The word “afford” is one that gets tossed around a lot – especially among those considering a large purchase.
I wonder, though: How many of us have stopped to think about what the word afford actually means?
The dictionary defines it this way:
af·ford əˈfôrd/ verb
Bankers have differing ways to determine the definition; however, the most commonly-accepted way is through the debt-to-income ratio. That is how much of your gross income is (or will be) used to service your debts. Generally speaking, banks look for a maximum DTI between 40 percent and 45 percent.
Depending on how much the purchaser wants the item, he or she may determine just how many meals get replaced with ramen noodles each week and for what period of time.
As you can see, afford is a word whose definition can be quite subjective.
But, wait! Banks use a ratio, and by definition, mathematical ratios are OBJECTIVE. Right?
Well, yes. And, no.
Yes. The mathematics behind the ratio are completely objective.
No. The motivation behind the ratio is rather subjective.
You’ll notice, I said bankers use gross income for the calculation. Just to clarify, Gross Income is the amount you see on your annual review form from HR – it’s the number you get when you multiply your hourly pay rate by the theoretical number of hours you work each year. It’s the number you discuss when you’re hiring in for a new job.
As in, [Future Boss] Congratulations, Ashley! We loved your interviews and we would like to offer you the job at a salary $40,000 per year.
And, as those of us who have been working at least a year or two know – the only time you’re likely to see that number is on your annual HR form. Since we know you are regularly contributing to your employer-sponsored 401(k) [You are aren’t you?], the income amount on your W-2 at the end of the year will be lower – and you will not have access to any of that money without significant penalties.
Gross income also doesn’t take taxes into account – and you’ve gotta pay those.
Measuring your DTI based on your gross income does no favors to your monthly cash flow.
So, why do banks do it?
Simple, banks use your gross income as the basis for your DTI so they can make more loans. And making loans is how banks make money. So, instead of looking out for you – like many of us have at one time assumed – banks are only looking out for themselves.
Don’t believe me? Let’s look at the math – Objectively.
Let’s assume a maximum DTI of 40% of your Gross Annual Income of $40,000.
|401(k) Contribution – 5%||– 2,000|
|Income Taxes – 25%||– 9,500|
After your 401(k) contribution and taxes, your $40,000 annual income drops by 28% to $28,500! That means, if you pushed your debt payments up to your bank’s maximum of 40% of your gross – or $16,000 per year – your debt would be 57% of your Net Income.
Mind you, for many people, deductions like insurance and benefits come out of that Net Income further reducing your take-home pay. So, in reality, you could see your debts taking up more than 60% of your take-home – that is, if you trust your bank. (Hint: Don’t trust your bank to look out for your best interests. That’s your job.)
So, before you ask your banker if he or she thinks you can “afford” that new car (or, worse yet, ask the F&I guy at the dealership), you first need to know what your definition of afford is.
Based on my experience, if you have to ask, the answer is “No. You can’t afford it.”
Start by understanding your finances. We can help.
It’s no secret, fraud is on the rise. Unfortunately, fraud has become so common, it is getting to the point where it is not news anymore. And, we know the truth of the old adage, Out of sight, out of mind. If we go by that truth, taking fraud reminders off the front page of the paper may make it easier for crooks to take cash out of your bank.
Out point here is to remind you of some things that are out there to scam you out of your hard-earned money. This is by no means an exhaustive list, so please be diligent. If you run across a new one that is not on this list, please contact us, or leave a comment so we can include it.
Enough has been written on this. Just Google Nigerian Phone Scam and you’ll have enough to read… well, until you get bored reading it. Let’s just suffice it to say that there are no princes in Nigeria or any other country willing to leave you – a totally anonymous person (or even a long, long-lost relative) any amount of money.
Very simply, this scam plays on your greed. Money is earned through hard work, not through answering random emails. Don’t fall for it.
Any time you have to pay money to receive money, beware – it’s probably a scam.
If you’ve ever sold anything on Craigslist (or a similar site) – especially anything with a price tag over $100 – odds are good you’ve received a response like this:
Response: Very interested in your item. Is it still for sale.
You: Yes. I still have it. Price is $325.
Response: What is your address? I will send a check for $4,500. Please pay my driver $3,500 for picking it up and delivering to me. The rest of the money is yours for the trouble.
Sound familiar? I’ve received several of these over the past few years of selling on Craigslist. I have never fallen for the scam, but I know people who have. Just so it doesn’t happen to you, here’s how it works:
The scammer, posing as just another person responding to your ad, is attempting to make you an offer you cannot refuse. Since many people who are posting items on CL and other such sites are doing so to make some much needed money, the odds are good that someone will eventually take the bait. In the case above, the scammer (Response) is offering to pay you $1,000 for an item you have listed for $325. That’s an offer that many of us would have a tough time passing up. But, as Momma always said, If something sounds too good to be true, it probably is. As much as we hate to admit it, Momma’s right again.
Let’s say you take the bait.
Scammer gets your address and either mails a check to you or sends a “driver” out to you with a check. You take the check to your bank and cash it, keeping the $1,000 you were promised and give the “driver” your item and $3,500 in cash. Driver takes off, never to be seen again. Within a few days, your bank calls and you learn a new vocabulary word: chargeback.
Instead of your banker teaching you this word, please allow me to explain the concept of a chargeback. A chargeback is what bankers call an item that was deposited, but sent back by the bank it was supposedly drawn on. So, any credit that you had received in your account for that item (or any credit you received using your account as recourse) gets charged back to your account.
Here is what the chargeback might look like in the above scenario:
Wednesday 17 August 2016
Your account balance (before the check): $50
You bring the $4,500 check to the bank and cash it. Whether or not you realize it, the bank – if it allows you to cash the check at all – will make note of your bank account as “recourse”, that is, if something goes wrong with the check, they know where to go to get the money back.
Your account balance (after the check): $50 (i.e. you took all of it in cash)
Monday 22 August 2016
Chargeback: $4,500 check (no such account)
Your account balance: – $4,450 as in, you owe the bank $4,450.
You see, what happened was the check was either not real or it was stolen. So, when your bank tried to run it through the bank it was supposedly drawn upon, there was no such account there. Or, maybe there was a stop payment on that check because it had been reported stolen.
This happens more often than most people realize.
This, too, happens frequently – and much of the time it happens innocently.
You are a hardworking person who manages your finances well. You have accounts at the local bank or credit union where your employer directly deposits your paycheck each payday. You probably even use the bank’s bill pay service to make sure all your payments are made on time.
You’ve sold some stuff online, and passed up the offers for someone to send you a check that you’ll cash and pay some driver. No way! It’s cash up front at an in-person meeting in a well-lit public place for you. You’re too smart for those scams.
It’s Friday, you’re off work after a hard week and looking forward to happy hour with your friends to get the weekend started right. On your way to the watering hole, you get a text from one of your friends, and he/she has a friend (that you may or may not know) who needs to cash a check so s/he can have some cash for happy hour. This friend-of-a-friend doesn’t have a bank account, and your mutual friend banks out of town. Can this person just sign the check over to you and you deposit it in your account and give him/her cash?
How does that sound to you? The check is for a couple hundred bucks. Not unreasonable. Your good friend knows this person and would gladly do this for him/her if the bank was closer. No big deal. Right?
Maybe. Maybe not.
Unfortunately, I’ve seen friendships end over situations just like this. Here’s how:
Let’s say your good friend, Chris is the one who sent you the text. Chris’s friend Jesse is in from out of town and is the one with the check. You don’t really know Jesse, but you don’t think it’s a big deal so you do it. You meet up with Chris and Jesse at your bank where Jesse signs the back of the check and makes it payable to you. (This is called a third-party check.) You sign the $200 check and hand it to the teller to cash. The teller looks and sees that you have $350 in your account (it’s payday, after all) so she hands you $200. You give the $200 to Jesse and don’t give it a second thought… Until your debit card doesn’t work when you go to pay for lunch on Wednesday.
What you didn’t know was that $200 check from Jesse’s uncle wasn’t from Jesse’s uncle. Jesse swiped some checks and forged his uncle’s signature and the bank caught the forgery and sent it back to your bank unpaid. All your bank can tell you is the check was sent back unpaid. If you want your 200 bucks, it’s up to you to track Jesse down.
Or maybe, it was Jesse’s paycheck and his boss fell on hard times and the bank sent the check back NSF (non-sufficient funds), meaning that the boss didn’t have enough in his account to cover the check. Now, you’ve got to track down the boss to get payment.
Either way, you’ve got a chargeback on your account – which makes you look bad to your bank, and probably costs you in bank fees. You are out $200. Worst of all, it’s your fault.
As you can see, this can happen not only as a scam, but as an innocent transaction. Jesse didn’t know his boss didn’t have enough money to pay him, but he spent the $200 over the weekend and doesn’t feel like he owes you anything – after all, it wasn’t his fault.
If you’re of the old school and you still write out checks by hand and put them in the mailbox in front of your house with the flag up, STOP IT! NOW!!
Seriously. Stop it. Now!
For decades, we have paid our bills with checks – and if you think about it, it is the STUPIDEST thing we could be doing.
Let’s reflect for a moment on what a check is. A check is a small slip of paper with your address, your bank, your bank’s routing number and YOUR CHECKING ACCOUNT NUMBER printed clearly on it for all to see. I remember when I was growing up (back in the dark ages of the 1980’s) some people would even have their social security and driver’s license numbers printed on them as well. Oh, yeah, and when you’re ready to pay someone with a check, you authorize payment from your bank account with your signature.
Heck, while we’re at it, why not include little copies of our birth certificates and passports too!
This is where check washing comes into play.
Crooks look for your mailbox flag to be up – assuming you’re paying a bill with a check. They then, take your check, and using cheap and easy-to-get chemicals wash off everything you’ve written on it – except for your signature. At this point, they literally have a blank check – with your signature – and they can write it for any amount they want. They can clean out your bank account, and the only way to re-secure your account is to close the old one and open a new one with a new account number.
One way to combat this is by using your bank’s online billpay feature. With this, the payment goes directly from your bank to the payee. Depending on your bank, the payments may be made electronically (without checks) or the checks may have different routing or account numbers on them to increase your security.
If you absolutely must write out your own checks, please place them in a USPS mail receptacle that is secure – like the ones found at or in front of Post Offices or on the streets of most major cities.
The overarching theme here is that scammers are after your money. Don’t make it easy for them. Guard your personal information very closely. Don’t forget that a checking account is a privilege that your bank allows you. They have a lot at risk, too, and if they think you are being too risky, they can ban you from having a checking account.
Vehicles are expensive. And for most of us in the United States, they are not just convenience items, they are necessary parts of our lives that allow us to get to work, school, the grocery store, etc. Most of us live our lives, at least in part, out of the reach of mass transit systems, so we need our own, independent methods of transportation. Plus, what says freedom more than hitting the open road with the windows down and the radio up? Well, for most Americans, that is not as freeing as it could be.
According to a recent study by Experian, the average new car payment in America is $503 per month for 68 months. As anyone who has been in bondage to debt can attest, monthly payments are the furthest things from freedom.
We just said that cars are expensive. We just said that cars are necessary. Doesn’t the combination of those two things mean that car payments are just a fact of life?
You can have both the freedom to travel AND the freedom from car payments. That is, if you’re willing to put in a little work.
Our Step-Up Method (SUM) requires a little work,but it is well worth it to be one step closer to Financial Freedom.
Our SUM begins with you saving as much money as you can, depending on your transportation needs to buy that first debt-free vehicle. While you are saving, be looking for the type of vehicle you want to purchase. This will educate you on what to look for and what to look out for and what you can expect to get in your price range. When you’ve saved enough – or as much as you feasibly can – start looking for the best deal on a car in that price range. Work your best deal – probably with more than one seller on more than one vehicle – and buy that vehicle. Keep saving while using (and caring for) this vehicle.
This is important: Do not make any unnecessary upgrades or customizations. No stereo systems. No tinted windows. No custom wheels and/or tires. You don’t have the money for that. Any money you have will be set aside in your car fund for necessary repairs and maintenance and/or your next vehicle.
If this vehicle does not meet your longer-term needs, keep saving. As your savings builds, start the shopping process over, looking for your next step-up vehicle. When you’ve built up enough to get you to the next level of vehicle, put your vehicle up for sale and sell it for as much as you can get for it, put that money with what you have saved, and negotiate your best deal on your next step-up vehicle.
Repeat this process until you’re driving the vehicle that is the right one for you and your situation.
If you did your homework and you negotiated shrewdly (but fairly), odds are that by the time you’ve saved enough for your next step-up one (or both) of two things has happened. Either a) you’ve managed to save enough to move up in vehicle within a few months and your vehicle has not gone down much – if any – in value or b) you have taken longer to save but have gotten significant use out of your vehicle in the meantime, which has far exceeded any additional drop in value since your purchase.
In either case, you need to make sure you do your homework and work hard to protect the money you’ve put into this vehicle. It may take more time to get the best deal, but remember: You worked hard to save the money for this car, and you’ll have to work hard to keep your money.
Sure, CarMax makes it easy to sell them your vehicle. They will give you a written offer even! The problem is, they don’t want to buy your vehicle for any more than they can buy a similar vehicle for at an auction. Given a little bit of time and effort, there is no doubt you will be able to sell your vehicle yourself for more (probably $1,000’s more) than what a dealer will pay for it.
If there is one rule here – well not only here but in life in general – it is this:
Convenience costs money
Dealers make it convenient for you to sell them your car, because they know you don’t want to put up with the hassle of selling it yourself on Craigslist. They also make it convenient to come to their lots and shop hundreds of vehicles to buy your next one, because they know you don’t want to put up with the hassle of shopping on Craigslist. Let’s be clear: These things will cost you money.
(Note about safety: I’ve done a lot of buying and selling on Craigslist, and never had a problem. However, sites like Craigslist make it easy for creeps to prey on people. Take precautions when meeting with people to buy or sell items – especially when dealing with large amounts of cash. There are plenty of resources out there on how to be safe in these situations, go check out some of them before agreeing to meet someone. Also, check fraud is becoming more common, so take caution when selling items to people. Always agree to meet in person. Never take a personal check. Never take a check for more than the purchase price and agree to give cash back to the buyer or his/her driver or delivery company – these are scams. We will write something more in-depth but take these, and other, things into account when buying and selling.)
In Part 1 of this series, we talked about new-car depreciation, in Part 2 we talked about the benefits of buying a used vehicle and in Part 3 we discussed some of the tradeoffs to consider when not buying a new car. In this last part, we will talk about things you can do with all the money you’ll save by buying used.
Though we’ve already talked about Certified Pre-Owned (CPO) warranties as compared to new car warranties, one thing we haven’t discussed is buying a used car without a warranty. This leads to one of the most heated of used-car-buying topics: “I can’t afford a used car because I can’t afford to pay for repairs.”
For the sake of clarity, please allow me to restate my position on vehicle financing: I am in favor of only one method of financing a vehicle: 100% down. That is paying for the vehicle either with cash or trade or both, but not with any type of loan.
Yes. It is possible to do. I’ve done it several times. Read about The Step-Up Method here.
I say this almost facetiously, but with a sense of seriousness: Did you know you don’t need a car loan? Yes, really. And you don’t have to be rich to own your car.
What happens if you don’t have a loan on your vehicle?
The thing that most people notice right away is that they don’t have to make a monthly loan payment. Let that sink in for a minute: No. Car. Payment.
Recent data from Experian indicate that the average new car payment in America is $503 per month. Just imagine what you could do with an extra $503 each month!
This gets to the heart of the issue we’ve taken four articles to get to.
The argument we commonly hear about people not being able to afford a used car is because they don’t have enough in savings to cover a major repair should one arise. (In all honesty, some of the people we speak with don’t have enough in savings to cover an oil change and have financed “service packages” with their new cars to cover such routine maintenance.)
By eliminating the car payments that most people are already making, those folks would have an extra $503 per month to put in savings to go toward any major repairs. The huge benefit here is that cash in savings could go toward shoring up the financial stability of the entire household – not just the car. When you make a car payment, you’re only covering the car. When you put the money in savings, you can take care of the car, or the house, or the doctor – you name it. Literally. Cash in savings is yours. You get to apply those funds to whatever you want.
That’s just one step down the path to Financial Freedom!
In Part 1 of this series, we covered the impact of depreciation (OUCH!) and in Part 2 we talked about the benefits of buying a used – even a Certified Pre-Owned (CPO) – vehicle. In this third part we will discuss some of the tradeoffs to consider when not buying a new car.
One thing for us all to keep in mind is this: Every car was a new car. And every car will be a used car.
Yep. Even my first car, a 1981 Ford Escort, was once a new car. Hard to believe, I know, but it is true, someone once chose to buy that Smurf-blue, four-door hatchback with matching Smurf-blue vinyl interior and a one-speaker AM radio over any other car on the lot. (I still can’t come up with a reason for that choice, unless pickin’s were really slim.)
Along that same line, even the shiniest, top-of-the-line 2017 Rolls Royce will be a used car (albeit a very nice one)… as soon as the ownership is transferred.
If you really think about it, having a “new car” is a myth. A vehicle only classifies as new until it has its first owner. So, why are so many people willing to pay so much for a myth?
Most of the arguments we hear are that repairs are so expensive that people neeeed the new car warranty. However, as we explored in Part 2, we saw that CPO vehicles can be a substantial savings over the cost of a new vehicle – and they can carry extended warranties on the most expensive parts of the vehicle. As far as the bumper-to-bumper aspects of a new car, most buyers of new cars have already dealt with any hassles related to curing the annoying squeaks and tweaks that commonly occur with new vehicles. With those out of the way, the drive train is the biggest area of concern.
However, given the high manufacturing standards in this era of modern manufacturing, the vehicles of the last five, 10, or even 15 years are far superior to those coming off the assembly lines in the 70’s and 80’s. Which is where, in my opinion, most of our trepidation about the mechanical reliability of our vehicles comes from.
Growing up, I can remember my parents having discussions about how close one of our vehicles was getting to the dreaded 100,000 mile mark. Heck, back then, the odometers didn’t even have six digits on them – which led many to believe that even the manufacturers didn’t expect them to last more than 99,999 miles. Like many people, I grew up believing that any vehicle even approaching 100,000 miles was living on borrowed time.
This is not the case any more. Most CPO warranties cover drivetrains up to 100,000 miles. Even some factory warranties cover vehicles with that many miles on the odometer. We are driving our cars, trucks and SUVs more than ever before, and they are holding up better than ever before.
So, why not buy used?
The biggest argument I’ve heard against buying used is Technology. Whether it the ubiquitous Bluetooth connectivity that extends our hands-free lifestyle into our vehicles, or the nearly-standard backup cameras in new cars that were on overpriced option just a few years ago, or those cool heads-up displays… The list goes on.
The truth of the matter is that technology is advancing at unprecedented speeds, and more and more technological advancements are making their ways into our new cars. If you are one of those who cannot live without the latest and greatest technotoys, I’ve got some bad news for you: You’re in for an expensive and disappointing life.
Today’s latest and greatest options will be next year’s standard equipment. Or may even be obsolete altogether (Facebook app for your car anyone?).
Take my 2011 Toyota Camry, for example. It has an AM/FM/CD stereo with AUX input. But it does not have a backup camera, Bluetooth, or one of those cool features that scrolls the name of the song and artist across the LCD readout. Would I like those features? Maybe. Probably. Well, yeah, I would like them. However, it’s a Camry, so a backup camera is definitely not a necessity – I can just turn my head and look behind me like my forebears did in their covered wagons and Plymouth Furys. And, through the marvels of modern technology (gotta love Amazon), I picked up a Bluetooth adapter that plugs into my AUX jack for $10 – it is definitely not as convenient as a native Bluetooth receiver, but it works well and was cheap.
I just can’t figure out how to get that scrolling readout without changing out my whole radio unit for an aftermarket one. That is an option that I could use to not only add the native Bluetooth and artist/song title scrolling, but a backup camera as well. I’ve seen these at Car Toys for around $1,000. For me, the “benefits” of such an aftermarket stereo do not justify the high sticker price. However, I’ll be the first to admit that I’d rather spring for a $1,000 stereo that will upgrade my car to the latest technology than spend thousands more to buy a vehicle that comes with these features.
What about you? Can you still justify the expense of a new car? Or do think you can afford to drive a used car?
This feels like the right place to end this article, but not yet conclude this series. Please read the conclusion piece – Part 4 – where we discuss what you can do with all the money you’ll save by buying used.
Have you ever thought about what you consider "Normal" financial behavior? Do you believe that "everyone uses credit cards"? Do you believe you "will always have a car payment"? Is your emergency fund your credit card? Have you never considered taking out a loan? Did you pay your way through college, and would not have it any other way? Do none of these describe you? Do you identify with more than one of these?
Do you know why you think that way?
The reason why, is your "Normal". Let us help you determine how you got here, so you can determine whether or not you will change.
Take a moment, or an hour, or half a day - what ever it takes, take the time you need and write down the answers to these questions. These answers are important. You will have a much easier time achieving Financial Freedom if you understand your basic feelings / thoughts about money. In essence, if you understand why your "Normal" is your Normal, you will have an easier time determining why and how you need to change your normal.
One of our favorite sayings is: "Your best thinking got you here."
So, if your up to your eyeballs (or past them) in debt, you got here because you made the decisions you thought were best. If you've got $100K+ in student debt and are earning $40K/year, you made your best decisions and got you to where you are. If you're debt free and have $1MM (million) + in investments... Well, congratulations! You don't need us, but we would love to hear from you. Please tell us how your best thinking got you to where you are - please leave a comment.
1. How do you feel about your current financial situation?
Are you where you want to be financially?
If not, what would your ideal financial situation look like? Write down, in detail what your ideal financial situation looks like.
2. What would you tell your younger self about money?
Did you sign up for too many credit cards in college? Maybe you bought that new car or house because the dealer told you you could "afford it".
3. What do you wish you knew?
Undoubtedly, you have learned something during your financial journey. Think otherwise? Look back at the last part. If you would tell your younger self something that would prevent you from being in your current predicament... you've learned something.
What have you learned?
Have you learned that new car warranties aren't all they're made out to be?
Have you learned that you can pay for college without going into thousands (or hundreds-of-thousands) of dollars in debt?
Have you learned that an emergency fund is better than a credit card?
What have you learned about finances during your journey so far?
4. How did your parents handle money & debt?
How did your parents handle money & debt?
What?!?! Who's bringing Mom & Dad (or Grandma & Grandpa) into this discussion?
The truth of the matter is that whether or not you want to admit it, the way the most important adults in your life (i.e. your Mom and Dad or Grandma and Grandpa - your legal guardians) handled money is going to impact the way you handle money as an adult.
Take inventory of how those influential adults handled money - did they live paycheck-to-paycheck? Did they live debt-free, care-free lives? Likely, they lived lives that were somewhere in between.
Either way, their lifestyles will impact your lifestyle as an adult.
How would you change it if you could.
You can change your life. How will you do it?
After you have completed each of the four activities above, check the box below and contact us.
(This is the first in a four-part series about the wise use of your Federal Income Tax Refund. With the exception of this first post, the advice in this series applies to any windfall – lottery winnings, gifts, even yard sale proceeds.)
It’s that time of year again. Our mail boxes are filing up with envelopes marked “Important Tax Documents”, the TV is littered with ads for H&R Block, Jackson Hewett, TurboTax and the like – heck, even the podcasts I listen to are advertising for TaxAct and TurboTax. We all know what that means: the deadline for filing our tax returns is looming.
I’ve also noticed something a little more subtle. I’ve recently noticed a lot more commercials – especially on radio, for some reason – for big-ticket electronics. Just this morning, I heard a commercial for Visio that blatantly pulled back the curtain to reveal to the world just what that company intended to do. The ad to which I am referring specifically addressed the consumer’s upcoming tax refund, as in, What at you going to do with your tax refund? Why not buy a Visio TV? (or something of that nature).
Please understand I’m not villainizing Visio, there are plenty of companies doing the same thing, it’s just that I heard the specific Visio ad today, which prompted this post.
It’s no wonder companies like Visio are out to get your hard-earned tax refund money. The problem is… YOU!
Yes. You. Well, maybe not you, but someone like you… and me.
The problem is, too many of us don’t realize that our tax refund money is OURS. I’ve heard too many people refer to their tax refund in a way that indicates they believe their tax refund is nothing more than their annual gift from the government, and therefore, why do anything more than use it to buy a gift for yourself – like a new TV.
Let’s start by breaking down the term “Tax Refund”. It’s one of those terms we’ve heard so much that we don’t even think about what it really means.
So, what is a tax, anyway? The dictionary defines tax (n) as a compulsory contribution to state revenue, levied by the government on workers’ income and business profits or added to the cost of some goods, services, and transactions. Don’t lose that first part – “a compulsory contribution”. That’s a fancy way to say the government takes it from us whether we want them to or not.
Google did a good job defining tax. Let’s see what it has to say about refund. Refund (n) a repayment of a sum of money, typically to a dissatisfied customer. Perfect! That means that in order to get a refund you had to pay something in to begin with. If you pay for something, you would have, presumably, worked for that money, right?
OK. Let me just pause for a moment to address those of you who are sniggering at me, saying under your breath something like, Yeah, but what about those get a refund when they didn’t pay anything in taxes to begin with? Or, those who get more back than they paid? I’m not talking about that; that is a political discussion I’m staying away from. Please don’t even waste your time in the comments writing about it – get your own blog.
What I have to say below is applicable to anyone who gets a refund.
Too many people don’t see that a tax refund is not a bonus you get from the government once a year. A tax refund is you proving to the government that it took too much of your money so it has to give it back to you – you are the dissatisfied customer to whom the government must repay money.
A tax refund is YOUR money. Not just because your name is on the check, but because it was yours all along – the government took too much so they have to give it back. So you can look at this a couple of ways.
A tax refund is either: a) a bonus from the government or b) a forced savings account that pays out annually.
I remember growing up, the bank we used was always advertising its Christmas Club and Vacation Club accounts. I never used one, but I knew plenty of people who did. The premise behind these clubs was simple: The bank automatically took a predetermined amount from your checking account on a regular schedule (weekly, biweekly, or monthly) and deposited it into your Club account. While these deposits were in your name, they were inaccessible, much like a Certificate of Deposit (CD). (A CD is a commitment to keep money on deposit for a set period of time for a guaranteed rate of interest – withdrawing early can result in forfeiting as much as all of the interest and even some of the principal.) The Club accounts had a maturity date where the bank would cut a check to the depositor for the amount saved. People loved these accounts because they were forced to save a set amount of money that would be paid out to them at a set time – Christmas Club paid out in late November (to pay for gifts) and Vacation Club paid out in early June (to pay for vacation).
What’s the difference between these Club accounts and your tax account with the IRS? Essentially nothing, other than you don’t know how much your refund will be until you complete your tax return.
Why does this matter? And what do we do now?
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(This is the second in a four-part series about the wise use of your Federal Income Tax Refund.With the exception of the first post, the advice in this series applies to any windfall – lottery winnings, gifts, even yard sale proceeds.)
In the first post in this series, we discussed the real meaning of a Tax Refund. In this post, I will explain how to get a guaranteed return on the investment of your refund.
Like I said, it is a Tax Refund. That it is the government returning money to you that it took from you in the first place. Let’s say it a different way: The government took more of your money than it was entitled to, so it has to give some of it back. In summary, a tax refund is your money because it already was your money. It is not a gift. It is more like a forced savings account.
The shortened version: A tax refund is the annual payout of your savings. (Kind of like the Christmas/Vacation Club accounts we talked about in the earlier post.)
Now that you’ve saved your money, what are you saving for?
You don’t know? Really?
Well, I’m not exactly surprised; it’s hard to know what your saving for when you don’t know how much you’ve been saving. Most of us don’t know how much we will be getting back each year because we’re not diligent about monitoring our withholding percentages and/or the tax code is too complex for us to comprehend. As for me, I’m guilty of both – especially the second.
Again, the complexity of the tax code and the distribution of refunds in excess of contributions leads to a political discussion that I’m not hosting here. Please don’t waste time in the comments on politics or the like.
That said, if you have not already, you are probably about to receive a check (or direct deposit) from the government for the forced savings account held at the IRS. Needless to say, the federal government is not paying any interest on the accounts that it has held for the last year. That does not mean that you must settle for this money to bring you no returns.
Many people I talk to are discouraged by the interest rates on deposits at their local banks. So discouraged, that many think the only alternative to a 0.01%APR savings account is to just spend the money on something they want – even if that is dinner or a big screen TV. Where’s the return there? (Hint: There isn’t one.)
So, what’s the best way to invest your tax refund and get a decent return?
It is much easier than you may think to get a guaranteed return on your investment – and you don’t need to pay a financial advisor to get that return. Do you know of any stocks or bonds that guarantee you a return of 5%, 8%, 15% or even 25%?
Don’t think too hard. I’ll answer for you – you don’t know of any such investments.
Mind you, I’m not talking about the one your cousin Willie’s neighbor Frankie’s uncle Louie heard about from a guy at a poker night somewhere. I’m talking about a legitimate investment that pays a legitimate, guaranteed rate of return.
Or, maybe you have heard about it… If you think of it differently.
According to BankRate.com, the average credit card interest rate (depending on the type of card) at the time of this writing is between 11.61% and 16.60%.
Follow me, here. I know I just went from talking about investments to talking about credit cards and that might seem like a bit of a jump. Just to be clear, credit cards are the opposite of investments – the former can cost you money while the latter can make you money. However, we are talking more about returns than investments.
Let’s think of it this way: If you carry $1,000 balance on a credit card that has a 15% interest rate, you’re paying $150 per year in interest. If you use your $1,000 tax return to pay off that balance, you are saving $150, effectively earning you a 15% return on your $1,000 – a return that is nearly guaranteed.
Notice I said “nearly” guaranteed. Yes, you paid off a $1,000 credit card with a 15% interest rate – you are guaranteed to make a 15% return on that $1,000. However, you will lose your return if you turn around and use that card to create a new balance. Paying off a credit card only to use that credit card again is no different than just blowing your tax refund. The only difference is that you are more likely to experience the discouragement that comes with realizing you’ve undone something that you were proud of doing. That’s a negative return.
This same principal works with any type of debt, whether you pay off the debt completely or not. Say you’ve got a car loan with a $15,000 balance at 7% and you get that same $1,000 tax return.
On the car loan, you’re paying 7%, or $70 per $1,000 owed, in interest – each year. Your monthly car payment is the sum of the interest that has accrued on the loan in the last month plus a calculated amount of principal. The principal portion is the part that pays down the loan balance.
If you use your $1,000 tax refund to pay down the balance of your car note from $15,000 to $14,000, you’re saving $70 per year, every year – that’s $350 over five years. Not to mention, you will pay your car off sooner.
It is exactly the same principle with your home mortgage, only you’re likely paying a lower interest rate over a longer period of time. Let’s say you’re paying 4% with 25 years left on your mortgage. Reducing the balance by $1,000 this year will save you $40 every year. Over the course of 24 years, that’s a savings of $960 – you will have nearly doubled your money. And, that’s just if you use your tax refund to pay down your mortgage this one year.
If you consistently use your tax refunds for this purpose, just imagine
Just wait, though, don’t start writing checks just yet – not for TVs and not for debt reduction. Just put your tax refund in a safe place until you read the next post: What’s the Value of An Umbrella In A Downpour? (coming soon)
Check out our next post. Or, sign up for our newsletter and download the entire series with exclusive bonus content in our FREE book What to do With a Windfall (click here).