Financial literacy for teens: Using credit cards wisely

Setting our kids up to manage money successfully can be tricky, because it means helping them find the sweet spot between two unhealthy extremes.

We don’t want our kids to focus on money too much – that is, to be motivated by greed. But we don’t want to see our kids caring about money too little either.

When our teens read in Hebrews 13:5 “Keep your life free from love of money, and be content with what you have . . .” we don’t want our kids to think that “being content” means they can be complacent about how they manage money.

When they’re careless with money or simply clueless about financial matters, a young person’s naivety can quickly get them into trouble. 

For an alarming number of youth, those financial troubles begin with their first credit card.

We see entry-level employees pile up credit card debt they can’t afford to pay off. And students who don’t realize that the dream job they hope to land after university still won’t pay enough to erase the hefty credit card debt they’re accumulating as they earn their degree.

Reality hits home for these debt-burdened youth when they’re turned down for a car loan or their first rental apartment, thanks to a poor credit score. Or when escalating debt forces an earlier-than-expected entry into the working world and plans to serve the Lord in missions must be put on hold, or plans to earn an advanced degree are scuttled.

As parents, we owe it to our kids to ensure they have the financial savvy they’ll need to use a credit card well. Before they’re issued a credit card, our teens need to understand that:

• Credit cards are not free money: a purchase on a credit card is a debt that has to be repaid
• Failing to repay credit card debt in a timely manner can lead to escalating debt that can be difficult to repay
• Poor management of credit card debt can negatively impact their future goals.

Could you use a little help when it comes to educating your teen? The remainder of this article hopes to make the task a little easier for you. It’s written as an explanatory letter that you can alter in any way you wish before you pass it on to your teen.

(The letter is designed as a follow-up to an earlier letter that teaches teens about compound interest and how it can super-size their savings. Ideally, you’ll give your teen the letter on compound interest first, which you can find here.)

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A letter for your teen about using credit cards wisely

Surprise! This is another letter about how to manage your money well!

My earlier letter discussed something that’s fun to think about. That is, how fast your savings can grow in long-term investments, thanks to the power of compound interest.

When interest is working for you and adding free, bonus money to your savings, that’s cool, right? No problem there!

But when you have to pay interest on money that you borrowed, that’s a very different story. Paying that extra money hurts!

Your first real experience with borrowing money will begin when you get your own credit card. You may not think of credit cards as a way of borrowing money, but that is exactly what you are doing when you use a credit card.

Borrowing money is a serious business.

Borrowing money means going into debt. And going into debt usually means you’ll be regularly paying interest for however long it takes to repay all your debt.

So using a credit card is a big responsibility.

Some financial experts even say they wish credit cards came with a warning label attached, much like a pack of cigarettes does. The warning label would say something like, Credit card debt can be hazardous to your financial future. Understand the risks and use this credit card responsibly! 

Let’s dive in and take a look at how credit cards work. As you’ll see, using a credit card calls for a great deal of caution.

How credit cards function

Have you ever asked a friend to buy something for you and promised to pay them back later?

Imagine a scenario like this for a moment:

Suppose you’re entering a movie theatre and then realize you’ve left your wallet at home. So you ask your friend to buy your $15 movie ticket for you.

Your friend says, “Sure, I can buy your ticket for you. But you’ll have to pay me back by Friday. Can you do that?”

“No problem!” you assure your friend.

Your friend hesitates for a moment then says, “Look, you’re a good friend, but I’ve had some bad experiences with friends who have owed me money in the past. Let’s make a deal:

“If you don’t pay me back the $15 for the movie ticket by Friday, every day after that I get to add a little bit extra to what you owe me. I find that gives my friends extra motivation to pay me back quickly.”

That sounds fair to you, so you agree to the deal.

End result: You’ve just borrowed $15 from your friend. And you’ve agreed to pay them interest if you don’t pay them back on time.

That simple scenario is similar to how a credit card works.

A credit card is like a permit to borrow money for things you want to buy.

When you “buy” an item with your credit card, you are borrowing the money (not from a friend, but from the credit card company) to pay for your purchase. And you are promising to pay that money back later.

So when you use your credit card in a store, you’re leaving the store carrying an item you haven’t actually paid for yet. In a sense, all you really handed over for your purchased item was an I.O.U. note – a promise that you will pay back your credit card company.

Once a month the credit card company issues a “statement” showing how much you owe them and the date you need to pay it back by. (You get to decide whether you want your statement mailed out to you, or whether you prefer monthly email reminders to look it up online.)

As in the scenario with your friend above, if you pay back everything that you owe by the due date, your debt is paid and there’s nothing to worry about.

So far, so good.

But if you don’t make the full payment by the due date, every single day after that the credit card company adds a little bit of interest to the amount that you still owe them.

Thinking about the scenario with your movie friend for a moment:

Suppose you got used to borrowing money from your friend. What might happen if you were always borrowing money from your friend for all sorts of purchases? 

It would be easy for you to lose track of how much you owed, and whether you have enough money to pay your friend back on time.

Here’s why you have to be so careful about using a credit card:

When you’re making your credit card purchases at the store (or maybe online), your bank is not checking whether you have enough money saved up somewhere to pay for everything you are charging on your credit card. That responsibility is up to you.

So a credit card works great for people who:

• keep track of what they’re spending each month,
• limit their credit card use to what they can afford to pay back, and
• pay off the full amount they owe on their credit card every month, by the due date. That way there’s no debt left on their credit card, so they don’t pay any interest.

They sound like pretty careful, self-disciplined people, right?

The problem is, lots of people aren’t that careful or disciplined.

As it turns out, many inexperienced credit-card users are terrible at checking whether they can really afford the items they charge on their credit card. 

When the time comes to pay their credit card bill, there’s an unpleasant surprise: they realize they can’t afford to pay the full amount, so they only pay off part of the debt they owe. (Of course, it’s not always mismanagement that leaves someone unable to pay off all their debt; unfortunate situations and unexpected expenses can arise too.)

That’s a tough situation to be in, because then they have to start paying interest on the debt that remains on their credit card. And it’s not just a little bit of interest. It’s loads of interest.

Just how steep is the interest rate? Well, consider this:

When you save money, the very best interest rate (i.e. extra money) you could ever hope to earn on your investments is 10% per year.

But when you owe money on your credit card, you’ll be paying an interest rate of around 20% per year. Those are horrible interest rates!

How credit card debt can pile up

Because the interest rates on money owed to credit card companies is so steep, people who can’t make their full payments each month can find themselves on a fast-track to overwhelming debt – especially if they’re paying interest on several different credit cards at the same time.

Their interest payments can become so high that the money they pay back to the credit card company each month is only covering the interest. They make hardly any progress in paying off the initial amount they borrowed.

Then they’re trapped in a cycle of having to pay money to the credit card company each month – money that gains them nothing.

Let’s take a look at an example, to give you an idea of what happens when you can only make small payments on your debt every month.

In particular, I want to show you what happens if you are misled into making the minimum payment possible each month. (Spoiler alert: Making just the minimum payment is a terrible idea!)

Meet Liam.

Liam recently received his first-ever credit card, and he used his credit card to buy a laptop online. The total price of the laptop, plus taxes, is $2,500. 

When Liam receives his credit card statement several weeks later, Liam learns he must make a payment by December 15, so Liam considers three payment options.

1. Pay off the full amount: If Liam pays the full amount of $2,500 by December 15, he will pay no interest.
   
   
2. Pay off part of the amount: Liam could decide to pay a big chunk, let’s say $1,000, by December 15. But after that date, he will start paying 20% annual interest or about 1.67% in interest each month on the $1,500 that he still owes.
   
   
3. Pay off the minimum amount: Liam is surprised to discover that his statement offers him the option of paying off just a small amount by December 15 – only $50! (That’s equal to 2% of the $2,500 he owes.)
   
    At first, that sounds amazing!
   
    But then Liam realizes that next month he’ll be charged about 1.67% interest on everything he didn’t pay off this month. So next month he’ll owe $2,450 for the laptop + $40.92 in interest = $2,490.92.
   
   There’s something sketchy going on here! Liam thinks to himself.
   
   The credit card company says it’s okay for me to pay them only 2% of my debt each month, which is $50 (the minimum payment). But each month they are charging me another 1.67% in interest, which is about $40.
   
   So each month, only about $10 of the $50 I’m paying is helping to pay off my original debt of $2,500. The rest of the money, (about $40), is interest fees I’m paying to the credit card company!
   
   Liam starts to wonder, At this rate, how long will it take me to pay off my full debt? Liam goes online and finds a credit card minimum payment calculator to do the calculations, and he’s shocked by the results.
   
   If he makes only the minimum payments, it will take him 39 years (470 months) to pay off his laptop and he will have paid over $9,600 in interest! In the long run, his laptop will cost him not $2,500 but $12,100!

Do you see how the interest that’s added on to what you owe each month could keep you making payments for a long time?

When you have a credit card, it’s always best to pay off the full amount that you owe every month, so you’ll pay no interest at all. If you can’t pay the full amount, pay off as much of your monthly bill as you possibly can. That will help make your interest payments smaller.

The very worst idea would be to make just the minimum payment. Minimum payments mean you’ll pay the maximum interest possible and it will take a really long time to pay off what you owe. 

Credit cards and credit scores

If credit cards lead so many people into making steep interest payments, or even into problems with managing debt, should you use one?

It may be that you eventually need to use one to build your borrowing reputation. In the financial world, that’s called your credit score.

Much like your GPA is a snapshot of your academic achievements, your credit score tells others how reliable you are at repaying money you have borrowed.

When you start using your credit card, it will start your track record of borrowing money, and that track record will be what your credit score is based on.

So right from the very beginning, making sure that you are conscientiously paying off your credit card debt each month will be important, because it will give you a good credit score.

On the other hand, you will seriously damage your credit score (and annoy the credit card company too) if you:

• are late in making your credit card payments (i.e. after the due date)
• forget to make your monthly payment
• often pay less than the full amount owing on your credit card
• don’t even review your statements from your credit card company.

Building a good credit score (by managing your credit card well) will be important for your future, because other people will be interested in your credit score.

When you need to borrow larger amounts of money – perhaps to buy a car or to buy your first home – a bank manager will want to check your credit score before they agree to give you the loan. When you apply to rent your first apartment, your prospective landlord will very likely check your credit score too.

A good credit score makes it more likely that your loan request, or rental application, will be approved.

On the other hand, having a poor credit score (or having no credit score attached to your name because you have no borrowing history) will make banks and prospective landlords unsure if they can trust you to repay what you owe them month by month.

To recap: A credit card is your financial proving ground. You’ll want to prove you can repay your debts so others will say “Yes!” when you ask for money or other privileges you’ll need in the future.

The golden rules for credit cards

Credit cards are super convenient and even necessary from time to time for things like online purchases and to establish your credit score. My advice is to always follow these principles:

• Don’t buy anything on a credit card if you don’t already have the money to pay for it.
• Always pay your credit card bill on time every month.
• And always pay off the full amount that you owe on your credit card every month so you won’t have to pay any interest.

As you can see, good personal organization is very important when you have a credit card. You’ll need to keep track of how much you owe and set reminders to ensure you pay your credit card bill on time. I can help you find systems that work for you, if you want, when you begin using a credit card.

One last thing . . . 

When you have a credit card, there’s an ever-present temptation to buy more than you can really afford to pay for. As you look around, you might see others your age seemingly “living the dream” and buying loads of cool stuff on their credit card. But I hope you won’t copy them; accumulating debt does eventually catch up with a person and it destroys their ability to save money for their future.

The words of Proverbs 13:7 seem especially relevant when it comes to credit cards. King Solomon says, “One man pretends to be rich, yet has nothing; another pretends to be poor, yet has great wealth.”

I’d love to see you investing your spare cash so you earn the interest on your savings. That’s so much better than being forced to pay your spare cash to a credit card company because of interest you owe to them!

I’m here for you whenever you’d like to talk about the responsibilities of using a credit card – or anything else, for that matter. 

Love Dad/Mom

Catherine Wilson is an associate editor at Focus on the Family Canada.