Teaching Kids About Debt: Understanding Borrowing and Interest Rates
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One of the most valuable gifts you can give to your children costs you nothing but your time and guidance – financial literacy. Explaining things like debt, borrowing and interest rates to your children at an early age won’t necessarily equip them with the knowledge to make a lot of money. What it will do is instill in them a cautious respect for both the pitfalls and potential benefits of borrowing, helping them avoid ending up on the wrong side of crippling debt and compounding interest.
Far too many people fall victim to high-interest loans and credit card debt early in life. This is largely due to aggressive, arguably predatory advertising by credit card companies and lenders who intentionally push easy credit access on young adults who were never taught about the dangers of debt by their parents or in school.
Your children or grandchildren don’t need to learn about debt and interest the hard way. Use opportunities in everyday life during their formative years to introduce the concepts and instill in them an appreciation and understanding of credit and loans.
The Basics: Explaining Debt
Debt isn’t an inherently difficult concept to grasp. One party owes a sum of money, the borrower, to another party, the lender. It arises when the borrower receives money from the lender and promises to repay it, typically with some form of interest.
Explaining the Appropriate Reasons to Borrow Money
One of the most common mistakes made by young adults with their first credit card is high interest borrowing to finance the purchase of unnecessary luxury goods. Fancy clothes, car modifications, the latest and greatest smartphone or vacations with friends may provide temporary happiness and fulfillment, but the fleeting dopamine rush is inevitably outweighed by the years of poor credit and the burden of trying to pay back ever-compounding interest.
Explaining to your children in their early years the more appropriate reasons for assuming debt can be particularly valuable.
You may find spontaneous situations in which these topics will come up in conversation, like if they ask what you’re doing when you’re reviewing your credit card statement or making your monthly mortgage payment. Some safely appropriate borrowing causes to teach include:
Purchasing a home
Explaining the basics of mortgages and home loans is often a good idea when a child is in their tween or teen years and have the capacity to grasp the idea and can look forward to the independence and freedom of future homeownership.
Education
Student loans to pay for college expenses, especially when that investment in a young adult’s future will pay dividends via higher salaries or fulfilling work.
Emergencies
Unexpected events, like medical emergencies or car repairs, often justify guilt-free borrowing.
Sustainable living expenses – Young people don’t intuitively understand how to build credit. One of the most reliable ways for a young person with no credit to earn good credit and eventually qualify for auto loans or mortgages with advantageous interest rates is to qualify for a credit card and use it to pay for everyday expenses. Just be sure to emphasize responsible credit card use, like not living beyond one’s means and paying off the balance each month.
Demonstrating Interest Rates with a Simple Activity
The next time your child asks for a toy, consider lending them the money instead of saying no.
Lend them $20 to buy a toy
Tell them you’re charging 25 percent interest per month and that they’ll owe you $25 one month from now
If they don’t have the money a month later, tell them they’ll owe $30 next month, and so on
Ask them how they feel about having to pay back more than they borrowed and discuss the benefits and risks of borrowing money
Whether you actually keep charging 25 percent interest to your kid if they fail to pay you back for several months is up to you, but it is a straightforward way to demonstrate borrowing and interest. Incorporating penalties or fees for late payments into your real-world example, especially when the consequences are very low risk, may be a good idea.
Good Debt Versus. Bad Debt
While it’s good for young people to approach debt with caution, it’s not necessarily beneficial to instill a sense of abject terror. Be sure to explain that not all debts are bad. Borrowing money for education or a home can be considered good debt because they can lead to positive outcomes in the future. However, borrowing for frivolous reasons, or without a plan to repay, should be discouraged.
Cultivating a Habit of Saving
Before delving into borrowing, introduce kids to the importance of saving. Having savings can reduce the need to borrow, providing a financial safety cushion.
Free Online Resources
Unsurprisingly, hundreds of thousands of parents and grandparents have sought engaging and creative ways to instill these important financial lessons in their children at an early age. This has led to a small but active cottage industry of financial literacy tools for children.
There are a handful of financial podcasts aimed at a young audience, including Million Bazillion and Money With Mak & G, as well as gamified apps like Savings Spree that encourage wealth generation via saving and delayed gratification. Many banks and credit unions also offer financial education resources aimed at children, like handsonbanking.org, a public service funded by Wells Fargo.
There are even some unexpected entrants into the financial learning game, like the educational comic books published by the Federal Reserve of New York.
Providing Advanced Guidance to Retirement Savers in Phoenix
Introducing kids to the concepts of debt, borrowing and interest rates is not just a financial lesson, but a life skill. The retirement savers and investors we work with come to us with a diverse array of financial literacy levels, ranging from expert day traders to people with only a basic understanding of retirement savings.
Our retirement planners and financial advisors can provide exceptional advice and guidance to people of all levels of financial literacy and understanding. Call us today at (623) 974-0300 to learn more about how we can help you.