you down a different path in life. Your bad credit might mean you don’t get the job you really wanted or you can’t get a car to get back and forth to work. The impact of that stays with you, even if you get your credit in good shape again.
3. Credit reports and credit scores
How does a lender or a store or an employer or a landlord know whether or not you’re trustworthy? There are a number of things they do, including background checks and Googling your name, but one big thing they do is that they access your credit report.
A credit report is simply a listing of places that have extended credit to you in the past and how that turned out. Did you make your payments on time? Did you borrow as much as you possibly could, or only what you needed? That’s what a credit report tells someone about you. Your credit report is built automatically in the background by businesses who collect reports about your payment history, assemble them and then provide them to other businesses who are trying to figure out whether you’re creditworthy. Those businesses are called credit bureaus. In the United States and Canada, there are three primary ones: Experian, Equifax, and TransUnion.
Obviously, reading through someone’s credit report takes time. It takes time to actually read it and then figure out what it’s all saying about you. As a short cut, there are other organizations that will automatically read your credit report and give you a score based on how credit-worthy your report says you are — that’s a credit score. A lot of times, businesses really only care what your credit score is and whether it’s good; they don’t have time to actually read your credit report.
So, let’s say you want to borrow money for a car loan. You go to someone who might lend you the money to buy a car. The lender wants to know whether you’re trustworthy and whether it should extend credit to you, so it will get a copy of your credit report and your credit score. Based on that, the lender decides whether to lend you money at all and, if so, what interest rate to charge you. The more trustworthy you are, the better the interest rate it’ll offer, because someone who is trustworthy is less of a risk to them. A person with good credit is more likely to pay what they borrowed back without any issues than someone with bad credit, so someone with good credit is likely to get a better interest rate and be able to borrow more than someone with bad credit.
Remember, your credit history is used for more than just car loans. It’s used to determine whether you get any kind of loan, and what interest rate you get. In addition, it is used sometimes to figure out whether you should be given an apartment lease, or even whether you should get a job, because employers are in the business of trusting their employees and credit is sometimes used as a way to evaluate that trustworthiness.
How to maintain good credit
It’s actually pretty easy to keep your credit in a good place. You don’t need to worry about it much at all as long as you do a few simple things.
- Pay all of your bills on time. That’s really the biggest thing you can do, to tell the truth. If a bill is due, get it paid before the due date. This not only keeps your credit healthy, it also helps you avoid late payments.
- Have a credit card or two, but use them sparingly. Only use it for very ordinary purchases that you’d make with cash. I basically just use mine for gas and groceries and occasional online purchases when I know I have more than enough to pay for it in my checking account. Nothing else. I don’t buy anything I couldn’t easily buy with cash.
- Never keep a balance on your credit card past your next due date; pay it off in full each month. It’s good to use your card a little because that shows that you’re using credit responsibly, but don’t get in a situation where you’re paying finance charges to your credit card company. Pay it off in full each month. That balance should never be very big.
- Keep your oldest credit card around, even if you don’t use it anymore. You want to keep at least one credit card that’s seven years old, if possible; if you don’t have one that you’ve had for that long, just keep your oldest card. It helps ensure the length of your credit history, and the longer it is, the better.
- Check your credit report at least once a year and make sure it’s accurate. Do it on your birthday, for example. Just go to AnnualCreditReport.com or CreditKarma, download your credit report, and go through it to make sure everything’s accurate. Occasionally, something that’s not attributable to you will show up on there and you want to get rid of that false information as soon as possible.
If you do those things faithfully, your credit will be good enough to get good rates when you need to borrow money or need insurance.
Practice using credit with your children
I have a simple method that I use conceptually to help my kids practice using credit. We give our children a small cash allowance each week that they can use for small expenditures or save up for big ones. I also allow them to borrow money from me, their lender. When they borrow money from me, I don’t charge them interest. I just tell them the maximum amount I’ll lend them and when I want to be paid back. I usually come up with some kind of payment plan that amounts to half of their allowance until it’s paid off. So, if we give one kid $5 a week in allowance and they want to borrow $20, I say they can, but they have to give me $10 at the end of the first month and the other $10 at the end of the next month.
In truth, they mostly only borrow money like this if they’re close to a big purchase they’ve been saving for. My youngest son might want a new video game that costs $50 and he has $30 saved up, so he’ll borrow $20 to have it now. Every time they pay me back at the end of the month, I’m willing to lend them more money. I keep track of it in a pocket notebook. Every time they make a successful payment for the month, I make a little plus sign by their name. Every plus sign means I’ll lend them up to two times their weekly allowance. I just keep track of how much they owe in total and change it each time they pay me.
What happens if the end of the month comes and they can’t pay me because they don’t have enough money? I simply erase two plus marks from their book. They have less ability to borrow. Then, for the next month, I keep half of their allowance to make up for the missed payment.
So, let’s say my youngest gets $5 a week in allowance. He wants to borrow $20 for his video game. I look in my book and he has two plus signs by his name, so I’m willing to lend him four times his weekly allowance, or $20. I tell him that he’ll owe me $10 at the end of next month and $10 at the end of the month after that, and he’s fine with it. So I give him the $20. At the end of the first month, he pays me $10, so I add a plus mark to his name. He now has three plus marks. At the end of the month, if he doesn’t pay, I erase two plus marks from the book, leaving him with one, and then I keep half of his allowance each week for the next month — he only gets $2.50 a week.
The next time he wants to borrow money, he comes to me and says, “I want to borrow $30.” I look in my book and there’s only one plus mark by his name, meaning I’ll only lend him $10. I tell him no and that I can only lend him $10 because he didn’t pay me back on time before.
My oldest child figured out before long that the best thing to do was to always borrow a little and keep paying me back on time.. If he decides to borrow a lot, he actually can do so — he has a ton of credit. (I’ll actually have to think about what to do if he wants to tap this because under this system he could actually borrow quite a lot.)
My middle child borrows as much as she can to make big purchases but pays them back faithfully. She realizes she only keeps half of her allowance and gives the rest to me to pay back her loan. She also has a bunch of plus marks, not quite as many as her brother, but plenty.
My youngest child is still figuring it out. He loses plus marks sometimes, mostly because he forgets about what he owes, but he’s getting better at it, and his older siblings are pointing out to him how to win at this system. He gets frustrated that he doesn’t have enough credit to do things sometimes, but I point out to him that if he just consistently pays back his loan, he’ll be able to borrow more in the future.
Remember, you win at this game by actually paying your bills on time. If you do that, you have good credit and you can borrow more when you need it. It’s the entire point of credit at work in a simple game.
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