Teenagers go to school to prepare for college and life after high school. One element that may fall through the cracks is financial literacy. You may have taught your teen about the importance of saving and working, but have you talked to them about credit? Once your teen turns 18, they will start receiving credit card offers, and it's important that they understand the impact credit has on their life. Here are a few topics you can teach to your teen about the wise use of credit.
A credit score is a three digit number that is calculated by the Fair Isaac Company (FICO) based on different criteria. This number will determine if the financial institution will agree to lend you money based on the amount of risk you have. If your credit score is high, then you're more likely to be approved for a loan, line of credit, or credit card. If your credit score is low, then you're less likely to be approved because there's a higher risk that you won't pay your loans on time.
The algorithm that FICO uses to calculate a credit score is based on these criteria:
- Payment History (35%) -- it's important to teach your teens that paying their bills on time, every time will positively impact their score. As soon as they start missing payments, their credit scores will start to decrease.
- Amount Owed (30%) -- this criteria measures the capacity of your loans. Basically, it looks at the balances on all of your accounts to determine if you're overextended in debt. It also takes into consideration the difference in revolving debt like credit cards and installment debt like loans. For credit cards, if you use the majority of your available credit, your score will decrease. It's important to make sure you teach your teen not to use too much of their credit card balance because it will negatively impact them. For installment loans, it's important to make payments on it and decrease the amount. FICO looks at how much the original balance was compared to the current balance and if it's decreasing, it means that your teen is able to pay the loan, which will increase your teen's score.
- Length of History (15%) -- when FICO calculates the score, it takes into consideration how long you've had your credit. The longer your credit length is, the better it is for your score. This means that you have a history of paying your credit on time and is better for your score. A score won't be calculated until you develop a credit history, so when your teen applies for credit for the first time, he/she won't have a score and the lender may require a co-signer.
- New Credit (10%) -- this is important when it comes to taking out credit. If your teen wants to take out a student loan, credit card, and auto loan within a short period of time, this could negatively impact their score. One thing to consider is that when shopping for a rate at different financial institutions, the credit bureaus will group them all together, so your teen's score isn't decreasing because you're rate shopping. However, it's important that they realize the more credit they take out in a short time frame will decrease their score.
- Types of Credit (10%) -- there are three types of credit that are important to have to build up a credit score -- installment loans, revolving credit, and mortgage loans. This mix gives your credit history diversity because it shows that your teen can balance having multiple accounts with different types of payment terms.
Why having good credit is beneficial
Having good credit is not only good for visiting the bank, but it can also impact jobs, utilities, housing, and insurance. Many of these companies will pull credit to ensure that you will pay your bills on time. Insurance companies may pull your credit and offer you a lower rate based on your credit score. By explaining to your teen why it's beneficial to have a good score, you'll help them avoid being denied for housing.
Establishing this education with your teen before they turn 18 will help set him/her up for success when the time comes to take out credit. Whether it's for school, or just to build up their score, these criteria impacts him/her in the same way. Don't let your teen suffer the consequences from making poor decisions because he/she didn't understand how important credit actually is.