Building strong credit as a teenager can help pave the way for long-term financial success. Here’s what teenagers need to know.
One of the easiest ways people can ensure their long-term financial success is by building their credit score when they are young. But what is a credit score, and why is it so important?
An individual’s credit score is determined based on their credit reports, and it indicates your credit behavior, such as how likely you are to pay a loan back on time. This is extremely important, and unfortunately, poor financial decisions at a young age will require an indescribable amount of effort to overcome in your later years.
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The Importance of Strong Credit
To illustrate the importance of a credit score, let’s break down how your score impacts future mortgage interest rates. When determining your mortgage rate, lenders account for factors in your control and those that are not. However, the most significant factor is credit score.
The lowest mortgage rates go to borrowers with credit scores of 740 or higher because lenders have confidence that these people will pay them back promptly. On the flip side, people with a credit score below 620 pay high interest rates and have few options in choosing where to borrow money from. If you still aren’t convinced, let’s look at the numbers:
Credit Score = 740
- National Average Mortgage APR = 6.97% (As of September 2023)
- Monthly Payment on a $400,000 house on a 30-year mortgage, assuming a 20% down payment of $80,000 = $2122.52
- Over 30 years, an individual is paying $764,107.20 –a lot more than the loan amount of $320,000
Credit Score = 620
- National Average Mortgage APR = 8.34% (As of September 2023)
- Monthly Payment on a $400,000 house on a30-year mortgage, assuming a 20% down payment of $80,000 = $2424.33
- Over 30 years, an individual is paying $872,398.80 – A LOT more than the loan amount of $320,000
Although it is important to note that interest rates are the highest in a decade, the discrepancy between a high and low credit score is evident. How can we teenagers ensure that we are free from paying thousands of dollars extra in the future? The answer: building credit.
What Steps Can a Teenager Take to Build Credit?
The easiest way to build credit as a teenager is via a credit card. However, for a parent, giving a credit card to their child brings new worries. So, how can you convince your parents that a credit card is beneficial? Not only can credit cards help enhance young adults’ financial responsibility, but they also can positively impact their credit score long term.
Having a parent supervise their teenager with a credit card teaches them about financial responsibility, such as paying back bills on time and tracking expenditures. It is essential to start this as early as possible because as soon as a teenager is 18 and in college, they will be bombarded with numerous credit card offers. Having a safe environment to start your journey with a credit card will be paramount to your credit success in the future.
Step #1: Allowance/Debit Card
Julie Higgins, a relationship manager at City National Bank, claims that children should start with the basics before using credit cards. They can do this with a cash allowance so children can become aware of their expenses and learn the fundamentals of budgeting. Eventually, parents can open a debit card for their children to cap their spending but still make teenagers familiar with using plastic for purchases. A debit card has additional advantages because it allows children to check their bank balance and understand how much daily expenses such as a Starbucks drink cost.
Step #2: Authorized User
Now that you have achieved foundational financial literacy skills, such as budgeting through allowances or debit cards, it is time to earn a credit card. However, you must realize that a credit card is not “free money.” Instead, it must be paid back at the end of each month. If you fail to pay your monthly bill, you will face the principal amount plus high interest rates. Therefore, it is essential that you only put purchases on your credit card so that you are confident you can pay off in full. To ensure a safe spending environment, it is ideal if your parents set up a credit limit and that they review your statement with you at the end of the month.
Unfortunately, if you are under 18, opening a credit card in your name is prohibited. However, this obstacle can be easily overcome by having your parents add you as an authorized user on their account. This process is relatively straightforward, and your parents can do this by contacting their bank or card issuer by calling the phone number on the back of their credit card. To become an authorized user, ensure your parents have crucial information such as your date of birth, social security number, etc. Being an authorized user will build your credit history because the payment history ties to your name.
Besides credit cards enabling you to build a credit history and learn more about financial literacy, they have other advantages like spending rewards. Many credit cards have a reward system, so when the credit card completes a transaction, you may receive a certain amount of points or a small percentage of cashback. Credit card points and rewards can quickly build up; soon, you may even be able to use them to take your dream vacation!
Step #3: Finding Your Credit Card
Once you are 18, you can open a credit card in your name! However, when you reach that pivotal age, credit card companies are likely bombarding you with offers. They do this with the hope they can turn a profit because you did not repay the credit on time. A great first credit card is typically a secured or student card.
Secured credit cards are powerful because they minimize the risk if you fall behind on your bills. However, you must give the credit card company a refundable security deposit, which will set your credit limit. Essentially, secured credit cards prohibit users from spending money they do not have. A common misconception is that users become trapped in an account at the risk of losing their original deposit. Luckily, this is not true because the deposits are refundable. The biggest downside to secured credit cards is their high fees, but there are viable solutions catered to your needs.
Student credit cards are unsecured (no security deposit required), but you are only eligible if you attend postsecondary education. These cards often have no annual fees and great rewards, but you will probably start with a low credit limit.
Choosing Your First Credit Card to Build Credit As a Teenager
Once you narrow down your list of potential credit cards, it is essential to remember the following before making your ultimate choice: credit card fees, interest rates, and rewards. Some cards have annual or monthly fees required to retain your status as a cardholder. Furthermore, there are foreign transaction fees, late fees, etc. Ensuring a safe interest rate is vital to your financial health because you want the lowest interest in the case of a late payment. This issue is avoidable if you pay your balance in full at the end of each month. Lastly, cards can offer rewards such as cashback, which can save you money in the future!
If you still need help, Nerd Wallet has a comprehensive list of potential first credit cards here!
For more personal finance tips, visit our Teen Financial Insights page.