Giving teens greater financial responsibility can be daunting. Whether or not you feel your teen is ready for credit, introducing them to the basics beforehand is vital to setting them up for financial success in the future.
What is Credit?
Credit is a form of borrowing that enables customers to obtain goods or services before payment, based on the trust that the payment will be made in the future.
Explaining Credit to Teens:
In the same way you don’t own the shirt you borrowed from a friend; you don’t own the money you borrow from the bank. It is important to stress to teens that any balance on their credit card must be repaid. To make this connection of cause and effect clear, parents can occasionally share their credit card bills with their teens.
Pros and Cons of Credit
Like anything in life, there are both pros and cons of using a credit card, and parents should help teens weigh up both sides of the credit coin to ensure they are making a well-informed decision. Some advantages and disadvantages of credit include:
Teens can practise making payments on time and being responsible with their finances.
They can start creating a good credit history early, which will benefit them later in life when making large investments.
Very useful for teens abroad or at university when there is an emergency and you’re not always able to send them funds quickly.
You can also see your teen’s credit card statement and monitor their spending to make sure they are not going overboard.
After paying interest, you’ll pay back a lot more than you originally borrowed.
If not used responsibly can result in overspending.
There are fees associated with having a credit card and if not managed carefully can end up costing a significant amount.
Easy to negatively impact your credit score if you forget to pay your bill on time.
From the first swipe of your credit card, a credit report is created. To calculate an individual’s score, a specific set of risk rules are applied to an algorithm, which draws some assumptions about the individual’s spending habits and then assigns a number – the score. This number indicates to lenders your capacity to repay a loan. The following factors can impact your credit score:
Payment History – Whether or not you pay your bills on time is the most important factor in your credit score - even the ones that seem small and insignificant.
Debt Accrued – Advise your teen to use less than 35% of their available credit limit – using a large amount of available credit may result in a large debt that is difficult to repay on time.
Length of Credit History – The longer your history, the more accurate your credit score will be. If your teen has only just started using credit, their score will be lower, but they can improve this over time. You may consider deferring credit for your teen if they are unable to make repayments on time.
Credit Applications – If you apply for more or new credit frequently, it generally is a warning sign to lenders that you’re having some sort of financial difficulty.
Explaining Credit Scores to Teens:
Maintaining a good credit score can help teens more easily qualify for a loan or mortgage later in life and save money on interest rates, as they will have already demonstrated responsible credit behaviour. A low credit score can make it difficult when qualifying for financing later on, because you are viewed as a higher risk. That being said, it is still possible to obtain a mortgage without a credit history.
Types of Credit
The three most common forms of credit include:
A credit card is a beneficial option for building your credit score at an early age. In general, credit cards are meant for very short-term borrowing, and they allow you to borrow without interest until your statement’s due date. After the due date, credit cards charge a high rate of interest starting from the date of your purchase. Annual interest rates on credit cards in the Cayman Islands can range from 20%-25% depending on where you bank, and this is then calculated daily. So, for instance, if your annual rate is 20% and you have an outstanding balance of $500, your daily rate would be 0.055%. Thus, $0.275 worth of interest will be added to your balance each day until the end of the month ($500.275 on the first day, and so on).
Lines of Credit
Often arranged between banks and their clients, a line of credit is one of the most flexible ways to borrow money because it is a set amount of funds that can be accessed at any time, but they don’t need to be used all at once. In addition, lines of credit generally tend to carry a lower interest rate.
A personal loan may be a good option in instances where you need to borrow a larger sum of money, such as for buying a car. A personal loan can generally be paid back in monthly increments over a number of years and interest rates decrease as money owed decreases. Interest rates on loans vary but they can start as low as 13% per annum.
The Bottom Line
Before your teen makes any rash decisions regarding credit or loans, make sure they fully understand the financial implications of late or failed payments and frivolous spending. Consider too whether they have demonstrated that they are financially responsible with their saving and spending habits. A universal rule of thumb that all teens should adhere to when first using credit is to not purchase anything that they could not afford using cash.
If you feel out of your depths answering any questions your teen may have, arrange a meeting with a financial advisor that you can both attend to determine whether it is time to sign your teen up for credit. Learn more about bank in Cayman and bank accounts for children.