The concept of borrowing money on credit is a daunting one to explain to young people. Most adults tend to avoid or put it off because it can get complicated. But did you know it’s the number one financial topic teens want to learn about?
Teaching your teen about credit is a long, patient process, but parents shouldn’t feel they need to explain everything at once. No need to explain the minutiae of credit scores, mortgage loans, and credit cards all in one conversation. Start with the basics and give them opportunities to explore the simpler elements before moving onto more complex ideas. Here are some basic credit concepts to start with.
What Credit Is
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 is a borrower and a lender. The money borrowed is repaid in regular payments (usually monthly) over time. The loan term is the amount time a lender agrees for the loan to be repaid. It's important to always remember that 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 terms require 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 which 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 that 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, 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 of 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 documentation required to qualify for traditional bank loans. Examples include payday loans, cash advance loans, rent-to-own contracts, pawn loans, title loans, 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.
VIDEO: What Is Credit?
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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.
Credit Basics, Take Charge Today, August 2019