The idea that children should be taught responsible borrowing habits and encouraged to build credit histories is fraught with controversy. Some high-profile financial gurus, perhaps most notably Dave Ramsey, preach the gospel of all debt being bad debt. Disciples of Dave proudly flaunt their zero credit scores — the result of not borrowing money for a decade or more — and call into his show to scream their heads off when they become debt-free. In Ramsey’s ideology, debt is nothing more than a trap, and if one cannot afford to pay cash for something, then that person probably does not need it.

The Dave Ramsey doctrine represents an extreme position on the role that responsible borrowing plays in household budgeting. Debt, when used responsibly, allows consumers to put other people’s money to work for them. For this reason, parents should help their children build good credit histories.

Leverage

Financing a major purchase, such as a home, education or even a car, rather than paying cash, frees up cash flow that can be used to make more lucrative investments. For example, borrowers with good credit usually can secure car loans at 3% interest or less. If they know how to use debt responsibly (which, given their good credit, they probably do) and they can earn, say, 10% annually in an investment account, then it makes little sense to pay cash for a car to save 3% in interest when that money could be put toward a much higher return.

Consider a person who buys a Ford Explorer for $30,000, puts 20% down and finances the rest over five years at 3% interest. The buyer’s total interest charges on the financed amount of $24,000 come to $1,875. Assume that the buyer has the money to pay cash but instead puts that $24,000 into a good index fund that averages 10% annual returns. The buyer’s interest income over five years totals $15,487. This is money that the buyer could not have earned by following Dave Ramsey’s advice and paying cash for the car.

To benefit from leverage and arbitrage like the consumer described above, good credit is required. A poor or mediocre credit score precludes the ability to secure a car loan at such a low rate.

Homebuying

As of April 2016, the median sales price for homes in the United States was $232,500. Assuming that one earns the median household income of $52,000 and saves money at the average rate of 5.4%, as of March 2016, it might take decades to pay cash for a home, even assuming that the money saved goes into an interest-bearing account. For the vast majority of American homebuyers, financing the purchase with a mortgage is a necessity.

Fortunately, mortgage rates, like auto loan rates, are extremely low for borrowers with good credit as of 2016. Borrowers with not-so-good credit, however, have found their mortgage search processes fraught with difficulty since the financial crisis of 2008. In the wake of the meltdown, lenders tightened standards significantly to avoid getting burned by defaults again. By teaching their children to build and maintain good credit, parents can prevent them from being excluded as homeowners due to a lack of mortgage availability.

Autonomy

Young people without strong credit histories frequently turn to their parents as cosigners when applying for a loan. Often, this happens right as the parents are planning for retirement. Already scrambling to determine how to live on a reduced income in their post-working years, the parents suddenly find themselves on the hook for a big college or car loan if their 20-year-old cannot keep up the payments. Starting children with a low-limit credit card or store card in high school not only helps them build credit so that they do not need a cosigner later in life, but it also teaches them the responsibility of keeping up with payments and managing debt properly. This way, children are less likely to encounter problems with debt in the future and also less likely to rely on their parents to bail them out later.

Read more: Retirement Planning: Why You Should Help Your Children Build Credit | Investopedia http://www.investopedia.com/articles/retirement/060616/retirement-planning-why-you-should-help-your-children-build-credit.asp#ixzz4AotYoA00
Follow us: Investopedia on Facebook

This is a syndicated post, which originally appeared at rss_articles.https://www.investopedia.com/