Credit cards in the hands of children may sound excessive, but in today’s swipe-happy consumer market, plastic rules.
According to the law, individuals younger than 18 must have the permission of a parent or legal guardian to obtain a credit card — and according to a 2006 study by the JumpStart Coalition for Personal Financial Literacy, 51.6 percent of high school students use credit cards.
Before parents pass the plastic to their kids — whether for emergencies or convenience — it’s important that they understand their options, and the advantages and disadvantages of each.
There are four basic routes that parents can pursue:
• Co-sign for a new credit card in your child’s name.
• Add the child as an authorized user to an existing or new credit card account.
• Get a prepaid card.
• Set up a debit card attached to a checking account, or secured card tied to a savings account.
Co-signing for a credit card
If your goal is to help your child establish credit, co-signing for a credit card in your child’s name is likely your best option. The days of authorized users “piggybacking” on a primary cardholder’s credit history are numbered. Last year, Fair Isaac Corp. established a new model for calculating FICO scores in an effort to stop opportunistic companies from “lending” stellar credit histories to people with poor credit. Under FICO 08, as the new model is called, authorized users will be reported to credit bureaus, but they will not be included in calculating the FICO score, says Fair Isaac Corp. senior consultant Julie Wooding.
“FICO 08 will be available to Experian and TransUnion by May,” she says. “We don’t have a date for Equifax just yet.”
According to Fair Isaac, the FICO calculation model has changed four times since its implementation in the late 1980s. Currently, 91 of the 100 largest banks in the United States refer to the score in their lending transactions.
Michael McAuliffe, president of Family Credit Counseling in Chicago, says co-signing on an account with your child will ensure that junior can build a credit history.
“You can still set the credit limit, closely monitor the account and teach your child the basics of credit card management while he or she establishes credit independently,” McAuliffe says. “However, there are downsides to this option.”
Both parties can build good credit on a co-signed account, but they also can drag each other down. If Junior goes on a spending spree and Mom and Dad aren’t paying attention, everyone’s credit scores are at risk.
“If it’s a joint account, both joint account holders are responsible for the account balance,” says Samuel Wang, Citigroup Global Consumer Group’s vice president of public affairs. “This means that should the account go into default, we can contact all joint account holders to seek payment.”
Adding an authorized user
Tom O’Donnell, a senior vice president for JPMorgan Chase in Wilmington, Delaware, says that most Chase account holders opt to add their children as authorized users on existing or new accounts. In this scenario, the primary account holder is the sole person responsible for payments on the account.
“It’s a great opportunity to educate your child about responsible credit management,” O’Donnell says.
Of course, the flipside is that — similar to a co-signed account — parents expose themselves to a credit risk. If your teenager racks up a big balance or is late in paying, your credit score suffers.
Get a debit or secured card
Debit cards leave credit scores out of the equation altogether because they are tied to a checking account; however, they still teach minors how to organize receipts, track spending and reconcile accounts. It’s a great precursor to using an actual credit card, McAuliffe says, but it’s not without risk.
“Because it’s tied to a checking account, you run the risk of overdraft fees if you don’t closely monitor account activity,” he says. “It may not affect your credit score, but it can be an expensive lesson if the account is mismanaged.”
Secured cards are tied to your child’s savings account, so if a payment is missed, the bank automatically debits the savings account to pay the balance. The upside is that a secured card allows a child to establish credit; the downside is that secured cards often carry high interest rates. If you choose this route, it’s imperative to pay balances in full and never carry a balance. Make sure that the bank is reporting a child’s payment record to the credit bureaus, or it will have no value in establishing credit.
Get a prepaid card
Prepaid or stored-value cards are perhaps the least risky route for parents because they don’t deal with potential overdraft fees, collectors or credit scores. Parents, or other authorized account holders, simply “load” the account with cash and that’s what the child has available to spend. The disadvantage? Banks often charge fees for everything from reloading cards to teller assistance. Also, it can be taxing trying to keep an operating balance on the account.
“It’s more costly to maintain, but if you’re concerned that your child isn’t responsible enough to manage a credit card, this might be a logical first step to prove that they can be financially responsible,” McAuliffe says.
No matter which type of card they choose, parents need to establish ground rules for using plastic and the consequences for breaking those rules.
“Do some math with them to help them understand how compound interest can be their enemy,” McAuliffe says. “Make sure they understand that a bad payment history can haunt them for a long time — affecting their ability to get a car loan, a student loan, an apartment or other major purchases down the road.”