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Helping young people set their “life strategy”
Your “life strategy” is something you should be working on during your twenties, if not before. This means setting and diligently pursuing personal long-term goals for adulthood. What can you do to support yourself now and in your later years? What money-management tactics can help set you on the right course?
This guide is designed to help younger people answer those questions and develop a concrete plan for achieving long-term financial goals, whether that includes owning a house, retiring by age 70, or putting children through college.
Here is an overview of what the guide will cover:
- Managing Expenses and Credit:
- Avoiding Identity Theft and Fraud:
- Calculating Car Costs—and Insurance
- Staying Alive with Insurance Coverage:
- Outsmarting Money Conflicts with your Partner:
- Retirement Planning in One Lesson:
- Making a Home:
1. Managing Expenses and Credit
If you can get into the habit of paying bills promptly, you will see where your money is going each month and avoid spending more than you earn. This allows you to set savings aside for yourself each month. When bills arrive, put them in a designated place. Get in a rhythm, whether that means paying bills at once twice a month or as they come in. When managing your funds available for bill payment, remember that three kinds of transactions affect your checking account: checks you write, ATM withdrawals you make, and debit card transactions you make.
Consider paying bills online, either as a general rule or as a backup. By being able to go online and make a payment that day through your checking account or credit card, you may be able to pay a bill later than usual while still avoiding late fees. Consider setting up automatic payments to put monthly payments on auto-pilot. When you don’t fall behind on payments, you help build your credit score.
By figuring out your preferred style of bill payment, you’re starting to make your own budget. If you’d like to set up a step-by-step budgetary plan, check out the AIER booklet “Sensible Budgeting with the Rubber Budget Account Book” by visiting www.aier.org/bookstore or calling 1-888-528-1216.
There are a number of documents you will need on hand to help you keep track of your financial life. Having organized files will give you a much better chance of handling the random expenses that pop up and help you present a healthy image of your financial health. Hold on to insurance policies you have, including details on what you are paying and what benefits they will provide if needed. Consider storing them in a fire-proof safe at home. Copies of legal or financial documents can be left with a lawyer or in a safe deposit box as backup. For tax purposes, retain hardcopy bank statements, in case of a tax audit, plus the previous seven years of tax returns. You can discard anything older than that, along with routine bills that you have paid, including utility and phone bills and food bills from groceries and restaurant meals.
Temptations: Credit Cards, Debit Cards, ATMs
Credit cards encourage short-sighted behavior and overspending. But they’re also necessary for certain transactions, like renting a car, and when you use a credit card you’re granted legal protections you do not have when you pay with cash or a debit card.
College students with little income often have a simpler time getting a credit card than many other individuals seeking credit for the first time. According to a 2009 study by the Sallie Mae Foundation, 84 percent of college students have a credit card, compared to 67 percent in 1998. These students carried an average $3,173 in debt, excluding student loans. These lingering debts can overpower recent college graduates and set them on a downward spiral of debt.
Perhaps the greatest risk of credit—and one that too many credit card holders have assumed—is the mass of debt that builds quickly with slow repayment. Making the minimum payment each month on a credit card balance will set you on a frustrating financial treadmill. If you paid the 2 percent minimum payment on a $5,000 balance on a credit card with an APR (annual percentage rate) of 11 percent, it would take more than 23 years and $3,979 in interest payments to pay it off. Increase the monthly payment to $250 and the balance would be paid off in 23 months at an interest cost of $549.
Student loans
Recent college graduates are said to carry an average of $29,400 in college debt (not including what may be accrued by those who go on to graduate school). Having a student loan along with credit-card debt can create a mountain of financial obligations just as you are trying to start your career. Here is a framework for handling credit and debit cards so you will not take on more debt than you have to:
Pay as you go. Use your credit card less and use ATMs or debit cards more often for purchases. Reserve your credit card for airplane flights or other big-ticket items, especially where frequent flyer miles or other rewards programs are in play.
Take charge of your checking account. Debit cards provide less consumer protection than credit cards in the event of a disputed payment. Also, if you use your debit card to rent a car or check into a hotel, the business may put a hold on your checking account for more than you end up paying, making your available balance temporarily smaller and increasing the likelihood of overdrafts. Banks want you to overdraw your checking account so they can charge you fees for cushioning you against insufficient-funds penalties. Avoid these problems by making sure that when your checking account is empty, your bank rejects both ATM withdrawals and debit-card payments.
Catch and fix credit card billing errors. Read each monthly credit card statement carefully to catch errors promptly. Keep receipts for items you charge so you can check that they appear correctly on your bill. If you find errors, you have 60 days from the date the bill was mailed to notify the creditor in writing, under the Fair Credit Billing Act. The law also provides that in the case of a lost or stolen card, there is a limit of $50 on the cardholder’s liability for each card used without authorization. Debit cards carry fewer safeguards against theft or abuse.
Why Your Credit Score is Important
If you want to take out a loan to help finance the purchase of a car or home, your FICO score will greatly impact what lenders will offer you. FICO stands for Fair Isaac Corporation, a company that gathers and processes statistical information about your credit history. Fair Isaac is at the top of a three-tiered pyramid of information- gathering agencies: local credit bureaus, three national credit-reporting companies, and Fair Isaac, which grades your ability to repay loans. FICO and other credit scores help determine whether or not you can get a loan and how much that loan will cost. A borrower with a high score will get better rates and lower payments. A FICO score is calculated based on five factors:
Credit payment history (35 percent of the total score): Credit bureau reports assess your record of on-time payment during the previous seven years. Creditors examine how serious, recent, and frequent your late payments have been within that seven-year reporting period.
Level of debt utilization (30 percent): Applicants who have maxed out their credit lines or are close to their credit limits will generally lose points because they are viewed as a higher risk to lenders.
Length of credit history (15 percent): The more years of credit experience you have—meaning taking out loans, having a credit card, or buying on credit—the better you will score.
Number of new credit applications (10 percent): Each time you apply for credit, it gets posted to a credit report as an inquiry. Too many inquiries (four or more in a six-month period) will cost you points on a credit score, since people who apply for credit often have poor repayment records.
A good mix of credit experience (10 percent): Having several major credit cards, as well as installment credit such as a car or student loan, will improve your credit score.
If you handle your finances carefully, you can boost your score. Specifically, pay bills on time and make good on missed payments as soon as possible. Keep credit-card balances low and pay off debt rather than shifting it from one account to another. People with brief credit histories should not open too many accounts right away. Monitor your own credit report. Have several credit cards and several installment loans, and keep current with payments.
You can review your credit reports to monitor for errors that could unfairly lower your FICO score. (Knowing your score can also help motivate you to work toward earning a higher score.) Every 12 months, you can order a free copy of your credit report from each of the three national credit bureaus. If you notice an inaccurate or outdated item on your credit report, you have the right to contest it. Credit bureaus are required to look into your request in a timely manner and report corrections to clean up your record.
2. Avoiding Identity Theft and Fraud
Identity theft is one of the fastest-growing crimes in the United States, victimizing an estimated 16.6 million Americans in 2012. It can occur when your personal information is stolen and used to commit fraud—such as obtaining a credit card, cell-phone account, or worse.
No matter how well you protect your personal information, you are still at risk for identity theft because hackers and other criminals may manage to access computer databases that contain personal information. Unfortunately, it can take days, months, or years before the victims of identity theft learn of the crime. It may occur when something you expect to receive in the mail—like a bill, an account statement from a bank, tax forms or newly ordered checks—fails to arrive. Or, you may receive an unexpected bill for something you never purchased. Similar red flags are unauthorized transactions on your bank statement, rejected loan applications, hostile approaches by the Internal Revenue Service or bill collectors, or unfamiliar accounts listed on your credit reports.
You can take a number of actions to safeguard your information. For one, protect your Social Security number, which is the key to your credit report, bank accounts, and other sensitive information. Ask why someone needs it and what it will be used for before you supply it. Never provide sensitive information over the internet (or phone) unless you were the one to initiate the contact, and then, make sure you’re using a website with a secure server with a URL that begins with https. Use an original password and change it periodically. Check your credit history once a year—you can access your free credit reports at www.annualcreditreport.com. Pay attention to billing cycles and check your account statements so you don’t overlook a missing bill. Finally, tear up pre-screened credit card offers or better yet, call 1-888-5-OPTOUT (1-888-567-8688), a number maintained by the three national credit bureaus for consumers who do not wish to receive such offers.
If you think you have been a victim of identity theft, contact any of the three national credit bureaus to place a fraud alert on your credit report:
Equifax: 1-800-525-6285; www.equifax.com; P.O. Box 740241, Atlanta, GA 30374-0241
Experian: 1-888-397-3742; www.experian.com; P.O. Box 9532, Allen, TX 75013
TransUnion: 1-800-680-7289; www.transunion.com; Fraud Victim Assistance Division, P.O. Box 6790, Fullerton, CA 92834-6790
The Federal Trade Commission offers an ID Theft Affidavit as a simple means of reporting the crime to most parties involved. Request a copy of the form by calling 1-877-438-4338 or visiting www.ftc.gov/bcp/edu/microsites/idtheft.
You can also consult the nonprofit Identity Theft Resource Center for guidance at www.idtheftcenter.org.
How to Avoid Financial Fraud
Fraud is an act of deceit or trickery by one party—the perpetrator—intended to induce another party—the victim—to part with something of value. The scam can be for a small amount of money or many millions of dollars in a high-end investment scheme. As you make your way up the investment ladder, you will receive more and more pitches from people with something to sell—simply because your increasing spending ability makes you a more attractive consumer. Healthy skepticism is always warranted when someone approaches you with a plan that seems too good to be true.
One way to lower your profile as a potential target is to limit your exposure to swindle attempts. Avoid getting telemarketing calls you do not want by contacting the Federal Trade Commission and have your phone number placed on the National Do Not Call Registry (register online at www.donotcall.gov or call 1-888-382-1222). Be wary of offers you receive by mail, as swindlers may use mail to prompt prospective victims to write or call for more information. Do not trust an offer simply because people you respect are involved—the $65 billion Ponzi scheme that Bernard Madoff was charged with running is a good example of how people in affinity groups can be defrauded. Finally, do not trust information you receive via the internet, which is an ideal tool for fraudsters. A scammer can easily—and with relative anonymity—build an impressive and credible-looking website, post a message on a bulletin board, join a chat room discussion, or send spam to reach a wide audience of potential targets. Do not automatically trust what you hear, and make sure you verify any claims before agreeing to an offer.
3. Calculating Car Costs—and Insurance
Next to housing costs, the cost of owning and operating a car—including what you must pay for insurance and gas, maintenance and registration—is the largest monthly and annual expense for many households. According to a 2014 study by the American Automobile Association, it costs $8,876 to own and drive a typical sedan and $11,039 for a four-wheel-drive sport utility vehicle. To keep the costs of a car under control, choose the right vehicle for you from the start and consider the longer-term sacrifices—either yours or your children’s—that may be required.
Knowing the rules of the car-dealer game can save you hundreds of dollars. For example, buyers should know the actual dealer cost of a car versus the sticker price, what profit margin is acceptable to the dealer, the most economical ways to purchase options, what sales tricks to expect, how to avoid dealer add-ons and packages like undercoating, and how to determine a reasonable trade-in amount for your old car. Consult Consumer Reports’ “Annual Auto Issue”, which comes out in April each year, for guidance on these bargaining matters.
The long-term financial aspects of car ownership are just as important as negotiating the sale price and managing the mechanical upkeep of a car. Insurance costs, for example, can make a car a significantly more expensive investment. According to the National Association of Insurance Commissioners, the average car owner spent $815 on auto insurance in 2012. There are three main categories of coverage—liability, collision, and comprehensive.
Liability insurance is legally required for drivers in every state. The amount of coverage required to register a vehicle is often grossly inadequate when you consider the vast sum you may be legally liable for in the event of a serious accident. Mandatory minimums may be as little as $15,000 coverage for death or injury to one person, with a $30,000 aggregate limit. It is advisable to carry bodily injury coverage of at least $100,000 per person and $300,000 per accident. The cost of this insurance varies depending on the locality, the make and model of car insured, the principal use of the vehicle, and the age, gender, and qualification of the driver.
Collision insurance is included in most policies and is usually subject to the deductible, which is the portion of any claim that the owner must before the insurance company pays anything. Coverage for damage incurred in a collision is costly, often accounting for more than half of a driver’s auto insurance premium. Collision coverage can also raise insurance costs sharply for new or luxury cars.
Comprehensive insurance provides protection against the loss of a vehicle through fire, theft, and other hazards (aside from collisions). Insurance companies determine premium cost by assessing the geographical location of the vehicle and the types of accidents that occur there.
For more information about car ownership, refer to AIER’s annually updated publication What Your Car Really Costs.
On a related note, your auto insurance (or even your credit card) may also cover you when you need to rent a car. Check with your insurance agent about what your policy covers, or call your credit card company if it offers an auto insurance benefit. Just make sure that anyone driving the vehicle is authorized to operate it under the terms of your insurance policy or credit card agreement.
4. Staying Alive with Insurance Coverage
Beyond insurance you buy for your car, there are a number of other kinds of insurance you can buy. Medical and disability insurance are critical. The need for other kinds of insurance depends on your circumstances. Here is an overview of what coverage is available so you can determine what is best for you, given the costs:
Life insurance: Does someone near and dear to you rely on your financial support and would this person suffer hardship if, against all odds, you died? If so, you might consider taking out a life insurance policy naming the person as a beneficiary. There are a number of types of life insurance—term, whole, permanent, or universal life. Once you have financial dependents, it is likely in your best interest to buy a term life insurance policy. The premium purchases coverage over a specific period of time, then it is renewable for additional term periods without a medical examination. That is why is makes sense to get coverage earlier in life, before age-related health problems become more likely. Your term-life policy should pay four to 10 times your annual income. If your employer does not offer that level of coverage, shop around to supplement it.
Disability insurance: These benefits are designed to replace your earnings in the event you (or a spouse covered by your plan) are physically unable to work. The coverage is expensive but a worthwhile investment. Without adequate disability insurance, loss of income because of protracted sickness or injury may be financially devastating. You should have coverage equal to 60 percent of your income.
Health insurance: You need health insurance regardless of your age and health status. There are a number of ways to secure coverage, depending on the scenario that applies to you. Five potential scenarios are outlined here: If you have a job, your employer likely provides a health insurance plan. If you’ve just lost your job and your former employer provided health insurance, you can shop the healthcare marketplace (www.healthcare.gov, or if applicable in your location, your state’s healthcare exchange) to search for a plan that meets your needs or continue more-expensive coverage under COBRA (the Consolidated Omnibus Budget Reconciliation Act) for 18 months if you enroll within two months of leaving your job. If you lack employer coverage, perhaps because you are self-employed, you can search the healthcare marketplace ( www.healthcare.gov or your state’s exchange, if applicable, during scheduled open enrollment periods for a plan that meets your medical and financial needs. If you are not working and have dependent children under age 19, you may be able to enroll in CHIPS (the Children’s Health Insurance Program at www.insurekidsnow.gov), which is designed for those who are not eligible for federal Medicaid and have limited or no health coverage. Finally, if you want to remain covered by your parents’ insurance, you are likely able to do so until you reach age 26.
It is possible you may want to purchase insurance beyond coverage offered through your employer. Make sure the insurance company is solid and will be around if you need to file a claim—and that the company will pay a valid claim quickly. Visit A.M. Best Company for financial strength ratings of insurance companies ( www.ambest.com/ratings ) and the Consumer Information Source of the National Association of Insurance Commissioners ( www.naic.org) to research companies’ reputations for paying claims.
5. Outsmarting Money Conflicts with your Partner
Money issues are the No. 1 reason why couples split. As with a business partnership, a marriage’s financial wellbeing depends on the partners’ communication and cooperation. Any couple contemplating marriage needs to have a pre-marital conversation about money matters. What will happen, for example, if one party runs up credit-card debt after the marriage and both parties are responsible for it?
If the two people getting married have sharp contrasts in their financial positions—perhaps due to differences in initial assets, incomes, insurance settlements, or prospects of financial windfall—a legally drafted pre-nuptial agreement may be necessary. People without such assets and with similar incomes and prospects do not need a legally drawn pre-nuptial agreement but they do need a mutually determined understanding about how they will work out money matters.
One practical tactic to help married couples manage their money is creating a house account that designates money as yours, mine, and ours. “Yours” is your spouse’s account, “mine” is your account,” and “ours” is the house account, which covers shared income and expenses. The house account can be used for whatever you both consume together—it could include electricity, heat, water, cable, phone, house repairs, lawn services, and other routine household expenses. For homeowners, this will probably also include property taxes and homeowners’ insurance. Some ambiguous payments can be paid partly by the house account and partly by a supplement paid by one party out of his or her account. Have a collaborative conversation to negotiate where to make those distinctions.
How should a couple finance the house account? Here are two examples, which assume both parties agree on how much is needed in the house account in light of specific expenses:
In a two-paycheck household in which one person has an income of $50,000 a year and the other an income of $30,000, the two parties contribute the same percentage of their incomes to the house account.
In the murkier case of a homemaker, specifically when there are children to be raised, one approach is for the person earning the income to bring that paycheck home and turn it over to the homemaker spouse, who then makes the financial decisions and handles payments and deposits. Some middle ground could work just as well, provided that the homemaker receives a stipend adequate to meet his or her individual expenses.
You will know that the house account needs adjustment if and when its funds cannot cover the cost of house bills. In that case, both parties may need to contribute more, if resources permit, perhaps in the same proportions as before.
6. Retirement Planning in One Lesson
The traditional three pillars of retirement financing—pensions, Social Security, and personal saving—have come to look increasingly shaky as the basis for most Americans’ retirement strategy. Why? The number of workers covered by traditional pensions (called “defined-benefit” plans), paid by an employer after a worker retires, is decreasing. Instead, 401(k) self-financing plans are eclipsing them. Social Security is underfunded, so future retirees will not be able to count on it to cover as much of their expenses as today’s retirees do. Finally, personal savings is becoming increasingly important as life expectancies rise. You will likely live longer than members of generations before you—good news, but a challenge if you have insufficient savings and must work longer than you wish to. Rising medical costs, along with employers’ cutbacks on retiree health benefits, only complicate matters.
Your personal savings plan is the key to whether you will have enough money to see you through your retirement years. Realistically, young people often have to focus on immediate needs like paying student loans, establishing a household and accumulating savings for marriage and raising a family. But whatever you can put aside early will have that much longer to pile up tax-free and grow. Aim for continued, uninterrupted funding of a savings plan in an amount you can reasonably afford. This point is illustrated in the table below:
As traditional pensions become scarcer, the other employer-based retirement program, the 401(k), becomes that much more important. These accounts are known as “defined-contribution” plans and include amounts you (and perhaps your employer) contribute into an investment account each month. The various other types of defined-contribution plans are the 403(b) for nonprofit organizations, 457 plans for state and local government employees, and Roth 401(k) plans, which are paid for with after-tax dollars that you can withdraw after a certain age without being taxed. The retirement benefit of these plans depends on the market value of the account when you retire. Some 70 percent of employees with 401(k) accounts receive matching employer contributions ranging from 25 to 100 percent of what the employee contributes.
There are important advantages to investing in a 401(k)-type plan. By directing your salary dollars to a retirement fund instead of to your paycheck, your earnings are not counted in your taxable income. The investment returns you earn are also tax-deferred. Employers may match your contribution in full or in part—as a result, you can earn a much higher return on your 401(k)-type investment than you could in comparable investments outside of the plan.
If you want to supplement your 401(k) or you don’t have access to one, you may want to open an Individual Retirement Account (IRA). There are several types of plans available, including traditional IRAs, Roth IRAs, SIMPLE and SEP plans, Keoghs, and solo 401(k)s. Each offers distinct tax benefits. Traditional IRAs, which are the most commonly used, offer two important tax advantages: Investment income on an IRA contribution accumulates tax-free until the funds are withdrawn. Your IRA contribution may also be tax-deductible. The maximum allowable contribution in 2015 is $5,500.
Whether you manage your investments on your own or through a financial adviser, aim to avoid exorbitant “management fees” on your various accounts. The fees can range from .5 percent or less to more than 2 percent on your assets per year. If a financial adviser is taking additional fees on top of this, there will be still less in your account at the end of each year to grow at compound interest rates. If you decide to hire a financial adviser, do it with care and research. For clear, objective information on investing, see AIER’s 2010 publication How to Invest Wisely, by Lawrence S. Pratt.
Buying your first home has traditionally served as a milestone on your drive for financial independence. Nevertheless, events in recent years suggest that the long-time prescription on buying a home (“as soon as you can”) no longer applies.
Whatever the state of the economy and whether you rent or buy, you will need some form of insurance to protect against accidents, mishaps or theft. If you purchase a home, homeowner’s insurance covers these risks. It also covers losses of personal property, legal judgments in favor of people injured on your property, living expenses incurred if your residence becomes uninhabitable, and water damage. Umbrella personal-liability coverage may be offered under the homeowner’s policy. Depending on the value of your house, homeowner’s insurance may cost $500 to $2,000 a year, or more. The coverage needs to be sufficient to rebuild the house if needed –it should not equal the market value of the house.
If you rent, you should purchase tenant’s insurance, which provides the same coverage as homeowner’s insurance except for that on the structure itself. List or video record your possessions to support any future claims you might have to make. Inspect the policy and eliminate any conditions that would void the insurance in the event of a claim. A tenant’s policy would cost commensurately less than a homeowner’s policy since your possessions are being insured, not the property.
Are there reliable rules of thumb to consider as to when to makes more sense to buy than to rent? MIT researchers have found a tendency for renters to have greater income growth over the duration of their careers, seemingly because when economic opportunity beckoned, they were free to move, without being tied down to a house when the market plummeted. To stay flexible, this seems to suggest, a person should rent. But if you total up all costs of owning a home (including utilities, taxes, and mortgage payments), you may find it costs about as much to rent as to buy. So the decision comes down to personal preferences. When the time comes for you to think about the choice, you may wish to obtain AIER’s in-depth analysis, Homeowner or Tenant? How to Make a Wise Choice. It provides worksheets and a detailed look at mortgages and financing. (Call 1-888-528-1216 or visit www.aier.org.)
