Understanding credit is essential for your child’s long-term financial success, however it is likely one of the topics they understand the least. Learning what credit is, and how it works will help your children make informed financial decisions for the rest of their lives.
What is credit?
Credit refers to borrowed money that you are obligated to pay back in the future. It is important that your child understands that it is not ‘free money’, and that it must be paid back, usually with interest. Furthermore, understanding interest and how different loans ‘cost’ different amounts is essential for your child to fully appreciate how credit works.
Types of credit
You may choose to introduce your child to the different types of credit: revolving credit allows the borrower to keep withdrawing up to a credit limit and pay it down over time. The most common example of this is in credit cards. Mortgages and car loans, however, are an example of instalment credit, where there is a fixed schedule which the borrower pays back their debt until it is settled.
It is also important for your child to understand when it is a good and a bad idea to open a line of credit. Taking out a mortgage is often seen as good credit as it allows you to buy a house, which is a powerful asset to own. On the other hand, having many credit cards to fund an overly lavish lifestyle is likely a bad idea.
Credit Scores
Your credit score is a number that represents how well you have handled your debt and credit. Good behaviour such as paying bills on time will improve your score while bad behaviour will reduce your score.
It is key for your child to understand that a good credit score can lead to lower interest rates on loans and better chances of being approved for a mortgage.
You can help your child to start building their credit score early. Registering to vote and sensibly managing a credit card are ways you can build your credit, albeit only once you have turned 18. Similarly, you should explain the consequences of missing a loan payment, or going into unarranged overdraft, and how this will affect their score in the future.
Budgeting and saving are also crucially important when discussing credit. Learning to live within your means and having some savings for unexpected expenses can prevent the need to rely heavily on credit.
Lead by Example
Children learn a lot by observing their parents. Demonstrate good financial habits, such as paying bills on time, budgeting, and using credit responsibly. Share stories of financial mistakes and successes from your own life to illustrate the long-term benefits of good credit practices. You could also show your children when you receive bills and explain how you budget for these payments.
Credit can be a difficult concept to understand, and it will be an ongoing process to learn about it as you raise your children. By starting early with the basics, you can ensure your children make informed financial decisions throughout their lives.