Teaching Your Kids To Be Credit Score Savvy
To prepare your children for successful financial futures, you open savings accounts, pay allowances, and teach them to spend wisely. And with financial institutions toppling all around us, the woes of poor money management is more in the face of this generation than ever before. That’s why it’s up to you to use all the negative economic news to emphasize – from this day forward – that every financial decision they make will impact their credit score.
In the midst of the current credit crisis, a young person's credit score is more essential than ever. "Young adults today are confronted with a series of financial challenges that their parents never had to experience," says Dara Duguay, director of Citi's Office of Financial Education and author of Please Send Money: A Financial Survival Guide for Young Adults on their Own. "They have easier access to credit than older generations. Credit is a powerful tool, and a big responsibility."
The Financial Fingerprint
Teens must understand that their credit (FICO) score will essentially become their financial DNA. Just like you'd drill them with new vocabulary words to prepare for the SAT, you should also make sure they absorb the ins and outs of credit information. Let them know that they're striving for a "perfect score" of 850. Just as colleges look at SAT scores as indicators of academic success, credit scores will be used to predict grades of potential borrowers.
"Credit scoring is more stringent than ever," says Beth Frantz, a loan originator with Eagle Nationwide Mortgage Company who’s worked in the financial industry for 25 years. "We cannot lend to anyone with a credit score below 580… period," says Frantz, explaining why an excellent credit score is so important. "[A score of] 740 is now the benchmark for determining the best credit, and additional fees are charged for anything below 740. This is not lender specific – these are Fannie Mae and Freddie Mac requirements now."
Adds Duguay, "Practicing good spending and payment habits now – and building a strong credit history – is essential to getting credit later to rent an apartment, buy or lease a car, or apply for a job."
While the mathematical models used to determine credit score are complex, the steps to obtaining one are not. Let your teen know that like a resume, a good credit score is something that is built over time – starting today.
Avoid the Early Credit Card Trap
"Credit cards have a message," says Paul Richard, the executive vice president of the National Center for Finance Education (NCFE), a nonprofit group dedicated to teaching money management. And that message is "spend."
The proper plastic position to take, says Frantz, is reminding your child that it's OK to be "poor" and do without while in college. "That's why they're there: to learn to earn."
Todd Huettner, a financial analyst and consultant specializing in credit issues, reminds parents that although these tips are obvious to adults, they may not be obvious to children who are accustomed to always seeing credit in use, so be sure to hammer the point home. "Use cash for all discretionary purchases," Huettner tells students. "If you run out of cash, then you are out of money. It takes self discipline."
So how can your teen build a credit history without plastic? For starters, consider that FICO uses credit diversity as 10 percent of the overall credit score. "The best way to establish credit is to save up enough money for a substantial down payment on a car," advises Frantz. "Teens may qualify for a car loan on their own or with their parents cosigning."
Officially on His Own
When your child is earning a regular income, he's finally ready for the responsibility of a credit card. Candi Hinton Sparks, author of the Can I Have Some Money?, puts it simply: "Have an income if you are going to use credit."
Encourage your teen to shop around. "Signing up for a credit card is not an impulse purchase – it takes research to find the best credit card," says Bill Hardekopf, CEO of Low Cards, the leading consumer resource for credit card information. "Compare cards by looking through terms and conditions and the actual interest rates and fees. Look for a card with a low APR, no annual fee, and a grace period of 21 days."
Dissuade your child from responding to every offer he receives "to build credit." Joseph Onesta, former director of education for Consumer Credit Counseling Service of Los Angeles, warns young adults to avoid the temptations of T-shirts and other freebies they can get for applying. "Excessive inquiries and application for credit can damage a credit score for upwards to two years," says Onesta, and such activity comprises 10 percent of the overall FICO.
And, don't try building your child's credit history by adding him as an authorized user on your own credit cards. "New FICO scoring guidelines don't create a score for authorized users," advises Siegel, "so this will not establish a credit profile."
Young adults can, however, build credit by taking out student loans, explains Bob Friedman, director of student finance at Yeshiva University. “Students should borrow only what is needed and exhaust federally guaranteed student loans first." Then they can use state and institution loan programs to bridge any gaps.
Using Credit Responsibly
The ultimate goal is not just to establish credit, but to establish good credit. At 35 percent, punctuality of payments is the single largest contributor to one's credit score. Since you won't always be around to remind your teen to send a payment, encourage her to sign up for payment alerts or schedule payments online.
And stress that credit does not replace cash. "Credit cards are not supplemental income intended to help people buy things they can't afford," reinforces Onesta. "Those who get the most out of their credit cards understand the value is convenience, not available credit."
It's just as important to not use all available credit. "Maxing out a credit card is nearly as bad as being late [with payments] in terms of the immediate impact on the credit scores," cautions Patrick Ritchie, author of The Credit Road Map. A significant 30 percent of the FICO score is represented by the utilization rate – the ratio of debt (balances owed) to total available credit (credit limits). The lower the utilization rate, the better the credit score.
Patience, Planning, and Self-Control
A good credit score takes years to develop, but far less time to destroy, and raising a low credit score isn't easy. Scott Mitic, founder and CEO of TrustedID, a consumer and business identity theft protection company, says, "There is no quick fix. It's like losing weight. There are things you can do to look better for a few weeks, but if you really want good credit health, you must behave well over a long period of time."
It's important to teach your kids about responsible spending while you are still there to support them. Gayle Reaume Skiera, founder of The Money Academy, an educational company that works with youth to help them become financially independent and responsible – sums it up well. "Kids learn best through hands-on experience. Transfer financial responsibility to kids gradually, letting them make decisions and mistakes while the stakes are small."