Teaching kids about credit in simple terms

If there's one area of finance your kids are unlikely to know about, it's credit. Yet, teaching your kids how credit works and how to spend responsibly is crucial to financial literacy and the foundation of good money habits. 

 

Louise Hill, COO and Co-founder of GoHenry says: "At GoHenry, we want to help make every kid smart with money so they understand money management basics around spending, saving, credit and investing. We're committed to doing this because our research shows that adults who don't learn about money when they are young are less able to save and more likely to fall into debt."

 

You may feel it's a while before your kids need to understand this, but as with all things financial, the sooner you start talking about it in an age-appropriate way, the easier it will be. Start with the credit basics and build up to the more complicated aspects – and reference your explanations with real-world examples. Here's expert advice on how to get started.

 

Related:  How old do you have to be to get a credit card? & Financial literacy for kids

 

Ways to teach kids about credit

• Explain why credit is important

• Explain the basics of credit

• Explain how to build credit

• Explain what responsible credit use looks like

• Show them what responsible credit use looks like

• Discuss how they can monitor their accounts

• Help them to start building credit for the first time

• Get them a prepaid debit card

Why credit matters

Understanding credit is vital as credit scores affect loan approvals, interest rates, and insurance premiums. A good credit score translates into a lower interest rate on loans, such as auto loans and mortgages, potentially saving a person hundreds of thousands of dollars in interest over time. A bad credit score leads to higher interest rates, higher insurance premiums, and even denial of rental applications. Therefore, building a good credit score requires responsible spending and timely payments, making it an essential financial skill. Explain to kids that good credit can help you to:

• Get a mortgage or car loan.

• Rent a place to live.

• Get a job.

• Open a current or savings account.

• Get a lower interest rate on loans.

• Save money on insurance premiums.

• Build your financial independence.

Explain the basics of credit

• Credit is when you borrow money from a lender (a person or company) on the understanding that you'll pay it back later. There is no good or bad to credit. This is because credit is a part of our financial lives, and it helps adults buy more important things, for example, a mortgage for a house, a car, or a loan so they can go to college.

• Interest is the money the lender will charge you for borrowing credit. This is also known as the cost of borrowing.

• A credit score is a number that represents whether you are a person who can be trusted to borrow money or not. Credit scores are based on your personal financial history, which shows how responsible you are with money.

• A credit bureau is also known as a credit reporting agency (CRA) and is a company that collects and maintains information about a person's credit history and financial behavior. The three major credit bureaus in the US are Equifax, Experian, and TransUnion. They gather information from various sources, such as banks, credit card companies, and other lenders, to create credit reports (see below).

• A credit report is a detailed record of an individual's credit history and financial behavior, including information such as credit accounts, payment history, outstanding debts, bankruptcies, and other financial transactions. Credit reports are used by lenders, landlords, employers, and other entities to evaluate an individual's creditworthiness and determine the terms and conditions of credit, loans, and other financial products.

 

The more responsible you are with your money, the more likely you'll be given the credit you apply for. All the information about your credit score will be available in your credit rating for a number of years, and banks and lenders can see this to judge whether or not to lend you money.

 

Related: Explaining interest to kids

Explain that credit is not free money

One important fact to talk about is how credit is not free money.

 

Not only does it have to be paid back, but often you will pay back more than you borrow (this is known as interest).

 

Ask your kids to think of it this way: Have you ever wanted to buy something for $15 but didn't have enough money? Maybe a video game, but you only have $5, so you need $10.

 

When this happens, you have three choices:

• Do without the item you want

• Save until you have $15

• Ask your mom or dad to lend you $10 and say you will repay them (this is credit).

If your parents say yes, they may also charge you an extra $1 for borrowing the money, known as interest.

 

This means the total you will pay back is $11. The $10 you borrowed + $1 in interest for borrowing it.

Explain how to build credit

There are several ways to teach your child how to build good credit as an adult. The most important way is to build a credit history. You can help build your child's credit history, but good credit is also built on good credit habits, knowing the dangers of not making repayments on time and spending more than you can afford. Other ways to build credit include:

• Keep your credit utilization low: Keep your credit card balances under 30% of your total limit.

• Open a credit card account: Consider opening one, and use it responsibly. Don't apply for too many credit accounts: Every time you apply for credit, it shows up on your credit report. Too many applications in a short period can lower your credit score.

Related: How to build child's credit

 

Explain what responsible credit use looks like

Responsible credit use means using credit (the money you borrow) wisely by only borrowing what you need and making payments on time. This includes:

• Only borrowing what you can afford to pay back. 

• Making payments on time.

• Keeping your balances low (the money you owe).

• Pay off any balances quickly to ensure you stay within your credit limit. 

• Avoiding unnecessary debts, which can lead to financial stress.

Responsible credit is an important part of financial planning, so explain to kids that they should only borrow what they can afford to repay what they borrow. And that they need to make repayments on time as late payments can damage your credit score and make it more challenging to borrow money in the future.

Show them what responsible credit use looks like

Before your children are adults, it’s important to show them what responsible credit use looks like. One way to do this is to agree with them that when they borrow money from you, they have to pay it back by a specific date. Explain if this doesn’t happen, you will charge them a bit more as interest. This way, they can start to understand how borrowing, repayment and interest works.

 

At the same time, showing them the figures for how your mortgage or credit card works can be helpful. Show them a statement, explain what all the parts mean and point out the interest payments.

Discuss how they can monitor their credit score

It also pays to talk to your kids about why they should monitor their credit score regularly to keep track of what they owe and better understand what affects their credit rating. They can:

• Get a free credit report annually; under the Fair Credit Reporting Act, you are entitled to one free credit report from each of the three credit bureaus (Equifax, Experian, and TransUnion) every 12 months. You can request your free credit report at AnnualCreditReport.com.

• Use a credit monitoring service. Companies like Credit Karma, Credit Sesame, and Identity Guard offer free and paid credit monitoring services that can track changes to your credit score, notify you of suspicious activity, and provide credit card monitoring.
  

Help them to start building credit for the first time

Although your teen can't get a credit card until 18, you can add a teen to a credit card as an authorized user. 

 

This is only something to try if you feel your child is ready, understands how credit works and can delay gratification. If you think they have grasped this, adding your teen to your credit card account can give them a deeper understanding of credit and debt.

 

Doing this will also allow them to use your credit card and build their own credit history, as they will be responsible for making all payments on time and in full. However, remember that it will reflect negatively on your credit report if they do not make their payments on time. 

 

Related: Can I add my child to my credit card? , Can teens get a credit card at 16?

Get them a prepaid debit card

A prepaid kids debit card like GoHenry can teach your child valuable lessons about money that will stand them in good stead when they eventually apply for credit. Lessons such as saving and spending, paying attention to balances, delaying gratification and budgeting. The app also has parental controls, which is useful when your child is taking their first steps towards independence, and you want to let them learn how to spend wisely.

 

 

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