In Hamlet, Polonius warned, “Neither a borrower nor a lender be.” His cautionary words still ring true today. Using credit has become a quick way to instant gratification: You can see it, want it, and buy it now (pay for it later). Borrowing certainly has a place in money management: It's a way of being able to buy something today that would otherwise be out of reach. Borrowing also is a way to build up a credit history to ensure continued borrowing ability in the future. But easy borrowing can lead to overextending oneself, which means that unwise money-managers might be unable to repay debt and might ruin their credit history.
Before your child becomes a credit card junkie and gets into serious debt, make sure he understands the uses and abuses of credit, starting with these issues:
- What borrowing is all about
- When credit should (and should not) be used
- What can happen if he gets into too much debt
- Why it's important to get—and keep—a good credit record
- How to get credit
When your child is young, she may want an advance on her allowance to buy something that her savings won't cover. Let's say that she sees a game for $25 and only has $20 saved up. She could wait, continue to save, and buy it later when she has saved another $5. Or, she could get an advance on her allowance of $5, buy it now, and repay the money (or forgo the allowance until the $5 has been made up). Is one way right or wrong? The answer depends on whether your child understands the consequences of borrowing and acts responsibly about it. (Advances on allowances are discussed in Advancing Money to Your Child.)
Borrowing money doesn't mean that your child has more money overall—she only has the use of more money. Of course, she also has the obligation of repaying what she has borrowed.
It's helpful for your child to get the names of the players in the credit game right:
- The borrower is the person who needs to do the borrowing. He's also called a debtor.
- The lender is the person with the money who makes the loan to the borrower. He's also called the creditor.
Borrowing can be helpful to pay for big-ticket items that are needed now but for which savings falls short. The cost of these things usually is high, and repayment of loans to afford them now can stretch for years. It's not unusual to borrow for these purposes:
- To buy a car
- To go to college
- To start a business
- To buy a home
Unless you, or a rich aunt or uncle, are the lender, borrowing usually isn't free. The cost of borrowing is the interest that's charged on the loan.
Let's look at an example to see what the real cost of borrowing is. Suppose your child needs to borrow $3,000 to buy a car (and a bank is willing to lend it to him based on his job or your agreement to make good on the loan if he doesn't). If the loan is for 36 months and the interest is 9 percent annually, his monthly payments are $95.40. After 36 months, he'll have repaid $3,434.40, which is $434.40 more than he borrowed. This additional amount represents interest.
Borrowing isn't limited to big-ticket items. Credit cards are often used to borrow money for smaller things, such as books at college, new jeans, or gas for a car. Credit cards are (or should be viewed as) a convenience. Instead of carrying cash that can be lost or stolen, many people use plastic to pay for things. The idea is to have on hand the money needed to pay the credit card bill when it comes due.
Unfortunately, many people find plastic too convenient and start to turn them into instant loans. Instead of paying the balance of the bill in full each month, they repay only a portion. The other portion becomes a loan, and these “loans” are generally at very high interest rates. Even though interest rates in general now stand at record lows, many credit cards still have annual rates of 18 percent or more.
The Importance of Having Good Credit
It's important to have good credit, and this is something your child should aim for. The reason is simple: Without good credit, a person can't borrow money—or if she can, she'll pay more than someone with good credit. For example, a person with bad credit may not even be able to get a credit card.
Bad credit not only affects a person's ability to borrow and what it costs her to so do, but it also can boost the car insurance premiums she'll have to pay. Bad credit can even keep a person from getting the job she want because some employers do credit checks on people they're thinking of hiring.
Your child will get good credit by building up a credit history of paying bills on time from the time she's 18 and onward. That's the time when she's old enough to make legally enforceable contracts under the law, so that's also the time when credit companies start keeping track of things. If she has never paid a telephone company bill or had a credit card, she probably doesn't have any credit history.
After she's 18, she'll start to be flooded with offers from credit card companies. Some kids think that because the credit card companies make the cards available, they can use them without regard to their ability to repay. They keeping using the cards until the credit card companies turn off the flow of money. As a result, they're in debt over their heads and have ruined their credit history.
Bad News of Borrowing
The concept that borrowing costs money isn't hard to grasp, but some people don't take this seriously and don't handle credit well. They borrow too much and can't repay in a timely fashion, which can get them into a lot of financial trouble:
- They wind up paying a lot of their income each month toward interest. At this point, they're unable to use their money on other things because they're using their money just to pay back what they owe. They can't save, and they can't get ahead.
- They may not be able to pay what's required. As a result, they might go into default on their obligation. At this point, they can lose the collateral for the loan (for example, a car can be repossessed on an unpaid car loan). They can be dunned for payment with phone calls and letter demanding immediate payment or else. Make sure that your child knows he has rights, though, even if things come to this. Under the Fair Credit Collection law, a person usually can be called only during business hours and can't be harassed.
- They may be sued by the credit card company or other lenders. Make sure that your child understands that she shouldn't ignore any official papers that may come her way to inform her of this legal step in the collection process. If she doesn't respond when she's supposed to, she loses her right to contest the claim later.
- They may be forced into bankruptcy. Bankruptcy is a court-supervised process of settling up debts with existing assets, maybe only for pennies on the dollar, and wiping a person's financial slate clean. Most debts are extinguished in bankruptcy so that the debtor can start anew. But bankruptcy stays on a person's credit history for 10 years, negatively affecting his ability to buy on credit during that time.
As a practical matter, if the debt is $50, no creditor is going to spend the time and effort to go this extra mile for collection. But if the debt runs in the thousands and many creditors are owed money, there may be no choice but to seek protection in bankruptcy—or be forced into it by creditors.
The Complete Guide to Personal Finance: For Teenagers
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