Learning how to manage finances – and spend responsibly – is key to financial success as an adult… and it’s never too soon to get started. Teaching your children about how credit works (and how to use this mechanism wisely) will not only help them build a good credit score, but also could improve their overall financial health in future. Here are a few tips on how to begin.
What is Credit?
The concept of credit is familiar to adults – but for kids, it might seem a little unusual. Is a credit card simply a magical bit of plastic that enables parents to buy anything they want?! Unfortunately, no!
It’s important to explain that credit is commonly used to buy items or services that you aren’t able to purchase outright, and that it’s a mechanism which allows you to pay off the total in regular, smaller (more manageable) quantities. However, ‘credit’ is something you’re lent, and a little bit of money is tacked on each time to pay the lender for their services. With this in mind, you can make it clear that if credit goes unpaid – that is, if you don’t keep up with your agreed payment schedule – it can end up costing you a lot more than the price of the original purchase.
Moreover, if you don’t keep up with payments, it can negatively affect your credit score (more on that below), making it harder to gain approval for credit in future.
What is a Credit Score?
Once you’ve talked your children through the concept of credit, it’s a good idea to introduce the idea of credit scoring – and the importance of not committing to a bigger amount than you can reasonably pay off, in case you fall behind. Explain that if you have a poor credit history, lenders will be unlikely to trust you with large sums of credit; so it’s a good idea to start off by using credit cards for small amounts, as that way you can easily keep up, and lenders will learn that they can trust you to spend responsibly.
Your children may wonder if it’s a good idea to have credit cards at all, if it can negatively impact your credit score; at this point, you’ll need to explain that it’s a delicate balance. After all, having no credit history can also work against a person, because it makes it harder for lenders to predict future spending behaviour. The important thing to remember is how lenders assess a person’s attractiveness for credit. Explain that a credit score is a prediction based on previous spending history and financial management – from a person’s debt history, to how many credit applications they’ve previously made, to how good they are at paying bills on time (and not just credit card bills – utility, mobile phone and even broadband providers have been known to share data).
Practise Makes Perfect
Now that your child understands the concept of credit, it’s time to allow them to practise managing a loan – from you! It doesn’t need to be a huge sum of money, but it should be large enough that you can devise a payment plan together (perhaps £40, with a £4 repayment each week for ten weeks). You will both need to agree to a realistic plan that your child can stick to, and discuss what
will happen if they ‘default’. The important thing is to build their confidence, so the terms shouldn’t be too onerous!
Encourage them to be honest, too, if they find it challenging to stick to the agreed schedule. It’s widely agreed that some adults get into more financial trouble because, if they’re struggling, they avoid their creditors. In fact, being proactive and speaking with lenders early is always best – so this is a great opportunity to build that skill. You can come up with a new solution together (perhaps your child will make a double payment next time).
On the flipside, you can offer incentives if your child is doing well (just like credit card companies do). Rewarding your child for good financial management will encourage healthy behaviours in future; so feel free to think of ‘rewards’ they could earn if they pay you back promptly, or perhaps give them a small bonus towards their pocket money. A little goes a long way!
Building good habits around money can serve children well for the rest of their lives. Looking for more tips? Check out our recent blog, ‘How to Teach Children About Money’, for some great insights into helping your children develop healthy financial behaviours.