This is Part III of the guide, Understanding Loans and Credit At Every Stage of Life.
Young adults, whether newly minted college graduates or those who choose not to pursue higher education, are beginning their lives without parental supervision. Establishing good credit (see Part II: Loans and Credit During the College Years), learning to budget and getting into the habit of saving are solid financial goals for this age group.
Buying a car is often the first major purchase for young adults, and for most that means taking out an auto loan. Learning the ins and outs of auto loans, researching your options and buying within your budget can be a good first step toward a lifetime of financially responsible choices.
The allure of a brand-new car is inarguable. However, careful examination of your financial situation and your vehicle needs may lead you to conclude that a used car is a better choice. There are positives and negatives to both choices.
New cars are free of damage and excess mileage. They also are accompanied by manufacturer warranties, so you are assured that you will not have to pay for mechanical problems for years to come. New cars also feature the newest technology, which may equate to lower miles per gallon and exciting features like built-in GPS systems and iPhone integration. Most new car sales also include roadside assistance for a number of years. Perhaps the best part for some is having control over the color, interior material and extra features. Lastly, you need not worry about a dealer’s honesty about the car’s history when buying new.
So why do used cars outsell new cars by 3:1? Used cars are popular choices because a 3-year-old model can cost as much as 40% less than the identical brand-new version. A late-model car that is loaded with features may cost less than its new, bare-bones counterpart. The catch lies in your knowledge of the car’s history. While auto dealers are required to disclose significant accident history, many shady dealers flaunt this legislation and defraud auto buyers. Unless you use a firm like Carfax or Autocheck, which track mileage and accident history by VIN number, you have no way to assess how well the car was maintained, whether the mileage is correct or if the car was wrecked. Most reputable dealers should be able to provide you a copy of the Carfax report on any vehicle, and you may also purchase a Carfax search for one car for under $30. If you do have its history, a used car with low mileage may be a more financially sound choice.
Whether you buy new or used, you may need to take a loan from the auto dealership to purchase your car. There are four elements of a car loan with which you should be familiar.
Example: An auto dealership promotes a 2% APR for qualified buyers. In each case dealer-specified qualifications apply toward establishing an interest amount, and generally a high credit score and a cash down payment will work to your benefit. While you are busily eyeing a $100,000 sports car, the dealer offers you the advertised APR. When your credit has been analyzed, you are offered a loan at 5% interest. In order to accurately assess your extra outlay past the sticker price, you must factor in: fees related to closing and car title, the length of your loan and the principal amount you will borrow. Ultimately, while you will pay 5% simple interest on the principal loan amount, the deal is structured so that your annual cost for the privilege of borrowing this money is 2% per year. Auto dealerships enjoy flexibility in their loan arrangements and can offer low APRs when in fact, the monthly interest payments are higher.
Most people at this age have few financial obligations, it may be tempting to enjoy a surplus of disposable income before you have a family or a mortgage (see Part IV: Loans and Credit Options for New Families). While you definitely should take advantage of the relative freedom in your life, you should not ignore your financial health. Making big mistakes now like amassing credit card debt can be expensive to fix later. Establishing a budget puts you on the road to financial responsibility.
The following percentages provide a rough outline of the best monthly income allocation for young adults.
The figures above do not allow for savings or retirement planning. Depending on your individual situation, you should be able to fine-tune your personal budget and create ways to save money. Financial analysts recommend that you save 10% of your net income every month, though this can be challenging in a struggling economy. It is also a good idea to have 2 to 6 months’ worth of your salary in an easily accessible account in case of emergencies.
While the once-popular practice of offering pensions is almost extinct today, they do exist; 7% of companies still offered them to employees in 2009. A pension is a defined benefit plan wherein your employer invests money in your name into a retirement account. You do not contribute financially to a pension, though most employers required that you work for the company for a number of years before enrollment. If you are lucky enough to have received a pension you will receive a fixed payout from that plan upon your retirement. The amount can be either a lump sum or distributed monthly, and is based on a defined formula that factors how long you worked for the company and your former salary. Pensions are dependable sources of income; the Employee Retirement Income Security Act (ERISA) of 1974 ensures that you will receive the funds as promised.
Because the cost of pension plans is very high for employers, most now offer a defined contribution plan instead. These are most often in the form of 401(k) plans that are administered by your employer. Retirement accounts like this allow you to make pre-tax investments into a retirement account that the company manages for you. Employers commonly offer a matching option and will fully or partially contribute the amount that you invest into their fund with each payroll period. Unlike pension plans, you do have control in how the money is invested with a 401(k) plan. The payout is based on how well your chosen investments have performed. While Roth IRAs are wise choices at any point in life, it is suggested that you divest some of your existing retirement funds to one of these vehicles after age 50.
While 401(k) plans are a very popular tool for retirement savings, there are significant tax implications. You must leave the money intact until age 59.5; if you withdraw funds before then for all but a handful of reasons, you will pay a 10% penalty for each early withdrawal. If you have a large part of your nest egg in a 401(k), that 10% means a hefty fine. While is not required that you carry a minimum balance in one of these plans, remember that withdrawals from 401(k) plans at any age are subject to income tax. Early withdrawals that carry a double tax penalty should only be made in dire emergencies; it is best to leave those funds alone until you need them.
Conditions under which early withdrawals are exempt from the 10% tax penalty include:
The tax limitations to employer-sponsored retirement plans have led to legislation that provides U.S. citizens with another option. A Roth 401(k), commonly known as a Roth IRA, is a retirement investment tool that you use without the help of an employer. You make all of the contributions, and you pay taxes at that time. The money that is invested in the account remains tax-free, so investment returns will never be taxed. Roth 401(k) plans offer more potential cash liquidity than traditional employer-sponsored retirement accounts because you control them. While a 10% tax penalty does exist for early withdrawals similar to a traditional 401(k), there are fewer restrictions. For example, Roth IRAs may be tapped for educational expenses or the purchase of a primary residence.
Both types of defined contribution retirement plans may offer you the option to borrow against the money you are accruing for your retirement. However, 401(k) loans are never considered prudent because you are taking money from yourself that could be better spent generating income via investments. Additionally, you pay income taxes on the loaned amount plus interest on the loan, which costs you more money in the long term.
Continue to Part IV: Loans and Credit Options for New Families.
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