Teach your college-age child to avoid debt pitfalls, control impulse buying and create a clean credit report for life.
You’ve prepared your child for academic success, the SATs, college interviews and even stocked up on dorm-room essentials for move-in day of freshman year. Yet three months in, while visiting during parents’ weekend, you discover a credit-card bill tucked in among the course books on his desk that makes your blood run cold. How does anyone rack up a balance that large in a few months?
Below are some timely and important financial tips to pass along, before small budgeting missteps lead to long-term debt and bad financial habits:
Credit and debt play a major role in almost everyone's financial life. But what do we mean by credit and debt management? What does it mean to be creditworthy?
Credit is not necessarily what people think it is. Most people associate credit with debt, as in the use of credit cards. Credit is really about trust. The word credit comes from the Latin word credere, which means to believe or trust.
Credit in a financial sense means an agreement for a borrower to repay at a later date something that is received now. It usually involves the additional payment of interest which is essentially “the cost” to borrow money. This can vary depending on the type of borrowing, the nature of collateral, if any—a concept I will discuss-- and the creditworthiness of the borrower.
Understanding credit from a young age is a way to understand that with borrowing comes responsibility.
The idea of creditworthiness – the belief that a debt will be repaid in full, in accordance with the terms that were originally agreed to, applies to individuals, companies, and all forms of government. When any person or entity needs to borrow money, the decision to lend, along with the required interest rate, will be based on the analysis of the risk level of the borrower, or in other words, how likely it is the loan will be repaid in full, according to the terms of the loan agreement.
Being creditworthy, or having good credit, allows both the opportunity to borrow money when needed, but also to receive lower interest rates when borrowing. It is important to be able to borrow money for those times when current income or savings is not sufficient to cover the cost of an important expenditure, like a home or a college education or when it otherwise makes financial sense to use borrowed funds rather than one’s own property.
Whether you’re applying for a mortgage, purchasing car insurance, renting a new apartment, arranging for utility services at that apartment or signing up with a new Internet provider, you will inevitably be asked about your credit.
The lender or provider will often look at your credit report. Think of your credit report as your personal financial report card. This report contains extensive information about your past and present loans and debts and includes your credit score. Your credit score ranges from 300 to 850 and tells lenders how risky you are as a borrower. Every time you pay your credit card balance or repay a loan, the transaction is reported to the credit bureaus and counts toward your total score. Lenders use this information when they are deciding whether to lend you money and what interest rate they will offer you.
It is important to understand how your score is calculated. The credit bureaus typically take the following five factors into account: Payment History, Length of your Credit History, Total Open Lines of Credit & Types of Credit Used, your Credit Utilization Ratio (which is the amount of credit you are using divided by the amount of credit available to you), and the Number of Hard Credit Inquiries (which is when a lender checks your credit in response to an application for a credit card or loan application, for example).
Low credit scores may result in higher interest rates and down payments because the lender considers you a "high risk" borrower.
Because of this, it’s important to know your credit score. You can find out your credit score by requesting a credit report from one of the three national credit bureaus online: Experian, Equifax, and TransUnion. We highly recommend that you check your reports frequently for accuracy.
To maintain good credit, it's essential to manage your debt properly. That starts with understanding an important distinction about debt.
On the one hand, you can take on debt to buy something that is likely to be valuable long after the loan is paid and may even help you build wealth. That could be something like a house or a college education. Some kinds of loans also provide deductions that can lower your tax bill.
On the other hand, borrowed money can be used to buy things that don't have lasting value, and the debt itself doesn’t provide any tax benefits. Some examples would be credit card debt, most personal loans, and even car loans. You may want to make an extra effort to minimize or eliminate this kind of debt on what are considered to be depreciating assets.
A very important takeaway about managing debt is to avoid the minimum payment trap for credit card debt
This example shows how a $6,000 bill can turn into a $14,000 burden that can take 20 years to pay off if the borrower makes only minimum payments. The best practice is to pay the entire balance each month or, at least, pay more than the minimum required payment.
Remember, managing your debt well is how you build and maintain good credit. And that, in turn, helps you borrow money when it makes sense to do so.
At Morgan Stanley, our work in Family Governance & Wealth Education, part of Family office Resources, helps families strive to maximize the value of their human capital by driving family wealth education. Please reach out to your Morgan Stanley Financial Advisor to learn more.
Students need to know some of the basics, as well as the fine-print rules, of credit-card responsibilities.
Not-So-Easy Credit
For many college students, the temptation to open a credit card account can be huge. Signing up for a high-interest-rate card—and falling behind on payments—is a major pitfall that many of them don’t see. A 2009 law tightened the requirements for college students to get a card, changing how and where issuers can promote their cards, and to whom. Prior to the Credit Card Accountability Responsibility and Disclosure (CARD) Act, which took effect in 2010, issuers could market cards and offer giveaways, like T-shirts and free food, right on campus.
Students can still get credit cards—and doing so is an important step toward learning how to use these tools to build and maintain their credit. The simplest way is for parents to add them as authorized users to their own accounts. If they wish to open their own account, they’ll need to find a co-signer, if they’re under the age of 21, or prove they have an independent source of income. Some card issuers have specific cards geared toward college students opening their first account.
Maintaining a Clean Credit Transcript
At that point, the student needs to know some of the basics, as well as the fine-print rules, of credit-card responsibilities. You’d be surprised (or not) by how little young consumers know about the rudimentary mechanics of how credit cards work.
Best to start with consequences, like what happens if they’re late or miss a payment, triggering high fees, higher interest rates, and a ding to their still-delicate credit score and report. In fact, a late payment can stay on their credit report for up to seven years1, leaving a mark well past graduation—much like a failed class during freshman year.
And then there’s the cautionary tale of credit card debt, which can take years to pay off. According to a U.S. News & World Report survey, 46% of U.S. college students say they have credit card debt with 27% saying their credit card debt exceeds $2,000.2 Most students would just shrug that off, but that’s because no one has told them that a $2,000 credit card balance with a typical annual rate of 24% (according to Forbes) and a monthly minimum payment of $100 would take more than two years to pay off.3 The interest alone on this debt would be $579 by the end of those two years. Larger amounts at different payment rates and durations can yield even more sobering costs. (Online credit card interest calculators can help quantify the long-lasting effects of carrying even a little card debt.)
Managing a credit card account continuously can teach important spending and budgeting lessons.
Learning Good Money Habits
Once you’ve instilled a little fear, don’t forget to communicate the positive aspects of signing up for a credit card. For one, your child establishes a credit history that, if handled properly, will be a huge boon once they graduate—from credit checks for their first apartment to getting financing for a car- or home-loan.
Managing a credit card account continuously can also teach important spending and budgeting lessons, not the least of which is how to spend within their means. Making timely monthly payments within budgetary bounds can help build discipline, while cutting down on outsized impulse spending, as they come to understand the difference between a need and a want through the impact to their budget at the end of the month. That can be particularly useful for those students who will need to start paying back student loans post-graduation.
To be sure, advice on good money habits may elicit some youthful eye-rolling, but having an open conversation about how to responsibly handle credit, as well as spending and budgeting, can have a lasting impact and leave your young adults with a stronger financial foundation as they transition out of school.
Morgan Stanley’s Spending and Budgeting Tool can make it easier for you to see your complete financial picture. Ask your Financial Advisor for more information.
