It is important to teach teens about credit so they will be able to make good financial decisions and avoid debt problems now and in the future. Credit is the ability to borrow money; when you borrow money on credit, you get a loan and promise to pay it back with a little extra (interest). Having good credit can make it easier to do things such as:
  • Borrow money
  • Get approved for a credit card
  • Rent an apartment or house
  • Qualify for a car loan
  • Get better interest rates on credit cards and loans
  • Get better car insurance rates
  • Avoid security deposits on utilities
A person's creditworthiness is typically measured with a credit score. The most common credit score is the FICO score, named after software developer Fair Isaac and Corporation. A person's FICO scores are provided to lenders by the three major credit reporting agencies - Experian, TransUnion and Equifax - to help lenders evaluate the risks of extending credit or loaning money to people.

Lenders typically review the Four Cs when making a decision to grant a loan:
  • Capacity - your present and future ability to meet your payment obligations
  • Capital - the value of your assets and your net worth
  • Character - your payment history
  • Collateral - the property or assets that will secure the loan
When evaluating the Four Cs, the loan officer may ask you and your teen questions such as:
  • Are you employed? How much money do you earn each month?
  • What are your monthly expenses?
  • How much money do you have in bank accounts?
  • Have you had credit in the past?
  • How many credit cards do you have?
  • What collateral can you offer?
You can be denied for a loan if you are unable to demonstrate that you have capacity, capital, character and collateral. For example, you may get turned down if you have:
  • A history of making late payments
  • Filed for bankruptcy
  • Had property repossessed or foreclosed
  • A court order requiring you to pay money to a lender or creditor
Your credit score affects your ability to qualify for different types of credit and varying interest rates. In general, the higher your credit score, the better your loan terms. The following charts details the annual percentage rates (APRs) available to people with different credit number ranges, along with the corresponding monthly payments and total interest paid. The chart assumes a 30-year fixed mortgage for $150,000 (interest rates current as of 3/26/13).

FICO Score APR Monthly Payment Total Interest
760-850 3.258 % $653 $85,249
700-759 3.480 % $672 $91,882
680-699 3.657 % $687 $97,241
660-679 3.871% $705 $103,804
640-659 4.301 % $742 $117,262
620-639 4.847 % $791 $134,855

These figures clearly show how your credit score can impact the interest you pay on a loan: a better credit score can save you tens of thousands of dollars on major loans such as a mortgage. To view different scenarios, visit (you can select the type of loan, the state where you live, the loan principal amount and different FICO Score ranges).

Unfortunately, we don't start with a clean slate as far as credit scores are concerned. Individuals have to earn their good numbers, and it takes time. According to data compiled by Credit Karma, there is a correlation between age and average credit scores, with scores rising as people age: the average credit score for 18-24 year olds is 638. Even when all other factors remain the same, a younger person will likely have a lower credit score than an older person. That's because the length of a credit history accounts for 15% of the credit score. Your teen or young adult can be at a disadvantage simply because he or she does not have the depth or length of credit history.

Five factors are included and weighted to calculate a person's FICO credit score:
  1. 35%: payment history
  2. 30%: amounts owed
  3. 15%: length of credit history
  4. 10%: new credit and recently opened accounts
  5. 10%: types of credit in use
How Can Teens Build Credit?
The most important thing you can do to help your child build credit is to teach him or her to manage money responsibly. Those skills and habits go a long way towards reaching a good credit score. That being said, there are a few options for helping your teen establish credit:
  • Add your child as an authorized user or a joint account holder or on your credit card. In order for this to work, you must pay the credit card bills on time; otherwise, it will end up hurting your child's credit.
  • Teach your children to use credit responsibly, even before they have their own credit card. For example, as an authorized user on your account, your child should avoid charging more than he or she can comfortably pay off in full each month, and balances should be kept well below the credit limit.
  • Some 18-year olds can get credit cards (though most will still need an adult cosigner until they hit 21), but will need a steady source of income to qualify (allowance doesn't count) to prove they can pay off the debt. Instruct your teen to avoid applying for multiple cards (even if the deals look great); applying for multiple cards can lower your score dramatically since you will appear desperate for credit.
  • Consider retail and gas cards since they are typically easier to obtain approval for than a Visa or MasterCard. Be sure to ask if the card requires payment in full each month or if it allows minimum payments (like a credit card). If the card must be paid in full each month, it may not be reported as revolving, and therefore will not help your teen's credit (encourage your child to pay off in full each month even if it is not required).
  • Make sure your teen pays all of his or her bills consistently and on time - including utilities, traffic fines and even library fees.
It is important to note that most prepaid credit cards and debit cards will not help your teen build credit. Read the fine print for details.

Next: Teaching Financial Literacy To Teens: Cars And College »

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