How to Explain the Different Kinds of Debt to Your Kids
Kids and money. It’s not always easy to help them learn how to manage it, but education certainly helps! In our last post, we discussed explaining the difference between a debit card and credit card to your child. The post prior to that focused on helping kids understand the concept of a debit card and getting some experience using one.
Debt can seem like a complex topic but, in its most simple form, it means owing someone something, usually money. Sure, that “someone” can be a bank or credit card company (or lots of other types of organizations), and instead of money, perhaps you owe them a candy bar, but the idea is the same.
A visual for kids: Understanding the basic concept of debt
To help children understand debt, a helpful visual can be to sit across the table from your child. Then you can explain that, where money and debt is concerned, there are always two parties:
The Lender
On one side of the table sits the lender. This person (or organization, like a bank) has the money and, if they lend it to the person on the other side of the table, they own the debt. Of course, there are more complex nuances and it can be risky (remember 2008?), but, for now, kids just need to understand that the lender OWNS the debt. This means that they are out that money for the duration that the borrower has it. But it also means that when the borrower pays off their IOU, the lender will make money, because they’ll earn interest (see below).
The Borrower
On the other side of the table sits the borrower. This person needs a certain amount of money and, when they borrow it, they owe that money back to the bank. In addition to the amount they borrow, they also owe the lender a fee called interest, which is the fee the lender charges for letting them use their money for a specified period of time.
As you have this conversation with your child, be sure to encourage questions. The lessons tend to stick a bit better when they’re engaged with the process. Find out:
what they’re interested in,
what they don’t understand, and
what they’re curious to learn more about.
A visual for when you use a credit card: you have an IOU to the bank
Set up chairs as if you were playing the game “musical chairs.” Place a piece of paper on the chairs that says either “owner” or “loaner.” Walk around and each choose a chair. If your chair says LOANER, you are the person with the credit card. When you use your credit card, you are essentially borrowing money for the purchase, which you must pay back, with interest. Because credit cards aren’t required to be paid off in full each month, if you don’t do so, the amount of
money you owe can grow substantially – it’s like a snowball effect – and you may end up owing twice as much as (or more!) than you borrowed.
If you get the chairs that says OWNER, you own the debt, which means you lent the money to the loaner. There is some risk for you, but there is also the potential to make money on the interest you charge, especially if the loaner does not pay his bills in full on time.
Of course, OWNER and LOANER doesn’t only apply to credit cards. It applies to any kind of lending/borrowing situation.
When each of you sit on a chair, one as the loaner and one as the owner, you can use a real-life example to help your child understand the difference. For high-school aged kids, you might use a situation like this one:
Let’s say your child has saved his money and has plenty of it in his bank account. His friend, who really wants to take a girl out on a date, has not. He asks your son to borrow $100 for the date. If your son agrees to the deal, he is the lender, or OWNER of the debt. His friend is the LOANER, or the one borrowing the money.
In that case, your son will have to decide when his friend has to pay him back the $100 and what kind of interest, if any, he wants to charge. It could be a certain amount of money, a bag of his favorite kind of candy, or anything else he specifies. They can also talk about, and write down, what happens if his friend does not pay on time and what extra “interest” your son will get in that situation.
Once your child understands basic idea of debt, and the lender (owner) vs. borrower (loaner), you can talk about the fact that there are several types of debt, each with pros and cons. Here are a few of the most common ones you might discuss:
Credit card: As you’ve already discussed with your child, a credit card can be helpful because it allows it’s nice you to purchase something you don’t have the money for quite yet, like college books. The downside, as we discussed above, is that if you don’t pay your bill in full each month, you’ll pay a very high interest rate and might end up owing much more than you expected.
Car Loan or Lease: Explain to your child that cars can cost quite a bit and that people often don’t have that much liquid cash on hand. Instead of paying for the car all at once, they often pay a smaller amount up front, which is called a “down payment.” Then, they take a loan from the bank and have an IOU, due every month, for several years, that they must pay. The plus side is that when the payments are done, they own the car outright.
Sometimes, people don’t want to put down money up front (the down payment) or they have other reasons for not wanting to purchase a car. Instead, they can lease one, which
means you make a payment every month to drive a car for a specified amount of time, but you don’t actually ever own it. Typically, after 2-3 years, people turn the car in and, at that time, then can decide if they want to buy it or lease a different car.
Student loans: Your kids probably already know that college is expensive and, quite often, students borrow money to pay for part or all of their education. These loans are usually offered at a lower interest rate, depending on if it’s a government or a private loan. The terms can be very different, so you should always carefully read through the terms and understand what type of student loans you qualify for.
Home Loan (Mortgage): Talk to your kids about how you approached buying a home and how a mortgage works. Explain that when they’re ready to buy a house one day, they’ll most likely want to borrow the money from the bank and that you pay the bank every month for 20 or 30 years in order to afford the house. Help them understand that, technically, the bank owns your home until the day you make your last mortgage payment.
As you go through each of these, keep in mind that this is a high-level overview. You just want your child to understand the basic ideas and give him or her the opportunity to ask questions. The more they ask, the more they’re likely to learn and retain.