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Dear Gary,
My 20 year old son will soon need to buy a car but he has no credit. What's the best way for him to establish credit? I don't know of any stores that will let him pay off a purchase without first checking his credit. Are there still credit cards that will let him put some money on hold in order to back any purchases he might make? How do I find them?
Margie
Margie's son is about to take one of the big steps to adulthood - establishing credit. And it's important that he get off to a good start. The record that he builds now will follow him throughout his life. And it will effect how much he pays when he borrows money.
A good first step is to open a checking or savings account. It's an easy way to demonstrate that he's able to handle money responsibly. Just making regular transactions without overdrawing the account will begin to build a good record.
The next step is to get a credit card. To qualify he'll need to be 18 years old and have either a steady source of income or a savings account. It's easiest to qualify for a department store or gasoline card.
If you're a full-time student you won't need to prove your income to qualify for a card with a low credit limit. Most card issuers are anxious to sign up college students. Even for major credit cards.
Ironically, it's harder to get a first credit card after graduation. The card issuers figure that parents will bail out students but not grads.
Margie's son shouldn't apply for a bunch of cards. That will hurt his credit rating. It's much better to get one card and pay it faithfully for a year. Then apply for a second card. That will demonstrate that he's managing his credit responsibly.
First time cardholders will not get the lowest rates. But if he pays the entire balance each month it won't make any difference. And paying bills on time is very important.
If Margie's son has trouble getting a card, he'll need to use the strategy that she mentioned and apply for a "secured card" first. Money is deposited with a bank which acts as security for your card. If you don't pay the bill, your money will be taken from the bank account.
There's enough competition now so that you can find a number of secured cards that don't require an application fee. Rates run from about 10% to 20% and annual fees range between $18 and $45. Margie's son can ask his bank or check out Bankrate Monitor to find a card issuer.
If you use a secured card properly it's possible that you'll get a better reception on a non-secured card after 12 to 18 months.
Margie's son needs to manage his use of the cards. The best (and cheapest) plan is to pay the entire bill each month and not carry a balance. Unfortunately, that's not what most first time cardholders do.
Experts say that monthly installment debt should not total more than 20% of your monthly take home pay. Even that level could be too high. For instance, that much money committed to installment debt could make it very hard to afford a house later.
Now we move on to the specific goal that Margie had - a car loan. It's likely that there won't be enough time for her son to build up a good credit history before he wants the car. He should apply for a loan at the bank or credit union where he keeps his checking or savings account. Hopefully his reputation there is good.
It's also possible that he'll be able to arrange credit through the dealer where he buys his car. Sometimes they'll make loans trying to attract younger buyers for their brand of car. If he does go through the dealer he'll probably pay a higher rate of interest.
Finally, if no one will give him a car loan, he can get a co-signer. Margie could agree to be responsible if he defaults on the loan. But that's a step that should only be taken after careful thought. Remember, the banks are saying that he's not a good credit risk. When you co-sign a loan, in effect you're saying that you know more than the bank. And you're willing to put your own money behind your beliefs. If anything happens she'd be responsible to make the payments.
Now that we've seen how Margie's son can establish credit, let's ask a different question. Is a car loan really the best way to go? Is it wise to borrow to buy a car?
Just to illustrate, let's assume that Margie's son borrows $10,000 to buy the car. He takes out a 4 year loan at the current rate of 8.8%. He'll be paying $347.90 per month or a total of $11,947 in payments. In effect, he's paid 20% more for the car than if he had paid cash.
And, he's created a pattern that could last a lifetime. If he's making car payments it will be hard to save up for his second car. So he'll be borrowing again. And again with the third. It's as if he's agreed to pay 20% more for every car he buys as long as he lives.
Sure, he probably can't afford to pay cash for the car he wants now. But by sacrificing with a cheaper, affordable car now, he could save himself tens of thousands of dollars over the years.
Pay Me First
The Dollar Stretcher
by Gary Foreman
I have a 30 year loan on my townhouse with 7% interest. I paid $75,500 and three years later I owe $73,000. My only other debt is a 6 year new car loan with 12.6% interest. I paid 23,770 and have not made my first payment yet.
If I have extra money each month to pay towards one of these debts, say $400, which one should it go to? Things to factor in: property values seem to have dropped the value of my house by about $10,000. I might live there forever but I might sell it in a couple of years even if I take a loss. What is the best thing for me to do and how much money would it save? I tried to calculate everything but ended up over my head with numbers. I am only 27 and have money currently going into retirement and investments. I want to get all of my debt paid off.
Thank You!!
Christine K.
Christine asks a good question. When there's some extra money at the end of the month, which debt should be paid off first. When you start to factor in home prices and possible moves, it can be confusing.
There's probably no one universal 'right' answer. With this type of question you can always come up with some unlikely situation that would favor one answer over another. We'll deal with the possibilities that are most likely to occur.
Let's take a look at the home mortgage. With a 30 year, 7% mortgage, Christine will be paying off between $60 and $70 principal each month. As time goes on the interest payment drops and the amount applied to principal increases a little. With 27 years to go on the mortgage she won't have a mortgage burning party until 2028. And she would have paid over $105,000 in interest over the whole life of the loan. So she'll make $180,000 in payments to pay for her $75,000 home.
What happens if she puts that $400 each month towards the mortgage. She'll have the mortgage paid off much sooner. In fact, it will only take ten years to have her home free and clear. And she'll reduce her interest expense to only $28,000. A significant difference.
Next, let's look at the car loan. As Christine said, it's a 6 year loan. Payments should be about $475 each month. Of that, about $225 is going to principal now. And, just like the home mortgage, each month a little more of her payment goes to reduce the loan balance.
If she doesn't prepay the loan she'll pay a total of $10,000 in interest. So the car will actually cost her a little less than $34,000. If Christine adds $400 to each car payment, she'll have the loan paid off in less than 3 years and reduce the amount of interest paid to $4,400.
So which is the better deal? Under most common circumstances she'll come out ahead by paying off the loan with the highest interest rate first. How do we know? Let's create a test. We'll see what Christine's debts will look like in two years under each strategy.
Begin with a scenario where she doesn't prepay anything. In two years she'll still owe $17,730 on her car and $73,910 on her home. Or a total of $91,640 in debts.
Now, let's suppose she used the $400 each month to prepay her mortgage. In that case two years from now she still owe $17,730 on her car. But her mortgage balance would be reduced to $63,638. So the total owed would be $81,368.
OK, so what happens if she applies the extra $400 to her car note? Then she'd still owe $73,910 on her home, but her auto loan would show a balance of $6,877 for a total debt of $80,787.
So she's $581 ahead by putting the extra money on her car loan. The longer she does that the bigger the difference.
There's one other advantage to paying off the car loan first. If she doesn't prepay it she'll almost certainly be 'upside down' in the car for years to come. So if she needed to sell it in a couple of years she'd actually have to pay to get someone to take over her payments.
What happens if Christine sells her home in a couple of years? Or if it's value decreases? Most likely, nothing. The only time she would have a problem is if she wanted to sell the home and it's value was less than the balance of her mortgage. And while that's possible, it's not too probable. Especially if her down payment was 10% or more.
But doesn't she lose the advantage of prepaying if she sells? No. When she sells her home she'll have to pay off the mortgage. So any prepayments that reduce the balance of the mortgage will increase the size of the check she would get when she sells. So she wouldn't lose anything.
One warning for Christine or anyone else making principal repayments. Make sure that any prepayment is applied to principal. Some lenders have a nasty tendency of applying extra money to your next month's payment. And that will drastically reduce the effectiveness of any prepayment.
A final comment. The same process could be used if Christine had credit card debts. Barring really unusual circumstances, it's always best to pay off the highest interest debt first.
Gary Foreman is a former financial planner who has published "The Dollar Stretcher."
Reducing Your Mortgage
The Dollar Stretcher
by Gary Foreman
Dear Dollar Stretcher,
I once heard that you can cut a mortgage in half by simply making one extra payment per year. Is this true? And does this work with any loans like...
car, personal and student loans?
Thanks.
Tanya P.
Like many of us, Tanya would like to get the mortgage paid off in something less than 30 years. And, she's willing to pay a little more than promised to accomplish that goal. So let's see whether one extra payment a year is enough to get the job done.
Tanya does have the right idea. Especially in the early years of a mortgage. Her monthly checks repay very little of the principal at first. It will be years before she's made much of a dent in the amount owed on the mortgage.
Let's take a standard 30 year, 8% mortgage. At the end of the first year, Tanya will still owe $991.65 for every $1,000 she borrowed. She will have written checks for $88.08 and only reduced principal by $8.35. So for the first year for every dollar that she paid, less than one thin dime went to repay the amount she owed.
So Tanya's strategy is a good one. Put more of each payment to work reducing principal because there's less interest owed.
But unfortunately she won't be able to cut her mortgage term in half with one extra payment per year. At least not at today's interest rates. In fact rates would have to be 17% for that to happen. But that doesn't mean that it's still not a valuable tool for Tanya to consider.
One extra payment per year on an 8% mortgage would move her payoff on a 30 year mortgage up seven years. Not a shabby reduction.
An alternative would be to add 1/12th of a payment to each monthly check. That would spread out the extra payment over the year. Doing that would pay off the mortgage a couple of months sooner than the extra annual payment.
So one extra payment wouldn't cut the mortgage in half, but it would cut about 25% off of the term.
What about other debts? The idea is the same. Paying additional principal means that more of each future payment is reducing even more debt rather than just paying the interest owed.
One major difference. The longer the life of the loan the bigger the effect of any prepayments. Paying extra principal on a 30 year mortgage makes a big difference. The difference on a 3 or 4 year auto loan isn't so significant.
For comparison, we're going to assume an 8% 48 month car loan. For every $1,000 borrowed the monthly payment would be $24.41. The payment is higher than for the mortgage because the $1,000 that was borrowed is being repaid over a much shorter period of time.
For instance, in the first month that $24.41 payment actually reduces the amount owed by $17.75. But adding one extra payment per year will only pay off the loan 3 months early. So paying extra principal on an auto loan won't make a huge difference.
But that doesn't mean that the strategy only works for mortgages. Credit card debts are another fine candidate for extra payments. Most credit cards are designed to keep you in debt forever.
Many payments are as low as 1.5% of the amount owed. That means that you'll be paying only $15 per $1,000 owed. And if your interest rate is 15% (a typical rate) you'll be paying off that debt for 133 months or over 11 years. Even if you don't charge another cent or trigger any fees on the account.
Doubling the $15 minimum payment to $30 would cause the loan to be repaid in just 43 months. A big difference.
So Tanya's on the right track. Paying extra can make a difference. To get the biggest bang for her buck she should use extra money to pay off loans that run for many years like mortgages. Or ones that carry a high rate of interest like credit cards.
Gary Foreman is a former financial planner who has published "The Dollar Stretcher."
Check In the Mail
The Dollar Stretcher
by Gary Foreman
gary@stretcher.com
Dear Gary,
This may be silly but I hear so much about rebates and getting
money back for your products. But how do rebates work? How can a company make
money if they just give it back?
Julie
Like Julie, most of us like to get a bargain. And when someone sends us a
check for buying their product, well that's even better! And manufacturers
offering rebates know that. They love it when we buy their product to get a
rebate check.
But Julie asks a good question. How can they afford to offer rebates?
Especially the large ones. Sometimes the "after rebate" price is free. Don't the
manufacturers need to make money to stay in business?
Manufacturers offer rebates for a number of reasons. They can be used to
clear extra inventory, control pricing structures and even provide some extra
cash flow for the manufacturer.
Sellers see rebates as a good tool to move excess inventory. It's also handy
when a new model is about to be introduced. Automakers use this strategy. So do
companies making appliances. They know that if prices are similar most consumers
will choose a newer model over an older one. A rebate allows them to easily
discount the older model and clear out the inventory.
Sometimes manufacturers use rebates to try out a lower price. A rebate
allows them to easily find out whether demand would increase at the lower price.
If it doesn't work they can always kill the rebate. On the other hand, once
lowered it's hard to raise prices back to their original level.
You'll find that some rebates seem to go on forever. If a rebate is active
for more than 90 days, it's probably the company's way of lowering the real
price without changing the 'official' price. Sometimes changing the official
price has legal consequences that they want to avoid.
Manufacturers also realize that every sale doesn't have to be profitable.
Sometimes they're willing to take a loss on one item in the hopes that you'll
buy other things. The goal is to make you profitable as a customer.
Computer printers are a good example. The manufacturer doesn't really need
to make money on the printer. If it takes a rebate to get you to buy their
model, that's fine. They're happy to make money on the ink cartridges that
you'll be buying on a regular basis. They know that most consumers will spend
more on the ink than they did on the printer.
Sometimes the "shipping and handling" charges provide the profit. What the
manufacturer gives up in product pricing they take back in shipping charges.
Some even cheat by raising their shipping charges above normal levels.
A recent trend has been for manufacturers to team up on rebates. One company
will offer a rebate if you sign a long-term contract with another company.
Computer manufacturers and internet service providers are big players.
Rebates also offer some interesting cash flow opportunities for
manufacturers. Remember that they get to use your money until you actually cash
a rebate check. It might not seem like much. But if they have hundreds of
thousands of dollars 'in float' all the time the interest earnings add up.
Manufacturers also know that not everyone will collect on their rebates.
Some won't bother to send it in. Others won't follow directions which
disqualifies their rebate. Although it's difficult to get figures, some experts
estimate that 20% of all rebates go uncollected.
So how can Julie make the most of rebates? She might want to consider some
guidelines to use before making a purchase with a rebate.
Make sure that you can and will send in the rebate form. That means getting
the necessary receipts and proofs of purchase. Verify that there's enough time
before expiration to send it in. And make sure that you're organized enough to
get the forms into the mail on time.
Don't buy just because you get a rebate. Some 'after rebate' prices still
don't offer good value for your money. And remember to include shipping and
handling charges in the price.
Make sure that the rebate doesn't obligate you to any other contracts.
Carefully read the rebate form. Understand any commitments you're asked to make.
It's important for Julie to be sure that she can afford to pay for any
purchases now. There's nothing worse than putting charges on your credit card
and paying interest while you wait for a rebate to arrive.
Be cautious of offers where the pre-rebate price is significantly higher
than the item's normal price. Especially on the internet. Some websites are
using large rebates in a desperate attempt to attract customers. A company that
goes out of business won't be honoring it's rebates.
When used properly, rebates can be a good tool for both the manufacturer and
the consumer. Thanks to Julie for a good question.
Savings Bonds and College
The Dollar Stretcher
by Gary Foreman
Dear Dollar Stretcher,
Our 17 year old will begin college in the fall. We have quite a few savings bonds for her and we'd like to cash in the mature ones. What do we need to know about any tax that will be due on them? Will she need to claim the money from them on her tax forms next year? She works part time and will likely continue in the summers. Is this considered "income" for her?
Thanks so much!
Trish
Trish is at an interesting time for parents. The point where pride in our kid's accomplishments runs smack into the pain of paying for college! And it does take a lot of money to get that college degree. According to CollegeBoard.com when you include tuition, books, room & board, transportation and personal expenses, the average student at a public college or university will spend $10,458 per year.
But, that shouldn't deter Trish or her daughter. The average college graduate earns 81% more than someone with a high school diploma. And, most college students receive financial aid. Of full-time students, sixty percent at public colleges and universities receive some form of aid. hopefully Trish's family has explored those options.
OK, let's take a look at that stash of savings bonds. There may be a happy surprise for Trish. We'll need to review savings bonds and how they work. About ten years ago savings bonds got a facelift and also got more complicated.
For years the most popular bond was the Series E/EE. You purchased a bond at a discount to the face amount of the bond. Gradually it gained value until the maturity date when you redeemed it at the full face amount. And that's when you paid federal income taxes on the interest earnings. Your principal and interest was guaranteed by the U.S. Government. You can still buy Series E/EE bonds.
Another group of savings bonds, Series H/HH, distribute income to you every six months. The lowest denomination is $500. The interest rate is set when you buy the bonds and is adjusted on the 10th anniversary of the issue date. They've paid 4% since 1993.
If you have E/EE bonds and want to begin collecting income without redeeming the bonds you can exchange them for HH bonds. That allows you to continue to defer much of the income tax until you cash in the HH bonds or they reach their maturity date.
Finally, there's a series of savings bonds that are adjustable for inflation. Series I bonds accrue interest. They're purchased at face value. Holders receive interest in two parts. You get a fixed return that is set at the time the bond is purchased. Then there's a variable return that's adjusted twice a year for inflation. I bonds come in denominations as small as $50.
Taxes on Series I bonds are delayed until you redeem the bond or begin to collect your interest. The income is exempt from state and local income taxes. For current rate information on all savings bonds call 1-800-487-2663.
Now, to answer Trish's first question. Yes, the income from the bonds is taxable under most circumstances and must be declared by the bond owner.
One thing could help Trish's family. Series EE bonds issued after January, 1990 and all series I bonds are eligible for the "Education Bond Program". If you spend money for tuition, room, board and other qualifying educational expenses the program allows for interest to be partially or completely excluded from Federal income tax.
The program does have some family income limits that could reduce or eliminate this benefit. It also requires that the bonds be owned by the parent(s) unless the student is 24 years old or older. But, even if Trish's daughter owns the bonds, under certain circumstances they can be re-registered. To learn more about the program visit the official Savings Bond website at www.savingsbonds.gov.
Trish's family will also want to take advantage of the standard deduction available to her daughter. She can earn up to $4,400 in wages or $700 in unearned income (i.e. interest from savings bonds) per year without having to pay taxes. That amount of income will still allow her parents to claim her as a dependent on their tax return. She will need to file a tax return to get a refund on taxes that were withheld.
Congrats to Trish's daughter on her high school graduation. Hopefully college will be a wonderful experience for her.
This Special Edition of the DOLLAR STRETCHER has been presented by:
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