How to Teach Your Children about Debt

Teach Kids About MoneyGenes are important. A mother’s sparkling eyes or a father’s big feet are among the countless traits parents pass to their children.

The same thing can happen with debt.

Though financial habits aren’t inherited, they often are passed along to children with just about as much certainty. Kids often learn how to handle money by watching mon and dad. The lessons can be good or bad, and they can set a pattern for a life.

Teaching kids about money is tremendously important. Children often thrill in taking risks, but you need to help them understand the benefits and pitfalls of risking money, about saving money and about dealing with debt. Parents need to teach children that money is a resource that needs to be carefully tended and deployed wisely.

They also should teach their offspring about borrowing, explaining when it is beneficial and when borrowing too much for the wrong things can be a step toward disaster.

Your children absorb many beliefs and attitudes from you, just as you picked up ideas and attributes from your parents. If, for instance, your parents were careless about spending, used credit and debt poorly, you might be prone to follow their bad example. If, on the other hand, you witnessed financial prudence and responsibility, you’re more likely to handle money well as an adult.

Teaching your kids about money should be as basic to their upbringing as learning what’s right and wrong. Even if you don’t talk directly about financial strategies, the way you relate to money speaks volumes. Do you argue loudly with your spouse over money? Have bill collectors called you at home? Are you visibly stressed out when sitting at your desk paying bills? Remember, children are copiers. They observe and emulate behavior — the good, the bad and the ugly. It doesn’t necessarily mean they will turn out to be like you, but it’s very possible.

Debt Cannot Be Taken Lightly

What does money mean to you? Is it primarily a tool to pay for the basics? Or is it a vehicle for telling the world who you are?  If you can define your relationship to money, you will better understand how you use it.  The better you understand your financial behavior, the easier it will be to teach your kids how to save money.

What are some basic attitudes that you would like to pass on? Well, unless you have unlimited resources and can always buy what you want, you should understand delayed gratification. This idea — that you may have to wait to enjoy something — is a key aspect of dealing with money. We want our kids to understand that not every desire can, or should, be instantly satisfied. Saving for, and working toward, a goal often makes its attainment more pleasing.

There are some things that we want to enjoy before we can afford to pay for them — a house or a college education. We might need to go into debt to get them. You should explain to your kids that sometimes it’s suitable to borrow money. Also, if they are old enough to understand the concept, discuss the difference between good and bad debt.

Good debts are really investments. When you buy a house, you’re both purchasing shelter and gaining an asset that will likely grow in value. Paying down a home loan might take decades, but as the equity grows and the value of the house increases, a house can easily become your most valuable investment. Other purchases do little financially but drain money. Vacations, fine dining and expensive cars might boost your ego but do nothing for your net worth. If you go into debt to get them, they can lead to financial despair.

It’s important that your children learn the difference between good and bad debts. You need to teach children how to save money for big purchases, emergencies and, ultimately, retirement. They need to know that taking on frivolous debts can undermine their life goals.

You also need to tell your kids, in whatever language is most age-appropriate, that a debt is an obligation that cannot be taken lightly. A promise to repay a debt is a serious a matter, and defaulting on a loan of any kind risks grave personal, financial and legal repercussions.  Indeed, a person may be judged by his or her capacity to repay debts in a timely manner.

You can demonstrate the concept of debt with younger children by advancing them small loans for things that they can’t afford but may desire.  For example: 11-year-old Emily’s friend, Sally, is going to the latest tween heartthrob’s concert this weekend. Sally’s mom will take them both if Emily can come up with $20 for the ticket. Emily only has $5 because she spent the rest of her money on a birthday present.

You could loan Emily the $15 and require repayment of $1 a week until the loan is paid off. Missing a payment will entail a penalty of 50 cents each time. In this way, Emily understands why going into debt is sometimes a preferable course of action, but that it is based upon a promise to repay according to a specific timetable, with built-in consequences for default. She also realizes that she will have to trim her expenses in the upcoming weeks if she intends to repay you on schedule — just like you have had to do, when paying off a debt of your own.

Teach Children How to Save

The first step in a child’s financial education often involves a bank account. Young children have piggy banks, but they don’t really understand what all those coins are for. Once they have a bank account, they begin to learn the value of having money available when they need it. More important, a monthly statement that shows a small interest payment is a first lesson in the time-value of money. It tells a child that saving not only creates a reserve for future spending, but puts money to work, generating an income with no effort from the account holder.

As your child’s bank account grows, discuss what it means. Tell your child that financial reserves protect against hardship and give their owner the ability to decide how to spend. Explain the downside of not having money in the bank. Tell your child how borrowing means interest payments to the lender, debt that can prove ruinous is the borrower can’t make payments on time.

When you child begins to master arithmetic, it might be a good time to introduce budgeting. Discuss how your household is really a balance sheet, with money flowing in from employment being divided into pots – one for saving, another to pay a mortgage and a car loan, still others to cover utilities, insurance and home repairs. If money is left over, it becomes discretionary and can be used to eat out or spend a weekend at the beach.

Once you child understands the outlines of your budget, encourage him or her to draw up a budget too. If you give an allowance, tell your child to put some of it in a bank account before using the rest for entertainment. Have the child write budget on paper or on a computer and review it together.

Discuss these concepts as your child is ready for them. In the meantime, encourage routine savings. Even if your child doesn’t fully understand the difference between savings and debt, the act of saving will teach an important lesson. The older you child becomes, the more receptive he or she will be to more complicated financial concepts. As children become teenagers, they’ll be ready to learn about credit.

The Anatomy of Credit

That childhood bank account taught important lessons, and the interest payment was a key one. The next step is explaining how interest flows in two directions – inward when you save, outward when you take a loan or run a balance on a credit card. Explain why lenders charge interest and why the interest rate on credit cards, or unsecured debt, is higher than on a house or car loan, which are backed by collateral.

Kids might not be ready to use a credit card themselves, but they can watch you using them. When the bills come in at the end of the month, you might let them look at your list of purchases. Explain why it’s better to pay off the full balance each month, and explain the penalty (interest charge) for not doing so.

You should also explain the tools lenders use when they make credit decisions. Though you don’t need to delve into the minutiae of how credit scores are derived – lots of adults only vaguely understand that themselves – you can say that paying off monthly balances when they are due is one of the surest paths to a strong credit score.

Finally, explain how all debt has risks. If your life takes a tumble because of a medical emergency, massive car repair or unemployment, even a reasonable debt load can become an unbearable burden. It’s important to understand the risks and build safeguards into a financial plan. Your family should have an emergency fund to cover mortgage and car payments, as well as utilities and food, if you become seriously ill or unemployed. Tell your child about the emergency fund and explain why it shouldn’t be touched when times are good.

Wants and Needs

Hopefully, your household sets a good spending example. If you don’t have the money for a luxury car, and even if you do, buying less expensive transportation can be a wise step. Cars serve a function – moving you from point A to point B – and a $20,000 vehicle can do it just as well as one that costs $40,000.

Talk to your child about that common sense approach. They might ask why your family doesn’t have a Beemer and you can explain that the money saved is going into their college fund instead. The distinction is about want and needs. Many of us would live to drive an exotic car, especially one that would make our friends salivate, but it’s wiser to save for a house or an education. Your child should learn that he or she will need a good education to compete in the world, and that spending her college money on a luxury car would be foolish. A good education is a need, the car is a want, and the difference is crucial.

Teenagers Can Learn Healthy Financial Habits

By the time your kids are teenagers, conversations about money are naturally going to get more involved, more protracted and even more contentious. They are struggling to be mature individuals, but are hamstrung by their inability to be independent financial agents, controlling their own income and expenses. However, they are more than ready to understand the complexities of adult financial life, and if you share aspects of your fiscal existence with them — the details of your mortgage, how your car loan works, the type of investments you have, how you pay your bills each month — you will likely cultivate in them a deeper appreciation of your prudent and careful handling of the family’s assets and liabilities.

By the time they are 18, your kids will receive offers of credit from department stores, oil companies and even banks. Hopefully, you have explained to them how credit cards work and why lenders are so willing to make them available because they make money off interest and fees.

You can help your young adults learn to handle a credit card by having them sign up for a secured credit card of $250 to $500. By paying off the small amount every month, and avoiding interest and late fees, they will learn the basics of owning a credit card without much risk.

You can also help them open a gas or department store credit card, with a low credit limit, provided it is paid off each month. Once they have developed prudent credit card habits, they should be allowed to make larger purchases, provided they understand the costs involved if they get behind in their payments. At some point, especially if they have their own jobs, they will qualify for their own credit accounts, with greater limits on what they can spend.

Another important conversation you will probably have with your older children concerning debt will be about college and student loans. College has never been more expensive, and most families simply cannot afford it without borrowing money. Students need to understand how the different types of education loans vary, in terms of interest and repayment periods, and how they all will require repayment — often over many years.

Knowing how to handle money, credit and debt are necessary skills in order to take full advantage of all a modern, capitalistic society has to offer. How you, as a parent, approach these responsibilities is key to your kids making smart and responsible decisions as they embark upon their own lives as accountable adults.

Bill Fay

Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

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