Financial Tips for Teens, Part 3 of 3

Published on June 16th, 2016

Financial Tips to Teach Your Teens

Part 3

In part 2 of Financial Tips to Teach Your Teens, it was primarily about credit reports and scores and the components of a credit score.  In this 3rd installment, I am going to discuss and demonstrate why having a clean credit report is so important for a teen that’s just starting to establish credit. 

Why is a clean credit report (or high credit score) important and what’s the best way to build one?  The simplest answer to the first part of the question is money.  Having a clean credit report and high credit score is going to save you a significant amount of money over the course of your lifetime.  After explaining several ways in which your credit score can cost or save you money, I will discuss a way to start establishing credit when you’re just getting started.

Different industries use credit reports and scores in different ways.  Typically, a person’s credit is important when it comes to borrowing, getting insurance, and even renting an apartment or house.  With insurers, they’ll look at a credit report and evaluate it from a risk aversion point of view.  Insurers are in the business of limiting losses.  They want to take in premiums and pay out as little in claims as possible.  They view a person with a poor credit report as someone that is more likely to engage in riskier behavior than someone that has taken the care to build and maintain a good credit file.  Therefore, they will charge higher premium rates for those with poorer credit or they may not even write an insurance policy for that person at all.  Landlords will evaluate a credit report somewhere between the way an insurer and a lender do.  They want to make sure that their tenants can afford to pay their rent and do so on time.  In addition, they want to make sure that their prospective tenants aren’t going to cause a loss by doing damage to their property and/or having to go through the eviction process.

The industry that I’m most familiar with and can speak with the most authority on is the banking/lending industry.  When applying for a loan, the credit report is one of the primary tools used to evaluate the application.  Depending on the lending institution, the credit score may be the deciding factor in what rate you have to pay on your loan and/or if you can get approved for your loan.  When you’re applying for a short term personal loan, the difference in loan rates due to credit scores is fairly minor.  As your need for larger loans grow (vehicle and/or house), the difference in rates due to credit scores becomes a much more significant factor in how much you’re going to have to pay in interest for a loan.

As loan amounts increase for bigger ticket items, the term needed to pay back the loans have to increase as well.  Auto loans are usually 60 months or more and the typical mortgage is 30 years.  As loan terms increase, the time value of money becomes a greater factor in interest costs and that’s where the real costs of having an average or poor credit score come into play. 

I’ll illustrate the concept with a couple of examples.  We’ll start with a $2000 personal loan for 12 month term.  At my credit union, the total difference in interest for someone with the best credit score versus someone with the worst credit score is a total of $91. For a new vehicle loan of $25,000 for 60 months, the total difference in interest for the best score versus our second worst score is $3,461.  We don’t break down our Mortgage rates the same way we do our personal and auto loans, but as a quick example, a 1% difference in rate on a $200,000, 30 year mortgage is approximately $44,000.  As you can see by the examples, there is a very real benefit to keeping your credit report/score as clean/high as possible.

Now that you know how much it can cost to have poor credit or, conversely, the benefit to having excellent credit, how do you go about establishing a good credit report when you’re just starting out?  How do you get credit when you don’t have any and your institution wants to see some sort of track record before they’re willing to lend to you? 

There’s no one specific way that will work for everyone, however I will give an example of a method that was taught to me by one of my college professors.  It does involve finding a financial institution that is willing to work with you.  The idea is that you start small and ask for the smallest loan that the financial institution will write, which will probably be $1000.  You explain to the loan officer that you are trying to establish credit and you want to use the loan funds to secure the loan.  Therefore, when the loan is disbursed, the funds are deposited into a savings account that is held or pledged as security against the loan. The loan term will be 12 months and the interest rate will be very reasonable, since the funds will be secured in your savings account.

The interest paid or finance charges that will be incurred over the course of the 12 monthly payments shouldn’t total more than $15.  The monthly payment should be around $85.  The key to this method is to make sure that you make all 12 payments on time and don’t pay the loan off early.  You want to make sure that each payment gets recorded and posted to your credit file.  The best part of going through this process is that at the end of the year, you’ve saved $1000 that you didn’t have before.  You can then repeat the process one more time, maybe with a higher dollar amount and/or a longer term to continue to feed your credit file good information.  I would wait three to six months before getting the second loan.  Once the second loan is paid off, you will have a good foundation to be able to get the credit you need for your future needs.  Try to stay away from opening too many credit cards and carrying balances on them.  One or two cards can successfully be used to continue building up your file.  Just make sure to pay the cards in full every month.

I hope that the information in the last three columns has been useful.  If you have any questions, comments or requests for future column topics, please email them to david.lukas@leydencu.org.

 


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