Understanding how to use and manage debt wisely is critical to financial well-being. Starting conversations around loans and credit early on will help to instill healthy money habits.
Start by discussing what a loan is and how loans work, but keep it simple:
- A loan is when a person borrows from another person or a bank with a promise to pay it back.
- Usually, you have to pay it back in a certain amount of time and you have to pay what you owe plus a little more. For example, a person might borrow a $100, but may have to pay back $105.
- This additional amount of $5 is called “interest”, and it is the cost of borrowing the money.
Next explain the purpose of a loan:
- People borrow money when they do not have enough money for something they need or want.
- If a person does not have enough money, they can choose to save until they have enough or they can try to borrow the money.
- A lot of times a loan is useful for larger purchases: a car, a home, or a college education.
- Other times it can be used for everyday or unexpected expenses.
You may want to emphasize that it is better to take out loans for things that will have a value versus using a loan for things they will consume.
Have a thoughtful conversation around borrowing by using an everyday life example:
- Borrowing a book from a library
- Borrowing a sibling’s toy or clothes
- Borrowing a pencil from a friend
Discuss the expectations around borrowing including giving it back within a certain amount of time, taking care of the item and returning it in good condition, and the consequences if the item is not returned.
Discuss the responsibilities of borrowing money including how:
- The extra interest makes everything cost more.
- Taking on too much debt can be stressful if they are unable to repay it.
- If they do not pay it back, they may not be able to get another loan.
- They should not take out loans if it is unnecessary.
- They should avoid making large purchases that they cannot afford (and the importance of living within/below their means).
Create an opportunity to practice how to manage debt.
Next time your child expresses a desire to purchase something but does not have enough money, consider extending them a loan. Alternatively, after this conversation, let them know that the next time they do not have enough money, you are willing to lend them a certain amount by giving them a line of credit. It should be an amount that can be repaid in a few months and that is affordable. For example, allow them to borrow up to $10 with a $1 interest. However, charging interest is optional.
Pre-determine a repayment schedule. Try to make the math easy, so in the example above, require a repayment over a 10 month period which would be $1.10 per month.
If your child misses a payment, be sure to remind them. If they do not pay assess a penalty. If they continue nonpayment, reduce or stop their allowance to ‘foreclose’ on the loan. Help them understand the consequences. Specifically, that you probably will not give them another loan.
Create a simple loan document and have it signed and dated.
I, (child’s name), can borrow up to $10. I promise to repay the amount borrowed of $10 plus interest of $1. The amount will be repaid over a minimum of 10 months and will be due on the 1st day of each month. Any late payments will cost an additional 50 cents per month until payment is made. If the loan payments are not made for 3 months, then the borrower can reduce or stop allowance until the debt is repaid in full.
It is suggested that making your child repay with cash versus deducting from their allowance or earnings will help them experience the transacting of the payment and will be more meaningful.
Additionally, if they do repay timely and responsibly, be sure to find a way to reward them such as extending a slightly larger loan next time, returning the interest, or charging less interest in the future.
Creating a safe training ground for learning how loans work and the rewards and consequences will help them to use loans effectively in the future. It will also shape their attitudes towards debt.