By: Investor Solutions
Like all important life lessons, teaching your children to be financially savvy should be taught early on. Giving them an allowance is usually the first logical step in this process. As they get older and the cost of their purchases grows, credit cards inevitably enter the scene. Although credit cards are not bad in their own right, it is important to teach kids how to use them, when to use them and what to avoid.
With online shopping as popular as it is, it is almost inevitable that at some point or other your kids will want a credit card. And it is important that they have one in order to build a credit history which will help them qualify for a car loan or mortgage later on in life. It is equally as important, however, that they know what the repercussions of making only minimum payments are, the effects of compound interest and cost of financing an asset with a decreasing value.
Let’s use a real life example. Suppose your son or daughter wants the new iPhone and they go to the local Apple store and buy it, on credit. They choose the cheapest monthly plan totaling $100 and prepay it (assuming they could do this), of course, on credit. If the credit card has a 24% annual interest rate and a 4% minimum monthly payment rate, it would take your child 8 years and 4 months to completely pay off the card assuming they made no additional purchases on it and paid only the minimum monthly amount. They would end up paying $2,574.95 on a $200 phone and a year’s worth of service. This is attributable to the compound interest on credit cards that charges interest on interest. Though this may be a great concept for a savings account or CD, it can be financially destructive when it comes to credit cards. Never mind that by the time the phone is paid off, it will be completely obsolete and will have already either died or been replaced with the latest version.
So what is a parent to do? TEACH! Teach your children what their options are and how to be responsible. Let’s explore the various possibilities that exist in getting your teens started with credit.
Debit cards are used to withdraw funds from a checking or savings account. As such, the possibility for overdrafts and the associated fees could be an issue if your child is not current on checking the account. Additionally, if fraud is committed or there is an issue with a merchant it may be difficult to recuperate the monies lost. This depends on the timing of the theft and notification to the card issuer. On the upside, debit cards issued by major credit card companies carry the same fraud protection as regular credit cards.
Prepaid cards are a safer alternative to debit cards in that the amount that can be “charged” on it is restricted. A prepaid card is not linked to a checking or savings account but rather it is funded with a deposit from a parent or other authorized user. You are essentially buying with cash but presenting the merchant with a credit card. Once the cash is gone, the spending stops. The possibility of an overdraft does not exist as with a debit card. Visa Buxx (http://usa.visa.com/personal/cards/prepaid/visa_buxx.html) is one of the more popular prepaid cards. MasterCard has similar product offerings called the Allow Card (http://www.allowcard.com/) and PAYjr (http://www.payjr.com/index.html?aspxerrorpath=/brandings/payjr/default.aspx.). The downside, however, is that there are fees (activation, membership, monthly maintenance, etc.) associated with this type of card so it is important for you and your kids to do your homework first.
A joint credit card is one that is in the child’s name but the parent co-signs on. As you may already know, an individual must be at least 18 years of age to obtain his/her own credit card so this is an opportunity to teach younger kids about credit and fiscal responsibility. These cards can typically be found with rather low credit limits so they are a good option for those just starting out.
Secured credit cards are linked to a teen’s savings account which serves as the collateral and credit limit for the card. If the value of the account is $500, so is the limit on the credit card. If a monthly payment is missed, it is automatically deducted from the savings account ensuring the teenager does not fall behind on payments. One of the downsides to these products is the fact that interest rates can be rather steep reaching 24%! Almost all secured credit cards charge some kind of annual fee so it is important to shop around for the best deal. Credit unions are the best place to start.
Naming your teenager as an authorized user on your credit card is yet another way to teach your kids about credit although it might not be the best way. Although it is convenient, if you have a kid that loves to shop and spend, it could potentially bust your budget and your credit especially if you bail your kids out or fail to make timely payments. I would proceed with caution on this option and restrict it only to kids that are responsible and understand the importance of timely payments and restraint as it is ultimately the parent’s responsibility to pay this debt.
Once you and your child have decided what type of card is best for them, it is important that you remind them that a credit card should be used:
- For emergencies only
- If their budget permits the purchase
- If they have the money to pay off the balance in full at the end of the month
- If they have tucked away enough in savings or for an emergency fund
Parents should also remember that bailing kids out when they get in over their heads is not going to help any. Young adults need to learn how to be financially responsible. It is an important lesson to learn and rather painless if learnt early on.