If you are like most Americans, you had to find out about credit reports, financing, interest rates, even how to balance a checkbook the hard way. One would think that such important topics would be covered in high school, but for the most part they are not. As a society, we try to shield our children from the financial stresses that we may be experiencing, hoping our kids can just be kids. Sometimes though, we forget that our kids need to know about finances before they go out into the world. We think they are too young to understand and we will teach them later, when it comes time. I challenge you to talk to your kids about money now! No matter their age, they can always learn something important about money.
As a small child, my son understood that once he spent all of the cash he had on hand, he couldn't buy any more. However he had a difficult time understanding the debit card concept. Because he only saw the swipe of the card, he didn't realize that there had to be money in the bank account in order to make purchases using the debit card. We spent a lot of time waiting in line at the cash register talking about why we could buy the items that we need, but not all of the items we want.
More recently, my teenager and I opened a joint checking account. He knows that I will deposit a certain amount each month, and he knows how long he must make that amount last. It is up to him to decide what he spends his money on. We talked about overdraft charges, and how nowadays the bank will allow you to continue to make purchases, even if there is not sufficient money in the account to cover the purchases. When he spends $1.50 for gum and a soda when there is only $1.05 in the account, he will actually be paying $36.50 for that gum and soda, which will be deducted from next month's deposit.
Of course, my son is going to overdraw the account. He knows I do not expect perfection, but I do expect him to check the balance frequently and tell me when he gets an overdraft charge. I expect him to talk to me when there is not enough money in the account to last until the end of the month, rather than continuing to spend when there are no funds available. This may not be exactly like the real world (when was the last time you called your mom because you got an overdraft fee?), but it will allow us to do some problem-solving together, create a budget, and mostly it just means we're talking about money and how to manage it.
It is important to me to help my son with these lessons before he leaves home. Once it is time for college, managing his money and sticking to a budget will be a necessity, and starting early can only help with his success.
"Credit card" is like a four-letter word in our house. This is not because I have been so fortunate as to never require the use of one. I remember in college being offered a t-shirt or towel, some token gift for my application for a credit card. Though we have seen recent legislation attempting to quell these types of practices, credit card companies will find other ways to entice young people to sign up. College students- DON'T DO IT!!! In my mind this is the most important financial issue to discuss with teenagers.
The following facts should get your attention: Eighty-four percent of the student population (including graduate and undergrad students) has a credit card. Half of college undergraduates had four or more credit cards in 2008. The average credit card balance of undergraduates is $3,173*. The average outstanding credit card debt among households that have a credit card was $10,679 in 2008**.
These figures are striking and should indicate a need to address the credit card trap with teens early on. Credit card companies make it all too easy to get into the habit of using their cards. The minimum monthly payment can be as low as three percent of the balance or $25 (whichever is higher). Who can't afford $25 per month? Let me show you why $25 per month is not a good deal. Let's say a college student has a credit card balance of $3,173 as mentioned above. At an average interest rate of 17% and a monthly payment of $95 (3% of the balance), it will take 130 months to pay off the balance- almost eleven years! That assumes that no more is added to the balance and there are no late fees, over limit fees, or increased interest rate. By the time the balance is paid, $3,173 will actually cost $5,569.
Now let's assume that this now college graduate did not pay off the balance. His credit limit was increased, as are his expenses and new lifestyle. Mr. College Grad went on a cruise to celebrate graduation, bought some furniture for his new place, and a few suits for his new job. Now Mr. College Grad has a balance of $10,679, also mentioned above. The minimum payment has jumped to $320 per month, and at 17% interest, it will take 206 months (over 17 years) to pay off the balance. Now the total amount paid is $19,791- almost double!
I don't expect young children to understand minimum payments and interest rates, and even teenagers may not grasp the concept completely. Make it simple. Ask your kids: If someone offered you $10,679 and a t-shirt today and all you had to do was pay $19,791 in exchange, would you do it?
*Sallie Mae, "How Undergraduate Students Use Credit Cards," April. 2009.
**Nilson Report, April 2009.
Credit reports and credit scores are the primary way lenders determine whether they should extend a loan to you and at what interest rate. It's important to teach young people the basics about credit reports because mistakes can cost a lot in the long run.
There are three different credit reporting agencies for individuals. Each agency has different ways of calculating your credit score and each agency uses a different numeric scale to determine your score. For all three agencies however, there are factors in common that will affect your credit score. Payment history, amounts owed, length of credit history, new credit, and types of credit used are all ways to measure "credit-worthiness."
So, what makesfor a good credit score? A very important factor is history of credit. Lenders want to see that borrowers have used financing in the past and have accounts with long and positive payment history. It goes without saying that paying bills on time has a big impact on your credit score. But factors that may not be as obvious: the types of credit accounts open and the ratio between credit limit and balance. Lenders want to see stability in finances. That means that having positive payment history on a mortgage will increase your credit score more than positive payment history on a credit card. Having ten credit card accounts with positive payment history may give you a lower credit score than three credit card accounts with positive payment history. Lenders want to see that a borrower isn't juggling too many balls. Having a credit card balance of $5,000 on an account with a $5,500 limit is not going to give you as high a credit score as an account balance of $1,000 on an account with a $7,500 limit.
In a perfect world, we would be rewarded for paying bills on time and in full, and given some leeway when mistakes were made. Unfortunately we don't live in a perfect world, and when we're talking about credit reports, it gets event worse than imperfect. It seems that no matter how diligent you may be, the credit report can be unforgiving when it comes to mistakes. Pay a bill 30 days late, a negative mark will be on your credit report for seven years and will bring your credit score down significantly.
The long tail of the credit report is the reason it is critical that we teach our children that managing finances will have an impact on their buying power. It's important to note that simply making payments on time doesn't always result in a great credit score, especially if all open accounts are credit card accounts. In my mind, it means more to teach children that financing all of their material desires is not a good idea and that saving for something in order to pay cash for it can be the smartest move they can make.
Attorney Denise K. Aguilar is an Ahwatukee resident whose bankruptcy practice is located in Ahwatukee. Denise can be reached at 480-455-1881 or 602-252-4991. Additional information regarding the Aguilar Law Firm, P.C. is available at http://www.aguilarlawonline.com/.