The Center for Financial Empowerment, the nonprofit organization founded by SCE Credit Union, has a mission to educate high school youth with personal finance concepts, preparing them to make smart financial decisions as they move into adulthood. As part of that mission, we encourage parents to take an active role in helping their teens establish strong financial habits for managing money.
In this post of our Teach Your Teen series, we discuss how to begin helping your teen understand the basics of credit.
The concept of borrowing money on credit is a daunting one to explain to young people. Most adults tend to avoid or put off talking about it because it can get complicated. But did you know it’s the number one financial topic teens want to learn about? They’ve heard horror stories of people who’ve been burdened by debt – and they want to avoid being one of them.
Teaching your teen about credit is a long, patient process, but parents shouldn’t feel they need to explain everything at once. Start with the basics and give them opportunities to explore the simpler elements before moving on to more complex ideas. Here are some basic credit concepts to start with.
What is credit
A person is using credit when they receive money, goods, or services in exchange for their promise to pay back the amount borrowed, plus interest, at a future date.
- Principal – The amount borrowed
- Interest – The charge for borrowing money
In every credit transaction, there’s a borrower and a lender. The money borrowed is repaid in regular payments (usually monthly) over time. The loan term is the amount of time a lender agrees for the loan to be repaid.
Borrowing is spending future income.
How credit is granted
The lender considers the borrower’s credit history – their records of borrowing and repaying credit used in the past – to decide if the borrower can be trusted to repay the loan.
A borrower’s credit history is shown on their credit report. A credit score is the numerical calculation of the information contained in the credit report.
For example, Toby was approved for a $10,000 loan at an 8% interest rate to purchase a used vehicle. The loan term requires him to make monthly payments of $313.36 for the next three years (36 months) to pay back the loan. In addition to paying back the original $10,000 borrowed, Toby will also be paying a total of $1,280.96 in interest. So, the total amount repaid over the 36 months will be $11,280.96.
Types of credit
Closed-end credit (also called installment credit) is a loan that you must repay in a specified number of equal monthly payments. Examples include vehicle loans, mortgages, and education loans.
Open-end credit (also called revolving credit) is extended as a line of credit established in advance, so you don’t have to apply for credit each time credit is desired. A feature of open‐end credit is you can pay the loan balance in a single payment or a series of equal or unequal monthly payments. The lender will typically require a specified minimum monthly payment towards the outstanding balance. Examples include credit cards and lines of credit.
Alternative credit comes in many forms, but its common feature is the high fees charged by the lender in exchange for fewer up-front requirements for the borrower. The high costs associated with these types of credit can keep people trapped in a vicious cycle of debt just to make ends meet. Alternative credit is promoted to people with low credit scores, negative credit history, or individuals who may lack the documentation required to qualify for traditional bank loans. Examples include payday loans, cash advance loans, rent-to-own contracts, pawn loans, title loans and refund anticipation loans.
Credit is an effective financial tool when managed responsibly. But, not managing credit wisely and over-obligating future income can lead to a decrease in a person’s future quality of life.
- Consumer Finance Protection Bureau – Conversations About Borrowing
- Video – What Is Credit?
- Video – What is Credit, Why is it important?
The Center for Financial Empowerment is a 501c3 nonprofit organization whose mission is to empower disadvantaged youth through financial literacy education. Find out more about our work at Center4FE.org.
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Credit Basics, Take Charge Today, August 2019