Reading Material

Depository Institutions

The two main types of depository institutions used by consumers are consumer banks and credit unions. A third type of depository institution, known as a virtual bank or internet bank, is becoming increasingly popular.

A consumer bank is a for-profit business owned by shareholders. Consumer banks are open to all customers.

A credit union is a non-profit organization that is owned by its members. Credit unions have varying membership requirements and only members can use its’ services. For example, one credit union may require its members to be military personnel or a family member of military personnel, while another may require its members to live or work in a specific location. Although there is a membership fee for a credit union, that fee is usually offset by lower interest rates on borrowed funds, higher interest rates on savings, and lower service fees, compared to a consumer bank.

Banks and credit unions provide a safe place to store money and services to assist you in managing your money. In both cases, deposits are federally insured for up to $250,000. As a members-only organization, a credit union services a smaller number of customers and is often able to provide more personalized customer service. However, credit unions usually have fewer branches and ATM(Automated Teller Machine) locations than banks. Some banks are regional, national and even international, which may make accessing financial services easier if you travel. Banks may also offer financial services such as brokerage accounts and certain types of loans that credit unions may not offer.

Another option is a virtual bank. This is a completely Internet-based financial institution with no brick and mortar locations or ATMs. For the customer, this means they will need to use an ATM associated with another bank which could result in fees from both banks and limits on the number of ATM transactions. Virtual banks have an online interface that is available 24/7. They usually provide 24/7 customer support (via online or telephone), and real-time account balance and transaction information. Deposits can be completed electronically or by mail. Virtual banks often have lower overhead costs which may result in higher interest rates on deposits, lower interest rates on loans and reduced fees compared to a traditional bank. Some drawbacks of virtual banks include the lack of certain services such as safe deposit boxes, the easy availability of certified payment and the fact that some financial transactions can only be done in person.

When selecting a depository institution, most individuals select one with at least one branch close to places they frequent, such as their home, work or school. Although technology is allowing more and more transactions to be performed without physically going to a branch, there are some transactions that can only be performed at a physical branch. Some individuals have accounts for each type of institution: a bank for their ATM locations, a credit union for lower auto loan rates, and a virtual bank for immediate transaction information. In the end, it is important to research the services and fees associated with those services before selecting the institution that best matches one’s lifestyle.

Services and Associated Fees

Not all account features are free. It is important to research fees before opening an account. For example, some institutions charge a fee to simply open an account. Student checking accounts are an excellent option for college students. They are often free to open, have no minimum balance, and offer lower fees. Banking fees can cause a $10 pizza to cost you $50 if you are not careful. An individual does not have to write a check or formally “pay” the financial institution for fees. The financial institution debits the amount of the fee from the individual’s account automatically when the fee is incurred.

ATM (Automated Teller Machine) Access

An ATM requires a card to access and allows transactions to be conducted without working directly with a teller at a branch. Institutions issue one card that has both the functionality of an ATM card and a debit card. When functioning as an ATM card The cardholder can use the card at an ATM to access their account to check balances, withdraw cash and make deposits. When opening an account the individual selects which account(s) will be accessible via the ATM with the ATM card. One idea is not to link your savings account to your ATM card, so you cannot easily access your savings. ATMs are often located at a branch office, some gas stations, grocery stores, and malls. For convenience, make sure there is an ATM associated with your institution near places you frequent. If an individual uses an ATM associated with another institution and not their own, often both the individual’s institution and the ATM’s institution will charge a fee. These fees can add up, so be careful.

Debit Card

A debit card allows the cardholder to make purchases at a point of sale (grocery store, retail store, online, etc.) without having to write a check or carry a large amount of cash. When making a purchase with a debit card the cardholder can select debit or credit. Selecting the debit option requires a PIN be entered and the funds are withdrawn from your bank account within about 24 hours. As a result, it is possible to overdraft an account using a debit card. If a cardholder with a $200 bank balance purchases a concert ticket for $150 the purchases will process. However, if later in the day, forgetting they already spent $150 of their $200 balance, they make an additional purchase for $75, they will overdraft their account.

Over Draft Protection (ODP)

When opening a checking account, you can designate an overdraft account. The overdraft account is typically a savings account or a credit card linked to the checking account from which funds are then used to pay the overdraft. If sufficient funds are available in the overdraft account, ODP will prevent the check from “bouncing” or the debit card transaction from being denied. This service may come with a monthly fee for having the service available and/or a usage fee charged each time you use it. ODP does not guarantee that debit card transactions will not be denied or that checks will not bounce. If sufficient funds are not available in the overdraft account to cover the overdraft, a debit card transaction will still be denied and the check will still bounce.

Online Banking

The number of individuals enrolling in online banking increases daily. With online banking, the account holder can monitor accounts, pay bills, transfer money between accounts, review banking history and track expenses. Some institutions also provide a free mobile banking app with electronic check deposit. The app may not provide all the same features as online banking, so check with the bank. Online and mobile banking provide the ability for account holders to pay bills via their bank’s website or app without writing a check. Consumers need to be aware of the institution’s process for electronic payments. There are two different processes used to pay your bills once you fill in the payee information, amount, and date of the transaction. For larger customers that the institution has a relationship with, the payment will be transferred electronically on the date the account holder selected when scheduling the payment. For others, the institution simply takes the information entered by the account holder and rather than electronically transferring the money, it writes a check and mails it on the account holder’s behalf.

There is a distinct difference between the institution electronically transferring the money to the vendor and writing a check and mailing it, to the vendor especially when it comes to your payment being on time or late. For a bill due on the 10th of the month where the vendor has a relationship with the institution the account holder can schedule the payment for the 10th of that month and the payment will be received on time by the vendor thanks to electronic funds transfer. On the other hand, when scheduling a payment for the same bill where the vendor does not have a relationship with the institution it will require the account holder to allow enough days for the mailed check to arrive at the vendor on time. In this instance, the bank may withdraw the money from your account the day it writes the check, say it is 10 days before the bill is due to allow for the mailing. The account holder is now losing about 10 days worth of interest on each payment every month. If this is the case the cardholder may be losing interest on thousands of dollars each month. For these reasons is it important to know which process is used by the bank for each vendor.

ACH (Automated Clearing House)

ACH is a type of electronic payment, giving a vendor or other originating institution permission and direct access to automatically debit the account holder's checking or savings account for the purpose of bill payment. Unlike with online bill pay, where the account holder initiates (pushes) the payment to the vendor, with ACH, the vendor initiates (pulls) the payment from the account holder’s bank account. ACH is a convenient way to deal with regularly occurring bill payments; especially if they are the same every month. Besides convenience, using ACH helps avoids missing payments and late fees being assessed. If using ACH, it is important for the account holder to keep a record of the vendor, date, and amount of all ACH agreements and to monitor their accounts frequently. If there are not adequate funds in their account when the ACH occurs, they could incur fees.

Additional services

Some institutions offer safe-deposit box rentals for storing valuables (the deed to a home, social security card, or jewelry), IRAs (individual retirement account), traveler’s checks, cashier’s checks, and other secure forms of payment. Banks may offer lines of credit, small business loans, and loans to purchase or refinance a home.

Types of Savings Tools

After the selection of the financial institution, the individual needs to decide in which type of account(s) to store their money. In this unit you will be introduced to four types of savings tools, checking accounts (referred to a draft share accounts at a credit union, savings accounts (referred to as share accounts at a credit union), money market accounts and certificates of deposit (CD). These tools are not mutually exclusive. Many individuals have money in more than one type of financial institution and in more than one type of account, based on the amount of money and purpose of the funds to be deposited in the account. In addition to the possible fees associated with the bank, there may also be fees associated with individual account types.

Checking versus Savings

The two most common savings tools offered by depository institutions are checking and savings. These are the two most liquid accounts, meaning out of the four savings tools the funds in these types of accounts are most quickly and easily converted to cash. After the selection of the financial institution, the individual needs to decide whether they need an account to make regular payments (checking) or if it is mainly a safe place to store funds (savings).

Money Market Accounts and Certificates of Deposit (CD)

Most depository institutions also offer money market accounts and certificates of deposit (CD). Both are less liquid than a savings account and are used for money that does not need to be accessed on a regular basis.

Money market accounts require a minimum deposit to open (usually $1,000) and have strict transaction rules, allowing a limited number of transactions per month or statement cycle. Money is deposited into a money market account for the purpose of earning interest, as it has a higher interest rate than checking and savings accounts. The idea behind a money market account is that if an individual has a $1,000 or more in a savings account beyond what they need as an emergency fund, they can earn a little more interest on those funds by depositing them into a money market account.

A CD is different than other savings tools because CDs are purchased; not opened as an account. CDs are purchased for a specific value and for a designated period of time. During that period of time deposits are not made to the CD and if the money in the CD is withdrawn before the designated period of time a penalty fee is charged to the holder of the CD. For example, an individual may elect to purchase a CD when they have $5,000 they want to save for a down payment on a car they plan to purchase in three years. Because they do not plan to withdraw the money for three years, they can put it into a CD and earn more interest than if they left it in a savings or money market account. When researching CDs, look for the highest interest rate possible being aware that some financial institutions may only offer CDs to account holders of the depository institution.

Good Banking Habits

Read bank communications

Banks send out letters and emails to account holders to communicate a myriad of things to include changes in bank processes, fees charged, and interest rate changes. These changes could result in the assessment of new fees or changes in services, so it is important to be aware of them.

Reconciling your account

Once a month the account holder will receive their bank statement either in the mail or gain access to it online. It is important the account holder compares each transaction recorded in the bank statement with the transactions they have been tracking in their check register. This comparison is called reconciling and can locate errors or unauthorized activity in the account. To reconcile a checking account, add all of the deposits the bank has not yet credited to the bank’s balance and subtract all the payments, withdrawals and bank fees the bank has not yet cleared from the subtotal. If the bank statement matches the check register you have reconciled the account. If not, review the check register for missed fees or payments that were not recorded. Contact the bank if you find a bank error. List what won’t be included in your online account balance, including pending bill pay transactions and pending withdrawals. If you’re relying on your bank to do the math for you, make sure to check for inaccuracies and to factor in outstanding transactions that have yet to post on your online banking history. The traditional process for tracking transactions and balancing a checking account is to record all account transactions, as they occur, in a physical check register. A more modern approach is to utilize a personal finance website or app on a smartphone to track and balance a checking account. Some personal finance websites and apps can be configured to automatically pull bank statement data from an account holder’s online banking system to then be used not only for balancing the account but for reconciling also. Using a mobile app is a convenient and easy method for recording transactions when they occur.

Why reconcile your account? Many account holders no longer see the need for balancing or reconciling their checking account now that they can view their account online. Due to online banking, these tasks are more important now than ever before. With the introduction of online banking came the ability for an individual to schedule future payments via recurring/automatic payments and have funds automatically debited from their account by vendors. These features now require the account holder to not only record each checking account transaction as it occurs but to also record future credits and debits to forecast future cash flow. Tracking each transaction provides a spending history the account holder can use to create a budget and creates a running daily balance that can be used when reconciling the account. Whether an account holder is using the traditional paper check register or a more modern electronic method all checking account transactions need to be recorded.

Checking account transactions can include:

• ATM withdrawals (save the receipt)

• Debit card purchases (save the receipt)

• Bank fees

• Scheduled online bill payments

• Automatic electronic debits setup by the account holder. (Ex: The $5.99 payment Spotify pulls from an account holder’s checking account every month.)

• Direct deposits of a paycheck

Direct Deposit

If an employer offers direct deposit take advantage of it. Direct Deposit is a safe and convenient way for an employer to pay an employee. Direct deposit electronically transfers the amount of the employee’s paycheck from the employer’s bank account and deposits it in the employee’s bank account. Often banks will provide incentives such as free checking with direct deposit. Since direct deposit occurs on a schedule, the employee can plan on the money in their account the same day and time each pay period. This is helpful for budgeting.

Automate your savings

With online banking, it is easier than ever to transfer funds between accounts. Open a checking and savings account at the same bank and establish an amount to regularly save. Then set up a recurring automatic transfer to your savings account to make saving an automatic event. This is a great way to build a savings account for emergencies.

Alerts

Account holders have the ability to set up email and text alerts through their bank’s website to alert them when their account balance goes below a specified amount or to pay a bill, etc. This may help avoid NSF, minimum balance, and negative balance fees.

Security Features

Many banks offer security features to help protect you if your debit card is lost or stolen. This includes security features on the card (such as photo ID or chip technology), monitoring your account for unusual purchases or purchases from abnormal locations, and protection against liability for fraudulent transactions reported within a specified period.

Debit cards offer security if your card is lost or stolen or if fraudulent purchases occur if you act quickly.

1. If you notify the financial institution within 2 business days after learning of the loss or theft of your card or PIN you are often not held responsible for the fraudulent use of the card. Your maximum loss is limited to $50. If you do not meet the 2-day deadline you could be responsible for up to $500 in fraudulent charges.

2. If you do not report an unauthorized transfer that appears on your statement within 60 days after the statement is mailed to you, you may be responsible for that transfer even if you did not authorize it.

Some banks provide the ability to place a virtual lock on the card via mobile app or online account if the account holder suspects the card has been lost or stolen. A debit card is directly attached to a bank account, making it riskier than a credit card. If a thief has access to a debit card they can make purchases or wipe out your account causing you to bounce checks, and rack up NSF and ODP fees. Take advantage of the security features offered by your bank to help protect against theft and fraud.

Wrap Up Banking Video

Reading Material

The Paystub

Every two weeks during the simulation money from your employer will be deposited directly into your Suburban City Bank account. This money is your only income in the simulation and refers to the money made by working for ProperLiving Widget Engineering and Design. Direct deposit is an electronic transfer of the employee’s net income for the pay period from the employer’s bank account to the employee’s bank account. The employer and the employee are not required to have accounts at the same bank; however, the employee is required to have a bank account in order to receive payment.

Direct deposit is beneficial to both the employer and the employee. It reduces the payroll cost of printing and distributing physical checks and deposits the employee’s net income into their bank account on a consistent date and time. Many banks offer free checking to customers that have direct deposit of payroll checks. An employee can elect to have their paycheck deposited into one or more accounts, such as a checking or savings account. Having a set amount of your paycheck direct deposited into a savings account each pay period is a great way to not only automatically save money, but to do so consistently.

The most common pay period is bi-weekly (every two weeks); however, some employers pay their employees bi-monthly (twice a month) or monthly (once a month). More frequent pay periods make managing cash flow easier. Each time you are paid by an employer you receive a paystub either as an electronic document you have access to online (usually only available with a password to protect your personal information) notifying you that the direct deposit transaction has gone through or attached to a physical paycheck. A pay stub will typically include details of the gross wages, also referred to as gross pay, for the pay period and the taxes and any other deductions the employer is required to make by law; as well as other voluntary deductions such as retirement plan or pension contributions, insurances, garnishments, or charitable contributions taken out of the gross pay amount to arrive at the final net pay amount. Paystubs often include the year-to-date totals of pay and deductions. You should review your paystub regularly to ensure you are compensated the correct amount and any accruals or deductions are accounted for properly. It is important to review personal information (name, address, and employee ID number) on your paystub as well. It is the responsibility of the employee to notify their employer of inaccurate information as it could have negative tax implications and create financial risk.

Gross Pay vs. Net Pay

Gross pay is the amount of earned income per pay period before any deductions or taxes are taken out.

• Julia is an hourly employee earning $10/hour at an ice cream shop. During this pay period, she worked 20 hours. Her gross pay is $200 ($10/hour * 20 hours).
• Juan is a salaried employee earning $60,000 a year working for a graphic design firm. During this pay period, Juan’s gross pay is $5,0000 ($60,000/year * 12 months).

Deductions decrease gross pay by the amount of the deduction; therefore, net pay is always less than gross pay. Some deductions are voluntary, while others are mandatory. Net pay is the amount received by the employee after all deductions (involuntary and voluntary) have been subtracted from gross pay. Net pay, disposable income, and ‘take-home pay” all refer to the amount of money an employee has to spend or save.

Gross pay - Deductions = Net Pay

Although the amount of disposable income varies from person to person based on an individual's circumstances, all individuals face the same task, that is, stretching each dollar as far as they can. Regardless of the amount of your net pay, you must decide how to use your disposable income for the greatest benefit.

Payroll Deductions

Involuntary Deductions

An employer determines what percentage of an employee's income to deduct for federal income taxes and state income taxes based on forms the employee completes when hired. The employer withholds taxes (federal withholding deduction) from the employee's pay based on information the employee enters on their required Form W-4. The W-4 has been redesigned for 2020 and is different than previous forms you might have completed for an employer. Accuracy is important when completing any tax form and the W-4 is no exception. Mistakes on a W-4 could prevent or delay a tax refund and result in Social Security payments being deposited into the wrong account.

The W-4 asks questions about filing status, marital status, if the filer has multiple jobs, if they itemize deductions and other questions to help determine the appropriate amount of money the employer should withhold for taxes. The W-4 also provides an opportunity for the filer to have extra money withheld from their pay. Some individuals have extra money taken out in taxes throughout the year to ensure they receive a tax refund. The opportunity cost is what they could have used the money for throughout the year. Ideally, you should try to have as much money withheld as will be due in taxes. Filers who underpay may have to pay a penalty, so many tax planners recommend erring on the side of having a little extra withheld.

For example, the individual could have used the money to increase their 401(k) contribution, start a college fund, pay off a credit card, or add to their savings for an emergency. Most people would not overpay their electric bill or other expense to get a refund at the end of the year. Saving a lump sum through payroll deduction is a smarter strategy than additional tax withholding.

FICA stands for the Federal Insurance Contributions Act and is a mandatory payroll deduction. The FICA tax rate is 7.65% and consists of Social Security tax (6.2%) and Medicare tax (1.45%). Social Security is a federal program that provides benefits for retirees, the disabled and minor children of deceased workers. Medicare is a federal program that provides hospital insurance benefits for the elderly.

FICA taxes are withheld up to a maximum amount, which changes each year. The maximum earnings subject to FICA in 2020 was $137,700. The employer makes an equal contribution to to the employee's Social Security and Medicare.

Voluntary deductions

These are typically pre-tax deductions, allowing you to set aside part of your gross income before taxes are applied and therefore reducing your taxable income. Employees elect to have this type of deduction automatically withheld from their gross income. Voluntary deductions are deductions the employee elects to have deducted from their gross pay to pay for a benefit chosen during the enrollment period for the designated benefits, such as the employee share of health insurance premiums and 401(k) contributions. There are a variety of voluntary payroll deductions.

In the simulation, there are two voluntary payroll deductions:

• Healthcare insurance (medical, dental, etc.) – Some employers offer group insurance plans to eligible employees at a reduced rate, covering a percentage of the health care cost for each employee. Employer-provided does not mean the employer provides health care to an employee for free. More detail about healthcare insurance will be provided in a later unit.
• 401(k) – A pre-tax retirement savings account provided by an employer. More detail about 401(k) accounts will be provided in a later unit.

Defining Earnings

There are several ways employees are paid. Each is different and has its own benefits and drawbacks. The most common methods of paying employees are salary, hourly wage, and base salary plus commission.

A salaried employee is paid a fixed amount of money for a period of employment. Some salaried employees receive an employment contract specifying conditions and length of their employment with most contracts being for a year. They are paid a fixed amount to perform their job, regardless of how many hours they work on any given day. Administrators, managers, directors, teachers, college professors, engineers and many other professionals are typically paid a salary. Salaried employees are usually not required to sign a time sheet and often have more flexibility in their work day than hourly workers. Because salaried employees receive a fixed amount of pay at a regular interval, it is often easier to budget with a salary than with hourly pay or salary plus commission. Because they have a contract, salaried employees enjoy a greater sense of security than non-contract hourly employees. Most salaried employees work full-time, defined as working 40 hours per week. Federal and state laws usually require overtime pay for any hours worked beyond 40 hours in a week, however, there is usually not overtime pay for salaried employees. Salaried employees may be expected to work more than forty hours in a week, including evenings and weekends because of their job expectations. Some salaried employees routinely work 50 or 60 hours a week. Salaried employees also typically receive valuable benefits such as health care, retirement, sick leave, paid holidays, paid time off and other benefits.

Hourly employees can be either non-contract or contract. There are significant differences between the two. A non-contract hourly employee is paid an hourly wage, can be full-time or part-time, and are only paid for the hours worked. If a non-contract hourly employee is ill or misses work for any reason they are not paid for the hours missed, unless they have paid time off (PTO). However, all hourly employees are compensated 1.5 times their hourly rate if they work more than the standard 40 hour work week. Hourly employees must document their hours worked by using a time clock system or completing a time sheet, which the employer verifies. There is no requirement that an hourly employee receives a specific number of hours of work a week. As a result, an hourly employee’s gross income could fluctuate from week to week making it difficult to create and maintain a budget. In addition, non-contracted hour employees may not receive employer-paid benefits except those required by law, such as the employer’s contribution to Social Security and Medicare. Because of this, salaried positions are usually viewed as more desirable than non-contracted hourly.

Contract hourly employees share characteristics of both salaried employees and hourly employees. Most unionized employees are contracted hourly employees as are employees in jobs that typically require overtime, such as hospital nurses and utility company electricians. Contract hourly employees have the security of a contract that typically guarantees them a certain number of hours a week. Contract hourly employees often have benefits similar to salaried employees. Unlike salaried employees, contracted hourly employees receive overtime pay for hours if they work more than 40 hours in a week.

Some salaried employees receive a commission in addition to their salary. A commission is money paid to an employee based on a percentage of their sale during a given pay period. Salary plus commission is commonly paid to workers in sales positions, such as realtors, industrial and commercial sales, pharmaceutical sales and vehicle sales. Salary plus commission rewards those who are better performers with increased earnings. Some sales have a seasonal nature or are sensitive to industry needs or economic cycles. Consequently, salary plus commission earnings can fluctuate from pay period to pay period making budgeting more difficult. Benefits that come with salary plus commission vary widely, though many come with health benefits, retirement plans and paid time off. In addition, some may offer bonus pay or use of a company vehicle.

Fringe Benefits

Fringe benefits, or simply benefits, are an important consideration in comparing compensation packages. Benefits can take a variety of forms including subsidized insurance, contributions to retirement savings, education, paid time off and more. According to the U.S. Department of Labor, the average benefits package is equivalent to about 30% of total compensation, but this can vary greatly. Unlike required employer contributions to Social Security and Medicare, most other benefits are not required by law. An additional advantage of benefits is they are usually exempt from payroll taxes.

Health insurance and employer contributions to employee retirement plans are some of the most valuable benefits for a recent college graduate. According to a Kaiser Family Foundation study, in 2017 the average annual employer contribution for health insurance was $5,477 for an individual policy and $13,049 for a family policy. According to a 2017 study by Vanguard Group, the average employer 401K match was 4.7%. For a recent college graduate with a $50,000 income, that would be $2,350.

Other insurance, such as vision, dental, and life insurance may be important but are less valuable than health insurance if purchased by the employee. These will be addressed in detail in a future unit. The value of other benefits such as tuition reimbursement, financial assistance for child care or others can be significant, depending on each individual’s situation.

Paid time off is another valuable benefit. Using the above salary, two weeks of paid vacation would be worth about $1,923. The amount of vacation time and other paid time off such as paid holidays, sick time and other leave vary from employer to employer.

To see how deductions are affecting your paycheck in the simulation click here to view the paycheck calculator

Reading Material

Saving for Retirement

Have you thought about what your life will look like when you retire or how much money you will need? Most college students spend little time thinking about saving for their “golden years”. After all, things like starting a career, paying off debt, buying a house or starting a family are all more immediate financial concerns, each requiring its own planning. When planning for retirement many individuals plan to travel, to pay off their home, or to buy a new home somewhere they have always wanted to live. However, many do not consider saving to cover medical expenses or to sustain the same standard of living in retirement that they have during their working years. As a result, many people face a decrease in their standard of living during retirement years. One of the keys to successful retirement saving is to start early. Saving for retirement requires you to be disciplined and consistent. The best way to accomplish this it to make it automatic by having money directly deposited into retirement savings account through a pre-tax payroll deduction. Investing in your future early in life can produce astounding retirement results. Money doesn’t grow on trees, but it does grow — thanks to compound interest. Saving some of your income now can pay off in years to come.

Saving for retirement is not one size fits all. How do you decide how much to contribute to your retirement? Does the contribution amount and tool for saving change over time? Decisions regarding retirement savings can be both personal and complex. Age, availability of an employer match, marital and family status, desired standard of living, desired age of retirement, and how much you can afford to save and still pay bills on time are all factors to consider in retirement planning. As these and other life situations change, you should review your budget and reassess your retirement contributions as the need to decrease or increase may arise.

Compound Interest

Saving consistently through payroll deduction increases your principal, which is the amount of money originally invested. Saving early combined with compound interest means more money saved for retirement. Compound interest allows you to not only earn interest on funds deposited into your retirement account but also on interest earned on those deposits. In essence, you are earning interest on interest. Compound interest is not just about how much you save, but how long you save and at what interest rate. The longer you wait to start saving for retirement, the more you miss out on the incredible benefit of compound interest.

For this example, assume each individual is earning the same annual interest rate on their investment, also known as an annual return.

Andrew saves $2,000 per year from ages 25 – 32 (8 years) and then stops saving. - $119,000

Bob waits to start saving and saves $2,000 a year from age 33 – 65 (32 years). - $128,000

Carol saves $2,000 from age 25 – 65 (40 years).

By saving early and often, Carol’s earnings were equal to Andrew and Bob’s combined at $248,095.37.

Sources of retirement income

Social Security

Your Social Security benefit is made up of the money you and your employer(s) contributed via payroll deduction for all the years you worked prior to retirement. Social Security is a mandatory plan for most workers with contribution amounts defined by the government. Social Security was created by the government during the Great Depression to provide supplementary income for retirees and others in need. Once a retiree begins collecting Social Security, they receive a monthly payout based on their lifetime earnings. There is concern that Social Security may not be able to meet the demands of the increasing number of retirees compared to those paying into the system. According to the U.S. Social Security Administration, in 2018, it took 2.8 current workers to support one retired worker. They predict that the ratio of current workers to retirees will fall to 2.6 by 2020 and to 2.1 by 2040. In order to sustain Social Security, it may be necessary to increase the age at which one becomes eligible for benefits, reduce the benefits provided, or both. Consequently, it is important for you to have additional sources of retirement income besides Social Security.

Employer-Sponsored Benefit Plans

Employer-sponsored retirement plans are usually voluntary and require you to sign up and make decisions regarding the amount you wish to save and what plan options to use.

Defined Benefit Plans

Defined benefit plans, often referred to as pensions, guarantee an employee a given amount of monthly income in retirement. Pension amounts are usually determined by a formula combining years of service and income earned. Pension funds are managed and provided by the employer who makes all investment and administration decisions. There is usually no employee contribution in a defined benefit plan. Twenty years ago, the majority of the private sector and government employers provided pensions, however, this is no longer the case. Increased life expediencies meant pensioners collected benefits longer than anticipated. Additionally, predictions regarding the number of future employees paying into the system and investment returns have been inaccurate and difficult to forecast. As a result, virtually all employers have moved from a defined benefit plan to a defined contribution plan.

Defined Contribution Plans

Defined contribution plans allow individual employees to select their own retirement investments from a list of options provided by the employer. These options typically include stock and bond mutual funds, money market funds and annuities. The move by companies from defined benefit plans to defined contribution plans has shifted the responsibility for retirement planning to employees.

The balance in the account at retirement is “defined by” how much (if any) your employer contributed to the plan, how much you as the employee contributed during your working years, how long the money was invested, and how well your investments within the plan performed in the market minus any fees charged by your plan administrator.

In Unit 2 we mentioned voluntary retirement payroll deductions. These deductions fund your retirement savings. Examples of this are a 401(k), 403(b), and Thrift Savings Plan (TSP) contributions. Named for the section of the tax code by which they are governed, both 401(k) and 403(b) have the same maximum contribution limits. As of 2019, the maximum annual employee contribution for any employer-sponsored pre-tax retirement plan is $19,000 (under age 50) and $25,000 (age 50 and over) and the maximum employer contribution is $37,000 for a contribution total of $56,000 (under age 50) and $62,000 (age 50 and older) for any one person for a tax-deferred retirement plan.

401(k)

A 401(k) is a retirement savings plan provided by an employer. It is beneficial to the employee to participate in a 401(k) plan because the employee is saving money for their retirement while reducing their current taxable income. Another benefit to participating in a 401(k) is your employer may provide a matching contribution. When you open a 401(k) account you do not make an initial deposit; instead, you and your employer, if they provide a match, contribute to your 401(k) plan each pay period. All 401(k) plans offer pre-tax employee contributions up to the IRS limit. The first table and explanations below compare the 401k options. The second table visually explains the mathematics behind the

Mutual funds

The most common investment choice offered by a 401(k) plan, can offer built-in diversification and professional management and can be designed to meet a wide variety of investment objectives. Be mindful that investing in a mutual fund involves certain risks, including the possibility that you may lose money.

Company stock

If you work for a publicly traded company, your 401(k) investment menu may include company stock or a fund that buys only your company’s stock. Employers may encourage you to invest in the company allowing you to buy the stock for less than the current market price or by contributing a higher percentage of your salary if you buy company stock. It is advisable to limit the amount of company stock in your retirement portfolio since any individual stock is subject to volatility and is inherently more risky than more diversified alternatives such as mutual funds.

Individual stocks, bonds, and other securities

Some 401(k) plans allow you to buy a wide assortment of securities through a brokerage account, sometimes called a brokerage window. You give buy and sell orders just as you do with a regular, taxable account. A 401(k) brokerage account generally has an annual fee, depending on the brokerage firm the plan uses. There may also be transaction costs and commissions on each trade you make through the account, and you could pay higher fees for mutual funds you buy through the account than on funds that are part of a menu.

Variable annuities

Some 401(k) plans include variable annuities which are tax-deferred retirement plans that allow you to choose from a selection of investments, which then pay you a level of income in retirement based on the performance of the investments you chose. Variable annuities offer the tax benefits of other retirement savings options and some of the income predictability of a defined benefit pension. The drawbacks are that variable annuities typically have significantly higher sales expenses and management fees compared to no-load mutual funds and may have additional costs to liquidate or transfer funds to a different account.

After-tax 401(k) contributions

If after contributing the pre-tax annual maximum for your age, you want to contribute more to your 401(k), you can do so with after-tax dollars or net income. These after-tax contributions can quickly accumulate a large addition to your retirement savings and may allow you to retire earlier than originally planned. For those who have enough disposable income to contribute after-tax dollars, it is a way to boost retirement savings.

Profit Sharing

Profit sharing is a way for a company to contribute to an employee’s retirement pre-tax based on quarterly or annual earnings of the company and a way for employees to share in the success of the company. Any company can offer profit sharing, including companies that offer other retirement plans like a 401(k).

Like a 401(k) profit sharing is a pre-tax contribution and the employer provides broker managed plan options for investment. Unlike a 401(k) employer match where the percentage of the match is guaranteed and is known to employees when they select a plan, a profit sharing plan is at the complete discretion of the company. The company must have a set formula for determining profit sharing contributions and decides what percentage it wants to allocate, if any, to every employee in the form of profit sharing.

The contribution limit per employee for a company profit sharing plan is 25% of the employee’s compensation or $55,000, whichever is less. Like other retirement plans, early withdrawals are subject to penalties. Profit sharing plans, like employer 401(k) match contributions, are most times subject to a vesting schedule, which means if you leave before the designated time in your profit sharing plan the amount contributed on your behalf is not transferred to you.

403(b)

The key difference between a 403(b) and a 401(k) is the type of employer who can offer them. 401(k) plans are offered by for-profit companies, and 403(b) plans are offered by tax-exempt organizations like religious organizations, governments, and schools. A 403(b) is similar to a 401(k) plan, in that it is employer-sponsored and taxes are paid on the funds at the time of withdrawal and both may offer an employer match, but most employers offering a 403(b) plan do not offer a match.

Thrift Savings Plan (TSP)

As a Federal employee or member of the uniformed services, you have the opportunity to participate in the Thrift Savings Plan (TSP), a pre-tax retirement savings plan, similar to 401(k) plans offered to private sector employees.

Vesting Schedule

Company matching and profit sharing funds usually vest over time, by percentage per year, or all at once after working for the company for a number of years. It is important to review the 401(k) plan documents when signing up and when changes are made to determine how long you are required to work there before becoming vested. Vesting requirements are used by employers to provide a financial incentive to stay with the organization. Each company is different, so know your vesting schedule. Leave or lose your job before you are 100% vested and you lose some or all of the employer match. This can be a significant amount of money. Many 403(b) plans vest immediately. Once fully vested you are entitled to 100% of the employer match and profit sharing funds. So what should you do with the money in your account?

When leaving the company there are three options for your account:

1. Cash out the money.
2. This is not your best option. Taking the money now decreases your retirement savings and you lose out on compound interest. Also, you will pay a 10% early withdrawal fee and be taxed on the full amount. This could mean you lose 40% of that money immediately. Avoid this option, if you can.
3. Leave the money in the account.
4. There are benefits and drawbacks to leaving your money with your previous employer. You may be familiar and comfortable with the investment options and your account may have access to lower cost investments. On the other hand, you may be charged a maintenance or management fee to keep your account there. In addition, over time you may end up with many accounts from different employers that make tracking and management of your retirement investments more difficult.
5. Roll the money over.
6. You have the option of rolling over your money to the 401(k) plan with your new employer if one is offered, or into an IRA of your choice. For a young professional, this is the best option in most circumstances. The benefit is that it can consolidate your retirement accounts in one place making management easier. It also tends to be more cost-effective. It can be easy to facilitate with the help of the plan manager at your previous employer. A drawback to a rollover is you might find the investment options of your new employer inferior to that of your previous plan. For example, your new employer’s plans could only offer funds that carry a sales charge when your former employer's plans are sales charge free. You may also feel less comfortable managing the funds yourself in an IRA than leaving them in your previous employer’s plan.

Personal Savings and Investments

The most common personal retirement savings plan is the Individual Retirement Account (IRA). An important advantage of saving in an IRA is reducing tax liability. Some accounts, such as 401(k) and 403(b) plans, provide an immediate tax benefit. Others, such as a ROTH IRA provide a tax benefit by allowing principal and earnings to be withdrawn tax-free. In addition, compounding of interest occurs tax-free, unlike non-retirement accounts where taxes must be paid annually on earnings. It is important when saving for retirement to invest in a retirement account. Whether an employee contributes to an employer-sponsored retirement plan or not, as long as they earn they are eligible to save for retirement with an Individual Retirement Account (IRA). An important distinction is that, while employer manages a 401(k) program and makes it available to employees, you must set up your own IRA. IRAs can be opened at banks, brokerage houses and directly with mutual fund companies. You can even set up a self-directed IRA that allows you to invest in almost anything, including real estate and commodities. There are two different types of IRAs, based on their different tax advantages.

Roth IRA

Contributions to a Roth IRA are made with after-tax income. Unlike a 401(k) or traditional IRA, you receive no up-front tax benefit. The benefit of a Roth IRA is all contributions and earnings can be withdrawn tax-free upon retirement. In addition, up to $10,000 can be withdrawn for the first-time purchase of a home, if the account has been open for at least five years. And because there was no up-front tax benefit, contributions to a Roth IRA can be withdrawn at any time without federal tax or penalties. There are eligibility limits for Roth IRA contributions based on annual income. For example, in 2019, a single individual with a modified adjusted gross income (MAGI) of no more than $137,000 can contribute the maximum of $6000 per year to their Roth IRA. Refer to the IRS website (www.irs.gov) for additional information on the breakdown of tax filing, income, and contribution limits.

Traditional IRA

Contributions to a traditional IRA can reduce your taxable income, and grow tax-free until withdrawn for retirement. While in the IRA, contributions and interest continue to grow tax-free. Any withdrawals made after retirement are taxable, but for many people, their tax rate is lower during retirement than when working. There are income limits for a traditional IRA to be tax deductible. These vary depending on whether or not a person is also covered by a retirement plan at work. For 2019, a single filer can have a modified adjusted gross income (MAGI) of up to $64,000 and receive a full deduction for their contribution, even if they have a retirement plan through their employer. With traditional IRAs, you may avoid taxes when you contribute the money. With Roth IRAs, you avoid taxes when you withdraw the money in retirement.

Managing your retirement investment

It is important that you take an active role in managing where your retirement funds are invested. You can control the investment portfolio in employer-sponsored defined contribution and profit sharing plan, as well as in IRAs. IRAs offer the widest range of investment options, more than any 401(k) plan, though more choices are not always better. Every 401(k) plan lets you decide how to invest the contributions you make. Most plans also let you decide how to invest your employer’s matching contributions, but a few allow the employer to make that choice. That includes the right to provide a match in company stock. With all of these choices for how to invest your 401(k) funds, it can be difficult to choose those best suited to your investment goals while staying within your risk tolerance. It is important to educate yourself on your 401(k) choices so that you can select the best options for your specific situation.

Planning for the future

It can be difficult to prioritize planning and saving for retirement, especially when it seems a long way off. However, with time on your side and the power of compounding, even relatively small contributions made consistently over time will add up. Making educated investment decisions, diversifying your investments and limiting investment in company stock, will increase your likelihood of success. Maximizing contributions to take advantage of any employer match and tax deferral will generate additional savings and earnings power. Be sure you are familiar with the vesting schedule for employer contributions and plan accordingly before you make a job change.

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Unexpected Events

Insurance Basics

Individuals purchase insurance to manage their financial losses when something goes wrong like fire, accident or injury. Insurance is based on the concept of shared financial risk among those insured. Some insurance companies are structured as for-profit corporations. Others are set up as non-profit cooperatives, similar to credit unions except for insurance instead of financial services. Some insurance programs, such as flood insurance or crop insurance, are sponsored by the federal government.

A unique aspect of insurance is that individuals purchase it hoping they won’t need to use it. Individuals choose different amounts of insurance coverage based on their willingness to accept the risk, as well as other factors such as their occupation, lifestyle, age, financial profile, and the price of insurance.

Two key insurance terms are premium and deductible. The premium is the money paid by the insured to the insurance company for a policy. The premium may be paid monthly, quarterly, semi-annually, or annually. There may be an additional fee to pay the premium by any frequency other than annually. If the premium is not paid the insurance will be canceled leaving the individual without coverage. In the event of a claim, the deductible is the amount the insured pays out-of-pocket before the insurance company pays.

Suri backs her car into Corinne’s parked car. The cost to repair Corinne’s vehicle is $1,500; there was no damage done to Suri’s car. Suri’s has a $500 car insurance deductible which means she is responsible for paying $500 for the repairs to Corinne’s car and her insurance company will pay the remaining $1,000.

The higher the cost of the premium, the lower the deductible, and vice versa. This is because a claim filed on a policy with a low deductible costs the insurance company more than when a claim is filed on a higher deductible policy. Why buy insurance? Why not simply save money for when something goes wrong? It may not be realistic or possible to save enough money to replace a car, house or future earning potential. One guideline for deciding whether to purchase insurance is if replacing it will create a financial hardship, insure it. It may be difficult to save the money to deal with all unexpected events, and a serious event could be financially devastating without insurance.

Types of Insurance

There are many types of insurance available. Some types of insurance are required by law while others are purchased to manage risk. In addition to the different types of insurance, the insurance coverage amounts and costs can vary depending on the product and the insured’s risk assessment by the carrier.

Auto

Auto insurance is required by law and each state determines which type of auto insurance is required. Some coverages in an auto insurance policy, such as collision and comprehensive, insure the vehicle, not the driver. This means regardless of who is driving the car, the owner of the car is responsible for filing the claim and paying the deductible should there be an accident. As a result of the accident, the insurance company may see you, the owner, as an increased risk and increase your insurance premium. The following are types of auto insurance:

Liability

This coverage pays to repair any property damaged and medical expenses of others injured in an accident when you are at fault. You as the insured are not covered by liability insurance and neither is your property (vehicle). Liability coverage is required by law in most states.

Collision

When you are at fault, collision insurance pays for the repairs to your vehicle but does not cover any medical costs. If the vehicle is totaled in an accident, it is the judgment of the insurer, not the insured to determine if the vehicle is a total loss. If deemed a total loss by the insurer they will pay out the value of the vehicle (based on the depreciated value) to the insured. Purchasing collision insurance for an older vehicle may not be cost-effective. Collision insurance is usually required by financial institutions as a condition for obtaining a loan, otherwise, it is optional.

Uninsured/Underinsured

Although states mandate liability insurance, not all drivers abide by this law and some who do, only purchase the minimum coverage required. When in an accident where the uninsured/underinsured driver is at fault, their policy may not be enough to cover the cost of repairing your vehicle. With this type of insurance, you will be covered for the damage done to your vehicle. This type of insurance is relatively inexpensive compared to what you may have to pay to repair your vehicle should you be in an accident with an uninsured/underinsured driver.

Comprehensive Coverage

Liability and collision insurance cover costs associated with an accident only. Comprehensive coverage will cover events such as severe weather causing damage to your home or vehicle, hitting a deer with your car, having your car stolen, etc. Depending on where you live and the level of risk you are willing to take on you should consider purchasing this type of coverage. If you have an auto loan this type of insurance is required, otherwise, it is optional.

Personal Injury Protection (PIP)

The cost of medical expenses due to an accident can add up quickly. With this type of coverage, medical bills of the insured and any person injured in the accident will be paid no matter who is a fault (up to the amount specified in the policy). PIP is mandatory in some states.

Health Insurance

Health insurance will be discussed in detail in a future unit.

Homeowner’s Insurance

For homeowners, insurance is essential. A homeowners policy covers the insured in the event the structures (house, garage) are damaged, destroyed or rendered unusable. Homeowners insurance covers both “acts of God” such as weather-related damage or forest fire as well as damage caused by individuals through accidents or negligence. Although the likelihood of a person’s house burning down is low, the cost to repair or rebuild, should it happen will probably be expensive.

Homeowners insurance covers not only the physical structure, but also the belongings inside the house. A homeowners policy for the structure is required by mortgage companies because the bank owns a percentage of the home until the mortgage is paid off. If it were damaged in a fire for example, the mortgage company wants to make sure it is covered.

It is worth pointing out that when a house is purchased, the buyer is purchasing both the house and the land it sits on. Since the land will never need to be replaced, it is important to use the cost of replacing the structure (including contents) and not the total purchase price of the house as the amount to insure with a homeowners policy.

A homeowners policy includes personal liability insurance. The personal liability insurance provides coverage for bodily injury and property damage sustained by others for which you or covered residents of your household are legally responsible. An example of this could be someone who steps off a deck and suffers an injury. It also includes coverage for additional living expenses in the event a fire or other event damages the insured’s home and they have to live elsewhere. Typical coverage would pay for expenses such as rent for up to six or nine months while the home is being repaired.

Homeowners insurance usually does not cover losses resulting from floods or earthquakes. The federal government and some state governments offer programs that provide coverage at an additional cost. These premiums can be very expensive in areas prone to floods and earthquakes.

Renter’s Insurance

Unlike homeowners, renters do not own the building, so renters insurance does not cover the building or other structures. A renter’s liability policy includes coverage for their physical belongings, bodily injury and property damage to the premises. It also provides for additional living expense coverage if the rental becomes uninhabitable and you have to live elsewhere.

Whether an individual rents or owns their home they should have an inventory of their belongings to substantiate ownership in the event of a claim. Ownership can be proven with the original receipt or by taking photos or video of belongings, ideally with descriptions of each item and the purchase price if known. Proof of ownership should be kept where it is safe and accessible in the event of a claim. Cloud storage and emailing it to one’s self are both good options. When filing a claim for homeowners or renters insurance a claims representative will typically require proof of loss. In the case of theft or vandalism, a police report may be required. In the event of an accident, photographs and specific information about the accident may be collected.

Two options when purchasing renters insurance are replacement value (higher premium) and actual value (lower premium). One covers the insured with funds to purchase the lost/stolen/damaged items at today’s prices, the other takes into account the depreciation of the items since the date of purchase.

John has a bicycle that he purchased 6 years ago at a cost of $1,000 and it is stolen. With actual value coverage, John will be reimbursed by the insurance company for the purchase price of the bicycle less an amount for depreciation. Depreciation is the decrease in value to the bicycle caused by the passage of time, due in particular to wear and tear. As a result, John may only receive $600 for the loss of the bicycle.

If John has replacement value coverage for the same bicycle and a new bicycle one now costs $1,200, John will be reimbursed $1,200 by the insurance company for the loss of the his bicycle.

Under both types of coverage, the insurance company provides John with funds, not with a physical good. John has the option of spending the money however he sees fit or by using the money to replace the stolen bicycle.

Life Insurance

Life insurance provides financial security for dependents in the event of the death of the insured. If a parent/guardian or primary wage-earner or care-giver passes away a dependent no longer has access to that income, hence the need for life insurance. Often life insurance is used to replace income, pay off a mortgage, or provide for the education of the dependent(s). Taking out life insurance on a spouse that works outside the home seems obvious, but what about a spouse who stays home to raise their child(ren)? Yes, these individuals need life insurance in the event of their death because of the need for money to hire a caregiver.

It is recommended that adults with dependents purchase three to ten times their annual income in life insurance. This amount varies greatly depending on debt load, the number of dependents and annual expenses. Some financial planners suggest purchasing enough insurance to fund specific goals such as paying off a mortgage and funding children’s college funds. Even if insurance is provided as a fringe benefit, it is normally inadequate for a household with dependents.

Children do not contribute to the household income and therefore do not have a need for life insurance to cover a loss of income. However, the average cost of a funeral in the United States today is $7,000 - $10,000. As a result, some individuals with dependents take-out life insurance on their dependents, not to cover the loss of income, but to cover funeral expenses. Some individuals without dependents purchase a small life insurance policy to cover their funeral to remove the financial burden from their family members upon their death.

When purchasing a life insurance policy the insured must name a primary beneficiary, the person who will receive the insurance money upon the death of the insured. The primary beneficiary can be one person or multiple people, including a non-profit organization, a college/university, a minor child where an adult is named as the custodian until the child comes of age. If multiple beneficiaries are listed, the policyholder will designate the percentage of the death benefit for each beneficiary. If a beneficiary has not been named the funds from the insurance policy must go through estate probate to determine how the funds will be disbursed, which can take months. It is important to name a beneficiary to ensure the money goes to the intended person and to avoid probate.

There are three types of life insurance policies to consider.

Term Life

This type of policy has a fixed premium for the duration of the policy, a defined number of years, and only pays out benefits if the insured passes away during the policy term. When the policy ends the coverage ends and premiums are no longer paid. For example, Caleb and his wife take out a 20-year term life insurance policy after having their first child at age 25. At age 45 the policy will end and they will need to purchase a new policy should they want to continue to have coverage. Assuming they live past the age of 45, the premiums paid will not be refunded to them and no benefits will be paid out. When purchasing a new policy at age 45, they will pay a higher premium on the new policy due to their age.

Whole Life

This type of policy has a fixed premium that is invested to build cash value. The insured can borrow against the cash value of the policy during their lifetime. The policy terminates at death or when canceled at which time benefits or cash value are paid out. This is different than term life in that the policy can pay out a benefit, the cash value, without the death of the insured. Purchasing whole life insurance is buying life insurance plus an investment. Consequently, the premiums are significantly higher than for term life insurance alone.

Universal Life

Both whole life and universal life build cash value, but universal life has a flexible premium. The premiums are flexible and based on the minimum and maximum range specified in the policy. The excess of premium payments above the current cost of insurance is credited to the cash value of the policy, or the insured could use the accumulated cash value to pay the premium. The policy terminates at death or when canceled and at that time benefits are paid out.

How to save money on insurance

As with any major purchase, it is important to compare policies and rates to find the best coverage for the lowest cost. Do not assume that online insurance companies offer the best deals. A knowledgeable insurance agent may carry policies from multiple companies and often is able to provide you with the best price. It is important to re-evaluate all insurance policies as financial, employment and family situations change. Here are a few ways to save money on insurance.

Bundle policies: Often when buying homeowners and auto, life, boat, and or motorcycle insurance from the same company, they will offer a discount. In some cases, this discount can be significant. This is like bundling able and internet with the same company. Be careful however not to purchase an additional policy you don't need just to receive a larger discount, unless that discount is greater than the cost of the additional policy

Ask about discounts: Often teen drivers or older drivers can receive a discount on auto insurance if they take a defensive driving course. Some insurance companies provide discounts if your vehicle comes with an alarm system or airbags. There are also good student and good driver discounts. Always ask what discounts are available.

Raise the deductibles on your policies: The more risk you accept, the lower your premiums. If you can afford it, raise your deductibles. As a result, you will pay less throughout the year in premium payments. It’s a good idea to make sure you set enough aside to cover the deductible should the need arise.

Eliminate duplicate coverage: Many auto policies include emergency roadside service coverage as an added cost. Most auto manufacturers include this as part of their bumper-to-bumper warranty which is a minimum of three years and 36,000 miles. Services like AAA also include emergency service and towing as part of their membership. Do not pay for unnecessary coverage.

Stay healthy: This is a great way to lower your cost of life insurance. When you take out a life insurance policy, often you are required to take a physical. The healthier you are, the lower your premium. For example, smokers typically pay more than twice as much for term life insurance than non-smokers. More and more employers are offering wellness and prevention programs. These programs are designed to decrease the healthcare insurance cost for the employer by preventing and detecting serious diseases of employees. This is a benefit to both the employer and the employee. These programs can include anything from free flu shots and gym memberships to smoking cessation and personal health coaching.

Ask First: The cost of auto insurance is not the same for every person or every vehicle. The age, gender of the owner, driving record, as well as the make, model, and year of the vehicle are all accounted for when determining the premium for an auto insurance policy. Before buying a car be sure to find out the cost of insurance for that specific make and model. Vehicles that are expensive to repair or have a greater probability of being in an accident are more expensive to insure.

Finally, when it comes to insurance, educate yourself. Read and understand your coverage and ask questions of your insurance provider if something is not clear.

Warranties

A warranty (which may or may not be written) is an assurance by the seller that the product being purchased will work properly or be repaired or replaced in the event of a failure caused by a manufacturing defect. A written warranty is sometimes provided at the time of sale, but it is not required by law. An implied warranty is an unspoken and unwritten guarantee the seller makes to the buyer that the product will work as advertised. For example, it is implied that a refrigerator purchased will keep food cold. All states have laws requiring implied warranties.

When purchasing a product an individual should make sure they understand the extent of the warranty provided. For example, a lifetime warranty on a car muffler could be the lifetime of the muffler, the car, or even the lifetime of the original purchaser. It may cover failure due to a manufacturer’s defect but not normal wear and tear. It may cover a new muffler but not the cost of the installation. When a written warranty is offered the seller has a legal responsibility to make sure the warranty language and intent are clear. However, the consumer should read and evaluate the extent of the warranty coverage before making a purchase decision.

An express warranty is a written guarantee that the seller makes to the buyer that the item being purchased will perform in a particular way and often for a specified period of time. As a general rule, if the warranty does not state a specific time period the consumer has up to four years from the date of purchase to file a warranty claim against a defect at purchase that took four years to show up.

A consumer who has purchased appliances or electronics has probably been offered the opportunity to purchase an extended warranty or service contract. Extended warranties typically become effective after the manufacturer’s warranty expires. Most extended warranties continue the terms of the manufacturer’s original warranty. That means they would cover failure due to manufacturers defects, but not due to damage or a product simply wearing out. Extended warranties are typically offered at the point of sale because the profit margin on extended warranties is high. In some cases, the sales commission can make up half of the price of the warranty itself. In many ways, the decision to purchase an extended warranty is similar to buying insurance. If the item is expensive, necessary and a buyer would not be able to afford a replacement, an extended warranty might make sense. For example, a student purchases an expensive laptop computer they plan to use for four years at school. In most cases, they do not.

The popularity of cell phones has made protection plans another option. Protection plans pay for the cost of repair or replacement of a phone or other product in certain situations. Protection plans may offer additional protection during the manufacturer’s warranty period or may extend the warranty and provide additional protection. The situations covered might include accidental damage, screen breakage, loss, theft or others. Protection plans vary greatly in price and coverage. Cell phone carriers who provide an expensive phone upfront with a signed contract for cell service may require a protection plan. Like any type of insurance, it is important for the consumer to understand what the coverage is, what the cost is and whether there are deductibles or limits on claims.

Besides the cost, there are other drawbacks to purchasing an extended warranty or service plan. In some cases, the buyer may no longer own the product by the time the extended warranty is to go into effect. Some people may forget they purchased an extended warranty or service plan or lose the information detailing how to file a claim. In most cases, purchasing an extended service plan does not make good financial sense.

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What is Health Insurance?

Health insurance pays for medical and surgical expenses incurred by the insured. Health insurance can reimburse the insured for expenses incurred from illness or injury, or pay the care provider directly. Health insurance is one of the most valuable benefits an employee can receive. Healthcare can be expensive, with and without insurance. The most common cause of bankruptcy is the inability to pay medical debt.

Health insurance covers a variety of medical costs: doctor appointments (illness and well visits), prescriptions, and emergency room visits to name a few. However, a visit to the doctor due to illness or injury, or filling a prescription can still result in charges because insurance does not usually cover all costs. It may be a specific fee called a co-pay, or a percentage of the bill, called coinsurance. Depending on the plan, there may be a deductible for the year or for specific services. A deductible is the amount of money you pay before insurance takes effect. If a plan has an out-of-pocket maximum, the insured is responsible for paying up to the stated amount in a given year for the benefits covered in your plan. Coinsurance and copays are all applied to the out-of-pocket maximum. After the out-of-pocket maximum is met for the year, the insurance company covers 100% of medical costs for benefits covered in the plan.

Insurance companies have preferred or in-network providers (doctors and hospitals) associated with each plan. Insurance companies negotiate discounted rates with these providers and encourage the insured to use them. Using a provider that is not in-network, in other words, "out-of-network, may result in paying more or even the entire cost of the service. In addition, the out-of-pocket maximum may not apply to out-of-network providers.

Paying for insurance

Two key insurance terms are premium and deductible. The premium is the money paid by the insured to the insurance company for an insurance policy. A deductible is the amount of money identified in the plan to be paid by the insured out-of-pocket before the insurance company pays toward a claim resulting from a claim. If the premium is not paid the insurance will be canceled leaving the individual with no insurance coverage.

If provided by the insurance plan and/or employer, the insured can use a Health Savings Account (HSA) or a Health Care Flexible Spending Account (HCFSA) to put money aside via a pre-tax payroll deduction to pay for eligible out-of-pocket medical expenses. Both have a maximum allowable yearly contribution and are voluntary. Contributing to either account will lower your taxable income.

How to obtain Health Insurance

There are several ways in which to purchase or obtain health insurance. Health insurance can be obtained through your employer, purchased by a consumer on your own directly from an insurance company, obtained through a group, or through an exchange operated by your state or the federal government.

Employer offered insurance

Many companies offer health insurance benefits to their full-time employees. Some offer health insurance to part-time employees. Currently, only employers with more than 50 full-time employees must offer them health insurance or pay a penalty. Employees who receive health insurance benefits select from the plans offered by the company. Companies may offer several choices of insurance with different coverages, co-pays, deductibles, and premiums, or they may offer a single plan. Most employer-provided plans require employees to pay part of the premium. According to a recent Kaiser Family Foundation study, the average cost of an employer-provided full family health insurance plan was $18,764 with the employee paying an average of $5714 or 31% of the premium and the employer paying the rest. Consequently, employer-paid health insurance is a very valuable fringe benefit.

Once a year during open enrollment, employees have the opportunity to change, add, or drop benefits. This is a good time for insured individuals to review their average medical costs for the previous year(s) to determine the best coverage for the next plan year. Once a benefit plan is selected for the year it cannot be changed unless there is a life event such as change of co-insurance from a spouse or change of family status.

The Health Insurance Marketplace

Some individuals purchase health insurance policies through an agent or directly from a company, much the same way they purchase homeowner’s or vehicle insurance. Purchasing health insurance however, can be much more complicated. Besides differing co-pays, deductibles and premiums, there are significant differences between what is and isn’t covered, as well as limits on treatment. This makes comparing health insurance policies difficult. Health insurance is also expensive. The Affordable Care Act provided for the creation of a Health Insurance Marketplace or Health Insurance Exchange where consumers could more easily compare policies at different levels of coverage. In addition to convenience, the Affordable Care Act created subsidies to help people purchase health insurance. In 2018, about nine million people purchased health insurance on an exchange and about 80% of them qualified for a federal subsidy to pay part of their premium. The average premium cost for those qualifying for subsidies was $89 per month.

Some states have created their own exchanges, though most use the one created by the federal government. Most consumers find it easier to shop for health insurance through the Health Insurance Marketplace, though in some states there are a limited number of insurers participating. Typical purchasers of health insurance are individuals who do not have health insurance through an employer or other source. In addition, if an individual’s employer does offer qualifying coverage, but it is too costly for the individual he/she is eligible to purchase health insurance from the Marketplace, however they will not qualify for a subsidy.

Health insurance for those under the age of 26

Generally, you can remain on a parent’s health insurance plan and stay on until you turn age 26 even if you live outside of your parents’ home, get married, turn down an offer of a job-based plan, start or leave school, or are no longer claimed as a dependent. This applies to both employer-provided plans and plans purchased through the Health Insurance Marketplace.

Coverage usually ends when the child turns age 26 but may extend to December 31st of that year. Ask your parent to check with their employer as plans can differ.

When a parent applies for a new plan in the Marketplace, they can include you on their application. If you are on your parent’s existing plan purchased through the Health Insurance Marketplace you can be added to the plan during open enrollment or a special enrollment period (SEP). You can stay on your parent’s Marketplace plan through December 31 of the year you turn 26 (or the age permitted in your state). Check with your state for details.

Group Insurance Plans

Group insurance is an insurance that covers a defined group of people, such as the members of a society or professional association. Grouping individuals together often results in lower rates because the risk is spread over a larger number of people and the insurance company sells multiple policies. By negotiating for a large number of customers the group can typically negotiate a lower premium payment than individuals could get on their own.

Types of Managed Healthcare

There are three main healthcare plans and they vary greatly. To select the best plan, there are three questions to consider:

1. Is it important to have the lowest co-pays possible?

2. How important is flexibility in choosing providers and services?

3. What doctors and/or specialists are covered under the plan?

The three major types of managed healthcare are Health Maintenance Organization (HMO), Point-of-Service (POS), and Preferred Provider Organization (PPO).

Health Maintenance Organization (HMO) – Of the three types of managed healthcare plans, this has the most restrictive network of providers, but usually has the lowest premiums. An HMO requires that you identify a primary care physician (PCP) to coordinate your care. This means a patient must be seen by their primary care physician (PCP) to receive a referral before going to a specialist. In addition, if a patient wants to be seen by a provider out of the network, they will pay the entire cost. Both of these restrictions are designed to reduce costs to the insurance company, resulting in lower claims and lower premiums.

Rebecca breaks her leg while skiing. Before Rebecca can be seen by an orthopedist she must first be seen by her PCP who must write a referral in order for Rebecca to see an orthopedist. This means more cost and more time for Rebecca.

Preferred Provider Organization (PPO) - This is the most flexible of the three managed healthcare plans, providing a larger network of providers, the ability to be seen by out-of-network providers without a referral, and not requiring identification of a primary care physician. The downside to all of this flexibility is typically higher premiums and deductibles.

Point of Service (POS) - This plan is a hybrid of the HMO and PPO. Like an HMO, the individual must name an in-network PCP. Like a PPO, they have the option to be seen by a provider outside of the network, however, going out of network will cost more unless a referral is made by the PCP. In a POS plan, a co-pay is paid when visiting an in-network provider. When going outside the network the insured pays more, usually a percentage of the bill.

Frank has a POS plan with a $20 copay and 80% - 20% coinsurance and an office visit costs $250.00

In this scenario, if Frank goes to an in-network provider he will pay $20 for the office visit. For the same visit to an out-of-network provider, Frank will have to pay the entire $250.00 out-of-pocket that day and then file a claim with his insurance company to be reimbursed for the 80% the insurance company will cover. In essence, Frank will get to see the doctor he wants, but it will cost him $50 rather than $20 and he will have to complete additional paperwork and wait for the $200 to be reimbursed by his insurance company.

Additional Healthcare Options

COBRA - COBRA stands for the Consolidated Omnibus Budget Reconciliation Act and requires employers to offer covered employees the option for them, their spouses, their former spouses, and their dependent children to stay on their employer-based healthcare coverage when coverage would be lost due to a specific event. Examples of this type of event are the death of a covered employee, divorce or legal separation from a covered employee, termination or reduction in the hours of a covered employee’s employment for reasons other than gross misconduct.

Even though the coverage is the same, the cost to the insured is usually higher under COBRA because the employer may no longer be paying a percentage of the premium and may require the insured pay an administrative charge.

While COBRA continuation coverage must be offered, it lasts only for a limited period of time and applies only to medical care. Life insurance and disability benefits are not covered by COBRA.

High-Deductible Health Plan (HDHP)

A high deductible health plan (HDHP) is an insurance policy combined with a health savings account (HSA), allowing you to pay for certain medical expenses with pre-tax income. The components of a HDHP can vary depending on the specific plan. For instance, one HDHP could be very similar to an HMO, while another could look more like a PPO. The distinguishing factor is the large deductible and Health Savings Account that is attached to it. HSAs are discussed in more detail in a later section.

The deductible is usually higher in a HDHP compared to other plans. For 2019, the IRS defined a HDHP plan as any plan with a deductible of at least $1,350 for an individual and $2,700 for a family. The insured pays that entire amount for healthcare expenses up to that amount before their health insurance begins paying. The average HDHP deductible is a little more than $2,000, but one-fifth of HDHP plan enrollees have a deductible of more than $3,000, according to the Kaiser Family Foundation.

HDHPs typically feature a Health Savings Account, which allows the insured to save money pre-tax to pay for qualified medical expenses. Some employers contribute to employee HSA accounts as part of the benefits package. It is important to know whether an employer contributes money to employee HSAs when making a health plan decision.

Much like a PPO, the insurer will begin to pay its share of the coinsurance once the deductible is reached. The insurer will cover all costs once the out-of-pocket maximum is reached.

HDHP usually have lower premiums, so they can be a less costly plan option -- especially for those who do not require a lot of medical care. HDHPs might be a good idea for single, healthy individuals, but could be more costly than other insurance options for older adults or young families.

Though many health care costs are unexpected, costs of regularly used prescription drugs and planned surgeries and medical treatments are known. Before deciding on a HDHP, it is important to consider potential health care costs to determine whether the savings from lower premiums will more than offset the potential costs of care.

Vision Insurance

Provides basic benefits for eye examinations, glasses, and contact lenses. There are often co-pays and maximum coverage limits for things like glass frames and contact lenses.

Dental Insurance

Provides insurance coverage for a variety of dental expenses, but not all. Plans typically have co-pays, maximum coverage limits, and exclusions.

Prescription Drug Program

A prescription drug program can be offered as part of a health insurance plan or as a separate program from medical insurance coverage that provides a discount for prescription drugs. Plans are typically designed to provide participants a cost-effective way to obtain maintenance medications or daily prescriptions. Plans of this type often allow the participant to purchase more than a 30 day supply of the maintenance medication and charge it as one prescription. In other words, if a 30-day supply has a $10 copay, with a prescription drug program the 90-day supply will cost the same $10 copay for three times the medication. Often, a prescription drug program has a mail-order option, so the medication will be mailed directly to the participant’s home.

Health Savings Account

An HSA requires a high deductible health plan (HDHP), and the contribution amount can be changed at any point during the plan year. In addition, the money the insured contributes but does not use during the plan year rolls over to the next plan year and should the individual leave the company with money in the account, the funds can often be transferred to an HSA account at the new employer. Combining a High Deductible Health Plan with a Health Savings Account (HSA) allows you to pay for certain medical expenses, like your deductible and copayments, with pre-tax dollars. High-deductible plans usually have lower monthly premiums than plans with lower deductibles. HSAs typically include a debit card which makes paying for eligible expenses convenient. They also may allow the participant to invest the money in the HSA. Individuals paying cash or writing a check for eligible services can reimburse themselves from their HSA.

Employers offering HDHPs often offer an HSA option along with the plan. An individual can also open their own HSA through their own bank or other financial institution. HSAs often include the ability to invest the funds in the account.

Health Care Flexible Spending Accounts (HCFSA)

This employer-sponsored account uses pre-tax dollars to pay for eligible health care expenses for an individual, their spouse, and their eligible dependents. Eligible expenses include medical, dental, and vision care expenses that are not covered by a health plan or other insurance. With an HCFSA, an individual uses pre-tax dollars to pay for qualified out-of-pocket health care expenses. The 2019 HCFSA pre-tax limit per individual is $2,700. With a HCFSA, the employer front loads the amount of money requested for the year, up to the legal limit. That amount is then withheld from the employers pay over the course of the year.

There are several benefits to a HCFSA. The employee is able to use the full yearly amount in advance, which can make budgeting for surgeries or other significant allowable expenses easier. Using pre-tax dollars saves money. There are drawbacks, however. Unlike FSAs, money in a HCFSA cannot be invested or earn interest. Most HCFSAs do not allow the carryover of funds from one year to the next. In other words, if you don’t use it, you lose it. Since the election must be made at the beginning of the year, use of an HCFSA requires careful planning to avoid losing money at the end of the year.

Some HCFSA plans offer the option of a debit card that allows payment for out-of-pocket expenses without having to file a manual claim for reimbursement. This saves the temporary out-of-pocket expense and the time it takes to be reimbursed. Otherwise, the individual must save receipts and submit them for reimbursement.

Open-Enrollment and Special Enrollment (SEP)

Open enrollment is a period of time (usually 3-4 weeks) when insured individuals can add, drop, and make changes to their insurance options. The time of year for open enrollment depends on the health care plan you choose. Employer-offered health insurance open enrollment periods are set by the employer and can happen at any time of the year. However, it's usually in the fall with the new coverage beginning January 1 of the next year. If a life event occurs requiring a change to your insurance outside of the open enrollment period, an employee will contact your provider to see if you qualify for a Special Enrollment Period (SEP). Some examples of a qualifying life event would be change or marital status, loss of existing insurance coverage, change in family status or significant change in residence. If you qualify for a SEP, you the individual usually has up to 60 days following the life event to enroll in a plan. If you miss that window, your failure to do so means an individual will have to wait until the next open enrollment period to apply.

It is important to know when open enrollment for health insurance is scheduled for your plan. In order to select the correct healthcare plan during open enrollment review the explanation of benefits, pay stubs, and out-of-pocket receipts for medical expenses from previous years to determine the average healthcare cost over the last few years. Then analyze those costs to determine the amount spent on premiums, deductibles, and out-out-of-pocket expenses to determine the best health care plan to select for the upcoming plan year.

Know your rights

Health insurance is a service, so if a claim is denied an appeal can be filed with the insurance company. Information on how to file an appeal can be found on the health insurer’s website. If the insurer denies the appeal, the insured has a right to file for an external review by a third-party. This process varies from state to state, but all states have a process.

For example, Noelle gave birth to a baby who needed immediate medical attention. The pediatrician on call provided immediate care in the hospital.

Later, Noelle received a bill in the mail for the full cost of the pediatrician in the hospital. The hospital and Noelle’s doctor delivering the baby were in-network providers, but the pediatrician that provided care to their newborn was out-of-network, so the cost of the pediatrician was charged at the out-of-pocket rate. Noelle contacted her insurance company to explain the extenuating circumstances in which the services were provided and the insurance company, in this instance, re-processed the claim as an in-network cost. This is just one example of a resolution and is not indicative of all appeals.

Reading Material

The financial impact of the credit score

Having a good credit score is very important. It’s comparable to grade point average (GPA) in that a low score will prevent you from doing things, while a high one will make more opportunities available. Like a GPA, mistakes made early can negatively affect your score years later. By maintaining too high a balance on a credit card or missing student loan payments, a young adult can set themselves up for a very expensive financial future. A poor credit score will result in higher interest rates when borrowing money for an auto loan or a mortgage or applying for a credit card. Credit scores can positively or negatively impact other important things besides loans. Credit scores can also affect auto and home owner’s insurance premiums. More and more employers consider an individual’s credit report as part of the hiring process, especially if the position is with a financial institution, the government, government contractor, or a position where the individual will be dealing with finances or proprietary information. The company may feel it is too risky to hire an individual with too much debt for fear the individual may embezzle from the company or sell proprietary information to pay off their debt. Other employers view a credit score as a tangible measure of personal responsibility that can easily be compared to other candidates. In addition, a prospective landlord may not rent to an individual with a history of making late or missed payments.

Credit

Credit is an agreement to receive goods or services with a promise to pay at a later date. This agreement occurs between a lender, the person or organization with the resources to provide the funds, and the borrower, the person or organization receiving the funds from the lender.

Two types of credit repayment plans:

Closed-end or installment credit

Used to pay back a one-time loan for a specified amount of money to be used for the purpose identified in the lender/borrower agreement. An automobile loan is an example of this type of credit.

Open-end or revolving credit

Used to pay back a pre-approved loan between a lender and borrower that may be used multiple times up to a specified limit and for any purpose? A credit limit will be established by the lender in the agreement. A credit card is an example of revolving credit where the cardholder is the borrower and the lender is a financial institution.

Credit Report

A credit report is a loan and bill payment history maintained by a credit reporting agency, also referred to as a credit bureau. Equifax, Transunion, and Experian are the three major Credit Reporting Agencies (CRA). These agencies acquire personal information, loan history, and credit information including balance and payment histories and revolving credit limits and utilization from a variety of creditors to produce a credit report. A credit report is unique to each individual and can vary from agency to agency, as companies may not provide data to all three agencies. With this information, the credit bureaus create a credit score. Since there are three main credit bureaus, an individual will have three different credit reports and as a result three different credit scores. Financial institutions and other potential lenders make inquiries of an individual’s credit report to determine their creditworthiness, or risk associated with loan repayment prior to granting a loan. CRAs do not decide whether an individual is granted credit or determine the interest rate of the loan. Those decisions are made by the lender. The CRA simply provides relevant information in the form of a credit report to assist the lender in making those decisions.

Credit Score

Credit scoring companies review an individual’s credit report to determine the risk associated with lending to the individual and apply a scoring formula to produce a 3-digit number or credit score.

Fair Isaac Corporation is responsible for the most commonly used credit score, referred to as the FICO score. A credit score is used to determine loan eligibility and the interest rate an individual receives when taking out a loan. The higher the credit score the more likely an individual is to receive the loan and at a lower interest rate than someone with a low credit score. The formula for the FICO score is proprietary; however, generally, the information used to develop a FICO score are payment history, the amount owed relative to available credit, the length of credit history, new credit, and types of credit. The FICO score ranges in number from 0 – 850 and is categorized as follows:

Payment history:

35% of the FICO score is based on an individual's payment history. The first thing a creditor wants to know before extending credit is if the individual has been successful in paying back debt. Since this is the largest percentage of the credit score it is important to make payments on time and in full to maintain a good credit score.

Credit utilization:

30% of a credit score is based on an individual’s utilization of credit or the ratio of available credit to the amount of credit used. Having a high credit card balance or maxing out a credit card can lower an individual’s credit score which in turn signals to future lenders that the individual cannot responsibly pay down their current debt. It is recommended that an individual maintain a balance less than 30% of their credit limit on each credit card, as well as, the overall utilization of all debt combined.

Assume an individual has six credit cards each with a $5,000 credit limit, for a total credit limit of $30,000. The individual should maintain a balance on each card of less than $1800 and a total balance on all cards of less than $9000.

Length of credit:

15% of the FICO score is based on how long an individual has had credit and how long it has been since there has been activity on the account. The longer the credit history the more information the lender has to evaluate when deciding on granting a loan. This can be positive or negative depending on your credit history. If an individual has never obtained credit they will not have a credit score.

New credit:

10% of the FICO score is based on an individual’s pursuit of new credit. An individual should avoid opening too many lines of credit in a short period of time since this behavior is a red flag to prospective lenders. Prospective lenders may see this new debt as a signal that the individual is in financial trouble and needs access to significant amounts of credit to make ends meet. This is especially true for those individuals obtaining credit for the first time.

Types of Credit:

10% of the FICO score considers the type of credit an individual has, revolving versus installment, with the goal to have a mix of each. Even within the installment category, it is better to have a mix of short-term, like an auto loan and long-term, like a mortgage rather than all of one type.

Carol has four credit cards each with a credit utilization of 40%, while Damian has an auto loan, a mortgage, and two credit cards each with a 40% utilization rate. Assuming all other factors related to scoring their credit are equal, Damian would have a better credit score.

How to build credit

There are many misconceptions about what will help build your credit score. As mentioned earlier, for some bills like cellular service, utilities, and rent payments, only negative transactions are reported. A college student who puts those bills in their own name will not see their credit score increase as a result. Obtaining an installment loan on a significant purchase like a vehicle and making all payments on-time will build your credit score, as it is likely to be reported to the major credit agencies. Obtaining a credit card in your name, charging small purchases to it, and always paying off the balance will quickly increase your credit score.

Obtaining credit for young adults can be difficult because typically they have not yet established a borrowing history and therefore, have either no credit score or a very low credit score. However, there are ways young adults can obtain a credit card to begin building credit.

Become an authorized user - A young adult can become an authorized user on a credit card of an individual over the age of 21 (usually a parent/guardian). An authorized user has a credit card with their name on it and is legally able to complete transactions using the credit card. However, the primary cardholder is the one liable for the payments on the card, not the young adult.

Obtain a cosigner - A young adult without an independent income must have a cosigner to obtain a credit card in their name. A cosigner is an individual (usually a parent/guardian) that agrees to be responsible for the debt on the card should the cardholder default. In the case of a cosigner, both parties share equal responsibility for the debt incurred on the card.

Apply for credit on your own - Young adults able to demonstrate proof of income and have some credit history established (by making car payments or student loan payments on time, for example) may be approved for a credit card on their own. In addition, some card companies offer low credit limit cards to college students in their junior or senior year, even if they have limited previous credit. To do so they must apply online or by completing an application and submitting it through the mail. Young adults may not apply for a new credit card over the phone.

When credit is denied

When an individual is denied credit they first need to find out why. By law, the lender must provide the credit applicant documentation identifying specifically why their request for credit was rejected. In addition, the rejection letter will identify the credit reporting agency that supplied the credit report for which their assessment of creditworthiness was based, the credit score used, and directions on how to request a free copy of the credit report from the reporting bureau. Unlike the credit report, the credit score is not provided for free. An individual will have to pay if they wish to access their credit score.

How to improve your credit score

Based on the categories of the FICO score the best way an individual can improve their credit score is by consistently making payments on time and keeping their credit utilization below 50% as these categories combined account for 65% of the credit score.

Those individuals with a credit history should avoid opening new credit card accounts or installment loans, keep their credit utilization below 50%, and use each credit card at least once a year. Canceling old credit cards may hurt a credit score by affecting the overall credit utilization. Infrequently used credit cards are sometimes closed by the credit card company to reduce administrative costs. Having a long-standing account canceled may lower your credit score.

Hannah has two credit cards each with a credit limit of $1,000 and cancels one because she no longer uses it. Her available credit is now cut in half, but her total debt has not changed. As a result, her credit score could drop preventing her from getting the job or apartment she desires, or possibly result in her having higher interest rates on a car loan or mortgage.

An individual trying to rebuild bad credit may want to obtain a secured credit card by depositing money with the credit card issuer as collateral. The credit limit on this type of card is equal to the dollar amount deposited. This reduces the risk to the issuer should the individual not make the payments and allows the individual to build credit.

Debt to income ratio

In addition to managing credit utilization, an individual must maintain an acceptable debt-to-income ratio (DTI). An individual’s debt-to-income ratio is another measure of risk considered by mortgage lenders as part of the mortgage underwriting process.

Debt-to-Income Ratio = Total recurring monthly debt/gross monthly income

The debt-to-income ratio is an important measure of your financial security and the lower the percentage, the better. Individuals with higher debt-to-income ratios are considered more likely to default on their mortgage and other debt. To obtain a Qualified Mortgage an individual can have a DTI of no more than 43%. A Qualified Mortgage is desirable because it provides more borrower protections, such as limits on fees. However, the goal is a DTI of no more than 36%, leaving an individual less vulnerable to changes in their income and expenses.

Elena’s gross monthly income is $4,500 and her recurring monthly debt, the total of all her monthly expenses, which include: mortgage (principal, taxes, interest, and insurance), home equity loan payment, car loan, student loan, and minimum monthly payments on credit cards is $1,800. Elena’s DTI is $1,800/$4,500 = 40% leaving Elena at risk of repaying her debt if her gross income should decrease or should she be hit with an unexpected medical expense, for example. This could leave her struggling to make payments on her monthly recurring debt and make her more of a credit risk to prospective lenders.

Credit Counseling Scams

Every day, companies appeal to consumers with poor credit histories -- promising, for a fee, to clean up their credit report so they can get a car loan, a home mortgage, insurance, or even a job. Unfortunately, after paying hundreds (or even thousands) of dollars in up-front fees, many consumers are in more debt than when they hired the company. Often the company has taken their money and done nothing to “clean” their credit history and/or has disappeared.

Tips to help consumers avoid “credit repair” scams include:

• If it sounds too good to be true, it probably is. Claims of helping you "get out of debt easily" are a red flag.
• Deal with a reputable agency. Check with state consumer agencies and the local Better Business Bureau to make sure there have been no or few complaints against the organization, and that any complaints were favorably resolved.
• Verify that the organization provides counseling and education, as well as debt consolidation and payment services, to help consumers achieve financial stability and remain debt-free.
• Avoid paying up-front fees and beware of high monthly service charges that may add to your overall debt load.
• Be aware of your consumer legal rights and actions you can take yourself to repair your credit, usually for free.
• Stay away from any company recommending all contact with the bureaus go through their company and that consumers not contact a credit bureau directly.