Debt 101 for Teens
More and more Americans seem to be struggling under the burden of debt. Whether it’s credit cards, student loans, or other forms, debt is all too common for many young adults. Unfortunately, financial education isn’t part of the curriculum in most U.S. schools. As a result, many teens aren’t financially literate which means they are unable to make good financial decisions in their adulthood.
Learning about money is the key to achieving financial security. That means it’s up to parents to teach teens the basics of debt and money management while they are still young. In addition to discussing financial matters, parents should remember that teens learn best by example, so it’s important to role model responsible borrowing behavior. This includes making smart borrowing decisions, paying bills on time, and avoiding excessive debt.
This blog provides parents with the important points to share so that they can prepare their children to make informed financial decisions in the future. Go over these key concepts with teens:
Define Debt and Interest
Debt is money that is borrowed from another party, such as an individual, bank, company or government. Any money that is borrowed must be paid back to the lender with certain terms, such as a schedule for repayment and the amount of interest to be paid. Interest is a percentage of the amount borrowed given to the lender. For example, if you borrow $100 with an interest rate of 10%, you will have to pay back $110. The higher the interest rate, the more you will have to repay. Whenever considering taking a loan or opening a credit card it’s important to always compare them among different lenders to find the one with the lowest interest rate and best terms.
Explain Different Types of Debt
Not all loans are created equal. Some debt can be very helpful. Good debt is used to invest in something that will increase in value over time, such as tuition towards an education or a mortgage for a home. When you buy a house, you’re both purchasing needed shelter and gaining an asset that will likely grow in value. Paying down a home loan might take decades, but as the equity grows and the value of the house increases, a house can easily become your most valuable investment. Bad debt does not provide any long-term benefits and can be difficult to pay off, such as credit card debt. Vacations, fine dining and expensive cars might be fun but they do not improve your net worth.
Define Credit Score
A credit score is a three-digit number, typically between 300 and 850, designed to represent your credit risk, or the likelihood you will pay your bills on time. Creditors and lenders use your credit score to decide whether to approve you for any form of loan or credit. Even landlords obtain your credit score to decide if they will rent a property or apartment to you or not. The most important way to increase your credit score is to pay all of your bills on time! Your credit score impacts the interest rate and other terms on any loan or other credit account for which you qualify. Higher credit scores generally result in more favorable credit terms.
Explain Credit Cards Aren’t Free Money
A credit card is a loan. Every time you use a credit card, you’re using someone else’s money. The longer you take to pay back the money, the more you pay for the item you purchased. The best way to use credit cards is to make a few small purchases and pay the balance in full, on time, every month. This strategy keeps the account active and shows creditors they can trust you to pay back what you borrow.
When you receive your credit card bill, you will see two possible payments: the minimum due and the statement balance. The minimum payment is the smallest amount of money that you have to pay each month to keep your account in good standing. The statement balance is the total balance on your account. Experts recommend you pay the statement balance in full every month. If you can’t pay off the entire amount, then pay off as much as you possibly can each month. It can be tempting to just pay that small minimum amount due on your credit card bill, but doing so can end up being really expensive. Making only the minimum payment on your credit card keeps your account in good standing and avoids late fees, but that’s about all it does. It won’t get you very far toward reducing your credit card debt. You will barely wipe out last month’s interest, and if you keep charging items to the card, you’ll fall further and further behind.
Imagine you owe $2,500 on a credit card with a 16% APR. If you opted to pay just the minimum payment of $50 due each month, and you did not charge anything else on the card, it would still take you almost 22 years and cost you around $6,500 to pay off the debt—you would end up paying $4,000 in interest.
Teach Teens 5 Tips for Avoiding Debt
- Only borrow what you can pay back. Delayed gratification — or the concept that you may have to wait to enjoy something — is a key aspect of dealing with money. Not every desire can, or should, be instantly satisfied. Saving for, and working toward, a goal often makes its attainment more satisfying. Additionally, it’s important to remember that if your life takes an unexpected turn because of a medical emergency, massive car repair or unemployment, even a reasonable debt load can suddenly become an unbearable burden.
- Learn to identify whether an item is a want or a need. Before making a purchase, consider whether the item is an essential or a nice-to-have. For example, cars can be an essential item. You likely need transportation. However, a luxury car is a want. Cars serve a function – moving you from point A to point B – and a $20,000 vehicle can do it just as well as one that costs $40,000. While we might like to drive a fancy car, it’s wiser to stay debt free or save for a house or a college education.
- Make a personal budget and stick to it. It’s more challenging to stay out of debt if you have no idea how much money is coming in or going out of your account. Allocate money for every upcoming bill and expense and then see how much money is left at the end so that you can make better financial decisions. Consider downloading a good budgeting app which can look at your spending habits and help you manage your finances so you can save money or pay down debt. It’s a good idea to save money for an emergency fund to cover a couple of months of expenses if you should ever become seriously ill or unemployed.
- Understand how much a loan will cost to repay. Before borrowing money, use an online debt calculator to determine how much you will have to pay and for how long. You should know how much extra you will have to pay in interest, so that you can decide whether the item is a good investment.
- Never ignore your debt. Borrowing money can have consequences if it is not managed responsibly. For example, if you borrow too much money and can’t make payments on time, it can damage your credit score and make it harder to borrow money in the future. You might have difficulty securing a mortgage or you might incur higher monthly payments to purchase a car. If your rent, student loan, credit card, or phone bill isn’t paid, those debts may be sent to a collection agency. If you borrow money, always work towards repaying it.
Teach your teenagers that borrowing money comes with responsibilities, such as making sure you can afford to pay it back on time, and that borrowing money has a significant impact on a person’s credit score which ultimately decides whether they can purchase large items, such as a house or car. Discussing the skills above now will help them avoid financial pitfalls and make smart borrowing decisions to achieve their goals as an adult.