How Do I Establish Credit For My Child? Understanding Credit And Credit Scores Are The First Step

We’ll teach you how to explain and build your child’s knowledge of credit right from the start

Like many other financial principles, most of us learn little to nothing about credit at an early age, despite its importance later in life. Most of us learn (and make mistakes) as we get older, which is one of the reasons why the average credit score of someone in the U.S. is almost 100 points higher at age 60 vs. age 25!

While there are a lot of things we can cover when it comes to credit (and we will in future posts or courses), we want to start with the basics aimed at helping you give your kid understand the key points.

If they can learn how to handle credit properly from an early age, and you feel comfortable allowing them small access to your credit (we will show you how to do this in a later post), the lessons they learn can give them a big head start for the rest of their lives.

What is credit? How does a credit score work?

A credit score is a number that lenders will use to evaluate how trustworthy you are to repay back the money they choose to lend to you.

There are several types of credit scores, but we are going to focus on your FICO score (as it is the most common score used by most lenders).

Your credit score is a number between 300–850 -- in the eyes of a lender, a higher score is “better” and a lower score is “worse."

Most of us are assigned a credit score once we turn 18 or when we start to apply for things like credit cards or loans. Each of us has at least three different FICO credit scores from the three main credit agencies in the United States: Experian, Equifax, and Transunion.

Each agency uses a slightly different formula to compute scores. Additionally, they may not receive the exact same information on you from lenders (you can call them to find out where they receive their information).

Below, you will see typical score ranges, along with how lenders tend to view each range. For reference, the average score is 700, but this can vary a lot by age

How is a credit score calculated?

Each agency uses five criteria to generate your score. Exactly how important each factor is may vary from one agency to the next:

Payment History (~35% of your FICO Score) This is the most important factor in most cases that determines you score. Credit-reporting agencies review your history of payments on things like credit cards and loans. Making on-time payments on a consistent basis will have a positive effect on your credit score over time.

Amount Owed (~30% of your FICO Score) How much debt do you currently have or how much money do you currently owe to lenders, banks, or other people? The amount of money you currently owe is called your utilization, a fancy term for how much of your available credit you are actually using at any point in time. Owing less money or keeping your utilization low will have a positive effect on your credit score over time.

Credit History Length (~15% of FICO Score) How long have you been borrowing money? For example, did you get your first credit card last week or have you been paying it off reliably for years? Like your payment history, having a longer (positive) credit history is good for your credit score.

Credit Mix (~10% of FICO Score) Your credit mix profiles the types of your debt (i.e., car loans, mortgages, credit cards). Managing a diverse sources of debt well is looked upon more favorably -- it shows that you can reliably juggle multiple responsibilities.

New Credit (~10% of FICO Score) This is the number of debt accounts you have opened recently, along with how may hard credit checks have been recently performed on you. Too many new accounts or hard checks can hurt your score.

Ways to stay on top of your credit score and credit reports?

There are a few free ways that you can stay on top of your credit score whether you are trying to simply monitor changes or know what the current state of the union looks like. Below we highlight a few that we find useful:

Credit Karma — Credit Karma works with Equifax and TransUnion, two of the three major credit bureaus talked to above, to give members access to their credit reports for free. You will also get free personalized offers and recommendations on their profiles to help you think about various financial moves.

Credit Sesame — Credit Sesame works with TransUnion but also credit card and loan options that might be better fits than what you leverage at the moment. Free membership includes $50,000 of identity theft insurance alongside free credit reports which is nice.

Experian — In addition to being able to check your Experian score, Experian provides is something called the Experian Boost, which is a free service that gives consumers credit for paying their phone bills and utility bills. The Experian Boost can raise FICO scores immediately.

Annual Credit Report — If you want more than just your scores and want to see your actual full credit report for all three agencies you can get it here. Remember, you are allowed one free report per year so this will not affect your score.

Ways to explain these concepts to your kids?

Breaking down all of the above to our kids can have tremendous benefits for boosting their understanding of credit and credit scores as well as overall financial literacy.

Below we have a few suggestions for activities or things you can do to drive some of the points above home.

• The next time you pay for an item with your credit card, use it as a teachable moment to explain the process to your kid. If you use a debit card, explain the difference between the credit card (borrowing money from a lender) and the debit card (drawing from money in your bank accounts, without paying interest).

• When you receive your monthly credit card statement and bill, this can be a great opportunity to explain the concept of how credit works to your kid. Talk about the key terms (using our glossary as a resource) and how they relate to that piece of plastic in your hands. Talk about what happens if you don’t make your payments on time and emphasize the responsibility that comes with borrowing money.

• Visiting the bank with your kid is another good idea. Explain how you use a bank and how banks lend money to you for loans or a mortgage. Talk to a teller or member of the bank and have them explain what they do to your kid and how how their job relates to credit.

• Once your child begins to understand the concept of credit from doing one or two of the activities above, you can introduce them to the concept of a credit score. Explain to them that a credit score is like a report card and you are graded on how well you pay people back. Talk to them about how and why a credit score is used for major decisions like buying a house, paying for school tuition, or obtaining a new credit card. You can check your credit score together by contacting your credit card issuer (most allow users to check for free, and as a soft check, your credit will not be negatively affected) or trying one of the services listed above. If you want to access your credit reports, know that you can access one free report per year from each of the three agencies (you can get them above from Annual Credit Report Link). It may be useful to obtain a report from a different agency every four months, rather than using up all of your free reports in one check.

Key terms to discuss with your kids

Credit — the ability to borrow money or access goods or services now with the understanding that you will pay it back later.

Credit Agencies — Companies that assign credit scores. Links to the main three can be found on page 2.

Credit Card — An agreement from the credit card company (lender) to extend you money to buy what you need with a promise that you will pay them back. You must be at least 18 years old to have a credit card.

Credit Inquiry — The process when an institution looks up your score or credit report, such as when you prepare to buy a house.

Credit Score — A number between 300–850 that is meant to symbolize how reliable you are to an institution that is deciding to lend you money.

Credit Report — A comprehensive look into the factors affecting your credit (including your credit score). You are entitled to one report every year from the main agencies.

Creditor — A person or institution that is lending you money.

Debtor — A person or institution that is borrowing money.

Debit Card — An item used to deposit or withdraw money from a bank account.

FICO Score — One type of credit score that is most commonly used by creditors as a factor to determine whether it is prudent to lend money to a debtor.

Hard Inquiry — The process by which a lender contacts the three main credit reporting agencies to check your credit history. This is usually performed prior to their decision to lend you money to determine if you have good or bad credit. A hard inquiry can lower your credit score modestly; multiple hard inquiries performed in a short amount of time can have a negative impact on your score.

Soft Inquiry — A soft credit inquiry allows potential lenders, employers, or insurance companies to review your credit; these reviews are usually not for the purpose of lending you money and rarely affect your credit score. • Utilization -- Your credit utilization refers to how much debt you are borrowing compared to your total capacity. For example, if you have spent $1,000 on your credit card and you have a $5,000 limit on that card, your credit utilization would be 20% ($1,000/$5,000)