My 19 year old went to the bank and they convinced him to apply for a student Visa card. He is a full-time student, has a job and pays his own cell phone bill. Isn’t that enough? Are there other ways for young people to establish credit?
Fire can be both useful and devastating. Used responsibly, it can heat your home and cook your meals. Used irresponsibly, it can burn you and destroy the things you hold most dear. Credit can be viewed the same way: very useful and potentially devastating.
I’m not going to try to teach my two-year-old how to use credit responsibly, but it will definitely be on the curriculum by the time she’s in her late teens. Now is the time for your son to learn about credit, for exactly the reason you mention: establishing a credit history. Having a great credit score will allow him to get the best interest rates possible when he needs to borrow down the line, for a car purchase or a mortgage for example.
What goes into a credit score?
Unfortunately, having a job and paying his own cell phone bill isn’t enough to establish great credit. He has to prove to potential lenders that he knows how to use it. His credit score will be calculated based mainly on these four things:
- Payment history: He needs to show that he pays off his debts consistently and on time. Without a credit card or line of credit he won’t establish a payment history.
- Outstanding debt: Lenders are worried about how leveraged he is. He will want to keep his outstanding debt below 50% of his total credit limit—this is called utilization. So if his student Visa card has a limit of $500, your son wouldn’t want the outstanding balance to be over $250, even if he’s making the minimum payments every month.
- Length of credit history: The longer the history the better and this is one reason to start establishing credit now instead of waiting until he is 25 years old. It is also the reason why, when he’s older, he should keep open the credit card he’s had the longest, even if he has moved most of his purchases to another card.
- Recent inquiries: Lenders get worried when there is a sudden surge in credit inquiries and applications. If your son gets a student Visa from the bank, recommend that he stop there. When I was his age I made the mistake of being drawn in by retailers offering fancy, free pens if you signed up for their store card. What on earth was so appealing about a free pen, I’ll never know, but it lead to a bunch of inquiries on my credit, as well as too many cards in my wallet.
How do you encourage good credit habits?
If your son does decide to get a credit card, here are some ideas on how to establish good habits from the get go.
- Help you son set up an automatic withdrawal to pay off the card off in full every month. Starting this way will encourage him to keep his eye on the outstanding balance and make sure he has the money to pay the amount that’s owed in full.
- Teach him to use to use the card sparingly. You might even encourage him not to carry it around in his wallet, so he isn’t tempted to use it. You want him to stop and think before he spends, a much more difficult thing to do if that gleaming piece of plastic is poking out at him all the time.
- Walk him through the math on interest charges. Even adults with lots of credit history can be oblivious to how much interest they are paying on outstanding balances. Give him some examples of how much he’ll be paying if he doesn’t pay off the card in full, money that he could instead be using for what he really, really wants.
- Take time to review the bill together every month. Your teen will likely roll his eyes—what teen doesn’t—but a little bit of supervision in those first few months can make a big difference as good habits are forming.
Is co-signing another ways to establish credit?
Parents can co-sign on a line of credit or a credit card for their teen. Clifton O’Neal with the credit-reporting agency TransUnion, says being a co-signer on a card will help the teen establish positive credit if a good payment history on the card is maintained each and every month. He adds that either a gas card or store-branded cards are good ones to start with.
But the plan comes with some risk for the co-signer. If the teen doesn’t make the payment, the co-signer’s credit score will likely take a hit. The parent-teen dynamic can be complicated enough with adding this into the mix. If your teen has reached the age of majority, he shouldn’t need a co-signer anyway, and there are a number of card options that have no requirement for income.
Managing your credit. Not playing with fire.
A two-year-old cannot be counted on for using fire responsibly. That is why you keep the matches out of arms reach. But you should be able to count on a 19 year old. And you should be able to count on him to use credit responsibly, too. Talk to your son and between the two of you determine if he is ready to get started practicing one of the most important financial lessons he’ll ever learn.