Part III: Budgeting and Taking Out Loans as a Young Adult

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.

Should I Buy a New or Used Car?

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.

Auto Loans

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.

  • Down payment: Most loans offered by dealerships expect some form of down payment on the loan. Muster the biggest down payment as possible, because this reduces the principal loan amount before taxes and fees. You may use the trade-in value of your old car if it is significant, but you might garner more cash by selling your old car yourself. An auto dealer will accept a trade­-in and a combination of cash; many dealers prefer that you put down at least 10% of the total cost, this percentage is negotiable.
  • Credit score: As discussed in Part I, your credit score is examined nearly every time you borrow money. For auto loans, a FICO score of over 720 is considered excellent and will provide you with competitive interest rates. If your score is less than 650, you are considered a high-risk borrower; if you are offered credit, you will pay higher interest rates for a sub-prime auto loan.
  • Interest rate: Car dealerships often market their product by advertising an annual percentage rate (APR). The APR is the most accurate figure to use when calculating the cost of a loan over a year’s time. This term is commonly confused with the simple interest rate; however, simple interest rates do not include the numerous fees associated with an auto loan. The dealership’s cost of providing you with a loan must be accounted for, and the APR reflects your total cost. Costs calculated into the APR include annualized interest, which equates to the price of a year’s worth of financing; this number differs from simple interest. An APR also reflects participation fees, discount points, loan origination fees, monthly service charges and late fees.

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.

  • Loan terms: Most dealerships offer loans that span 3 to 5 years. If your goal is a lower payment, choose a loan with a longer term. Keep in mind that even though your monthly payments may be more affordable, you pay the lender more interest over time. Short-term loans lower your total cost of purchase significantly. Regardless of terms, you should plan to spend no more than 20% of your monthly net income for a car payment.

Should I Have a Budget?

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.

  • Housing: About 25% of your income should go to rent or a mortgage. More than that puts you at risk of being “house-poor,” living in a beautiful home with no cash flow.
  • Transportation: Spend around 5% to 20% of your income on transportation, be it public transit or a car note. Don’t forget to add in extra costs like fuel, insurance and maintenance on your vehicle.
  • Food: While this is category can easily be manipulated, 15% of your net income is a good baseline rule.
  • Personal care: Include clothing, haircuts and grooming expenses in this category, which should amount to 5% to 10% of your income.
  • Health care: Insurance premiums and co-pays should equal about 10% to 15% of your monthly budget.
  • Loans: Student loan debt and credit card payments should amount to 7% to 15% of your expenses.
  • Utilities: Depending where you live, utilities should cost you another 7% to 15% of your income.
  • Entertainment: While it may seem of utmost importance, your entertainment expenses should be kept to about 1% to 5% of your monthly net.

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.

Retirement Plan Options

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:

  • At your death, when the account is paid out to your designated beneficiary
  • If you are permanently disabled
  • If you quit your job and are over 55
  • If you withdraw for medical expenses; your employer plan will designate an allowable amount
  • If you make substantial monthly payments as defined by your employer
  • If you are required to as part of a divorce settlement

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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