Friday, September 6, 2019
Teaching young adults how to use credit responsibly can help ensure a successful financial future
Your child won’t be young forever. At some point, they’ll need to start preparing themselves for adulthood, particularly when it comes to managing their finances.
As a parent, you’ve taught them everything from tying their shoes to riding a bike. But once they reach adulthood, your role as a teacher doesn’t stop.
We created this guide to help parents start the conversation with their adult children around how to be strategic and efficient with the use of credit.
Credit 101 for Young Adults: Exploring the Basics
Young adults today grew up in an era in which plastic cards replaced piggy banks. For as far back as they can remember, your child saw you pull out a credit card to pay for gas, groceries, or clothing. That dynamic prevents children from seeing the dollar value behind each credit card purchase, leaving them with little or no knowledge of creditors, monthly statements, or interest rates.
Now that they’re older, your child should understand the concept of credit before they acquire credit of their own. Begin by explaining that credit is like a loan. Your bank, lender, or creditor sets the amount of credit available to you. You can spend up to that amount with the promise of repaying whatever you spend—at a price.
Unless you have an introductory zero annual percentage rate (APR), your credit card company will charge you interest on the loan you created when completing a transaction using your credit card. Any balance that isn’t paid off each month will be charged interest, which averages roughly 16 percent.
The credit trap occurs when a purchase ends up costing more than the price at which it was bought.
Most credit card companies determine a minimum payment that hovers around 2 percent of your balance due, barely covering the interest payments each month. Let’s put this into perspective:
Your daughter makes $1,000 in credit card purchases to furnish and set-up her dorm room. She pays the minimum payment of $20, thinking she’s being smart with her money. What she doesn’t realize is that, if she pays nothing more than the minimum each month, it will take her more than 10 years to pay off the original balance—plus nearly $1,000 in interest charges!
This problem is called the “credit trap.” The credit trap occurs any time something you purchase ends up costing you more than the price at which it was bought. It’s the first mistake many young adults make on their financial journey.
It’s easy to see how debt can spiral out of control. To get out of debt, your child needs to prioritize paying down their credit card balance as quickly as possible. To stay out of debt, they need to understand how credit cards work and pay off their entire balance at the end of each month.
When Should Young Adults Apply for Their Own Credit Card?
Once your child turns 18, they are eligible to apply for their own credit card. But age doesn’t reflect responsibility, so you may want to co-sign on a card with them, open a secured credit card, or have them use a debit card for the time being.
Before your child applies for credit, make sure they are familiar with APR, minimum payments, the credit trap, and the effect that these items have on their future credit history or reputation.
Because they’re technically an adult, they will be targeted by credit card companies offering attractive gifts and miles. Ideally, you’ll have had these discussions with them before they turn 18 and are free to make their own choices.
Setting Goals for Credit Use
There are two main reasons why your child will need a credit card: to build credit and to learn how to manage their money responsibly.
When they go to buy a car or home, their credit will matter. When they go to rent an apartment, apply for a job, or obtain insurance, their credit will matter.
Take time to discuss what good credit looks like and why it can be an advantage. For example, they can get lower interest rates for loans, which will save them money in the long run.
Also, talk to them about what determines their credit score:
- Making payments on time
- Paying off their balance in full
- Maintaining a credit card for a long period of time
- Using only a portion (30 percent) of their credit limit
- Applying for credit only when needed
The goal shouldn’t be to avoid paying for things upfront, but rather to make sound financial decisions and use credit cards to have a positive effect on their future.
Exploring Different Types of Credit Cards
Some credit cards are better than others, especially for young adults trying to build credit for the first time.
Student credit cards are designed for young adults going to college who don’t have credit. The upside? The cardholder can establish credit before leaving school and entering “the real world.”
Another option is a secured credit card. This type of card is similar to a debit card in that it requires a deposit (your cash deposit is usually your credit limit). The credit card company reports activity to the credit bureaus to help establish a credit history.
Setting a Credit Limit for a Daily Use Card
It’s a good idea to talk to your child about setting a credit limit. Think about how much money they’d need to access in a given month: groceries, gas, clothes, a potential emergency, and a little for discretionary use. Aim for using less than 30 percent of the credit limit.
There’s no set number of credit cards that anyone should own, regardless of age. However, ideally, young adults will start with one credit card and ensure they can manage it well.
The more credit they have, the more they might be tempted to rely on it. But with limits, they’re forced to get creative with how they spend that money and are more likely to pay more than the minimum each month.
When to Have the Credit Conversation with Your Child
Given the current financial state of affairs among young people in the United States, it’s never too early to start building good financial habits. Even children as young as elementary school-age can begin to understand the difference between financial wants and financial needs. The more you practice great financial health, the better the chance your children have of putting their knowledge to good use.
Have questions on how to prepare your child for financial wellness? We’re here to help.
Reach out to Brighton Jones today with your financial questions.
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