In Hamlet, Polonius warned, “Neither a borrower nor a lender be.” His cautionary words still ring true today. Using credit has become a quick way to instant gratification: You can see it, want it, and buy it now (pay for it later). Borrowing certainly has a place in money management: It's a way of being able to buy something today that would otherwise be out of reach. Borrowing also is a way to build up a credit history to ensure continued borrowing ability in the future. But easy borrowing can lead to overextending oneself, which means that unwise money-managers might be unable to repay debt and might ruin their credit history.
Credit has two meanings when it comes to money. First, it's the amount remaining in a person's bank account. Second, with respect to borrowing, credit is the extent to which a person is trusted to make repayment of a loan.
Before your child becomes a credit card junkie and gets into serious debt, make sure he understands the uses and abuses of credit, starting with these issues:
- What borrowing is all about
- When credit should (and should not) be used
- What can happen if he gets into too much debt
- Why it's important to get—and keep—a good credit record
- How to get credit
When your child is young, she may want an advance on her allowance to buy something that her savings won't cover. Let's say that she sees a game for $25 and only has $20 saved up. She could wait, continue to save, and buy it later when she has saved another $5. Or, she could get an advance on her allowance of $5, buy it now, and repay the money (or forgo the allowance until the $5 has been made up). Is one way right or wrong? The answer depends on whether your child understands the consequences of borrowing and acts responsibly about it. (Advances on allowances are discussed in Advancing Money to Your Child.)
Borrowing money doesn't mean that your child has more money overall—she only has the use of more money. Of course, she also has the obligation of repaying what she has borrowed.
It's helpful for your child to get the names of the players in the credit game right:
- The borrower is the person who needs to do the borrowing. He's also called a debtor.
- The lender is the person with the money who makes the loan to the borrower. He's also called the creditor.
Borrowing can be helpful to pay for big-ticket items that are needed now but for which savings falls short. The cost of these things usually is high, and repayment of loans to afford them now can stretch for years. It's not unusual to borrow for these purposes:
Unless you, or a rich aunt or uncle, are the lender, borrowing usually isn't free. The cost of borrowing is the interest that's charged on the loan.
Let's look at an example to see what the real cost of borrowing is. Suppose your child needs to borrow $3,000 to buy a car (and a bank is willing to lend it to him based on his job or your agreement to make good on the loan if he doesn't). If the loan is for 36 months and the interest is 9 percent annually, his monthly payments are $95.40. After 36 months, he'll have repaid $3,434.40, which is $434.40 more than he borrowed. This additional amount represents interest.
Borrowing isn't limited to big-ticket items. Credit cards are often used to borrow money for smaller things, such as books at college, new jeans, or gas for a car. Credit cards are (or should be viewed as) a convenience. Instead of carrying cash that can be lost or stolen, many people use plastic to pay for things. The idea is to have on hand the money needed to pay the credit card bill when it comes due.
Interest is an amount of money that's owed in addition to the amount borrowed. Interest is calculated on a percentage of the amount borrowed.
Unfortunately, many people find plastic too convenient and start to turn them into instant loans. Instead of paying the balance of the bill in full each month, they repay only a portion. The other portion becomes a loan, and these “loans” are generally at very high interest rates. Even though interest rates in general now stand at record lows, many credit cards still have annual rates of 18 percent or more.