Ask Dr. Per Cap

Ask Dr. Per Cap is a program funded by First Nations Development Institute with assistance from the FINRA Investor Education Foundation. Nimiipuu Community Development is happy to share this column as partner with Native Financial Learning Network funded by Northwest Area Foundation.

Upside Down

Dear Dr. Per Cap: I just bought a new war pony.  It’s a nice vehicle but last week when I traded in my old ride the car dealer told me that I was “upside down” on my loan and would need a new loan for more than the cost of the new car.  That seemed ridiculous but I really needed a new ride.  So, what gives?  And what does it mean to be “upside down” on a car loan?

Signed, Confused and Frustrated


Dear Confused and Frustrated:

Ok, your dilemma is pretty common these days, and unfortunately it all goes back to when you bought that war pony you just traded in.  Here’s an example to put things in perspective.  Let’s say a person wants to buy a vehicle that costs $31,000 (the average price for a new car in the U.S. according to TrueCar.com…….yikes!).  However, he only has $5,000 to put down so he needs a $26,000 loan to make up the difference.  Now let’s say the buyer is in his early twenties, carries high credit card balances, or has other issues that hurt his credit.  The dealer, or whoever it is that he’s applying to for a loan, considers him a riskier borrower and the best interest rate he can offer is 13%.  Now, for most folks a sensible car loan should have an interest rate of 8% or less. And it shouldn’t be for much longer than 3 years or 36 months. But this guy is stuck with a 13% interest rate and with a 3-year mortgage, that would mean a  Godzilla-sized monthly payment of $876, which is more than most people are willing to pay each month.  So the easiest way to lower that payment without buying a cheaper car is to extend the life of the loan, to, let’s say, six years or 72 months.  This now spreads the payments over more years and lowers the monthly payment to a more affordable $521 per month. The buyer can now afford the car, and everyone goes home happy, right?

Wrong!  The problem is that the buyer is now paying a lot more for the loan because even though his monthly payment is less, he’s making twice as many payments.  In fact, as the chart below shows, the cost of credit (the amount paid for interest in addition to the original $26,000 borrowed) after 6 years is more than $11,500!  Hey, that’s enough to buy a good used car…..hint, hint.

Loan Amount
$26,000
3 years or 36 months Loan Term
13% Interest Rate
$876 Monthly Payment
TOTAL COST OF LOAN $31,536
TOTAL COST OF INTEREST ON LOAN $5,536

$26,000
6 years or 72 months Loan Term
13%
$521 Monthly Payment
TOTAL COST OF LOAN $37,512
TOTAL COST OF INTEREST ON LOAN $11,512

Now think about how much a car will depreciate, or lose value over the length of the loan.  Miles driven, every day wear and tear, and other factors cause most new vehicles to lose about half of their value in the first five years.  In fact, it’s not uncommon when a borrower makes a small down payment (less than 25% of the purchase price) on a high interest, long-term auto loan that the car can actually depreciate faster than you can pay it off.  So the car can lose value faster than you can pay down the loan – and this is especially true if you put a lot of miles on the car each year. So that is what it means to be “upside down” on a loan: You owe more on the car than it’s worth.

And in your case, because your old war pony was worth less than the amount you owed on it, the dealer simply tacked that outstanding loan balance onto your new loan, leaving you with an even bigger loan.  It also meant that you had no equity, or value, left in the old vehicle so when you traded it in, you didn’t get any extra money for the down payment on the new purchase.  A tough break, one that makes you miss simpler days when war ponies ran on hay instead of gasoline.

So how can you avoid being “upside down” on your next car loan? Here are some tips:

  1. Pay at least 25% of the purchase price of the vehicle up front when you buy it.

  2. Try to avoid car loans any longer than 3 years or 36 months (but up to 5 years is ok).

  3. Push for the lowest interest rate possible – 8% or less is ideal. And shop around to find the best deal!

  4. Don’t let your monthly car payment and cost of insurance exceed 25% of your total monthly income.

  5. Take good care of your vehicle – try to drive fewer than 12,000 miles a year and keep up with scheduled maintenance and repairs.

Follow these five simple steps and I guarantee you’ll never be “upside down” on a loan again.  I understand this might mean you’ll have to purchase a more modest war pony than you had hoped for, but who cares?  It’s the person driving the car that counts, not the other way around!

Big Risk

Dear Dr. Per Cap: Last month, after 30 long years, my husband and I finally made the final mortgage payment on our home.  We’re thrilled to no longer have a monthly mortgage payment and look forward to saving some extra money for a much needed vacation.  But now my husband thinks that because we are no longer required to have homeowner’s insurance, we can save even more money by dropping the coverage.  Is this a smart move?

Signed, a Proud Homeowner

Dear Proud Homeowner:

That’s great news about paying off your mortgage!  So happy to hear you and your husband finally own your home free and clear.  I’m also glad you will be able to save some extra money now that the burden of a monthly mortgage payment is gone.  But dropping your homeowners insurance is not, I repeat not, a smart move.  Here’s why.

Regardless of who owns your home, you or the bank, the risk of losing your home due to fire, vandalism, or certain acts of nature is always present.  So in the unfortunate event that your house burns down, a good homeowner’s policy will pay out the value of your home so you can rebuild or purchase a new home.  A mortgage company will always require a borrower to have homeowner’s insurance because it has a vested interest in the property.  But that motivation is to protect its interest, not yours.  When a homeowner finally pays the mortgage off, the company could care less whether or not the home is insured, because it no longer has a financial interest in the property.  But you and your husband sure do.  And it would be a shame to lose the home you’ve worked so hard for and not have it insured.  Sadly, I’ve seen uninsured homes on the rez destroyed by fire, especially some of the older tribal homes that have long since been paid off, or even homes that people have built themselves without ever having a mortgage.  Believe me, it’s not a pretty sight.

I think sometimes people also just don’t understand how important insurance is because it’s not something we think about every day.  Whether we’re talking auto, homeowner’s, life, or health insurance – you name it – it often gets forgotten.  But it’s another financial product just like a credit card or a bank account, and it protects individuals and families against various risks they face throughout their lives.   Moreover, homeowner’s insurance is really cheap compared to other types of insurance, such as auto insurance.  It’s also easy to purchase regardless of whether you live in the city or on tribal land, and is readily available from a wide range of insurance companies.  So do yourself and your family a big favor and keep your homeowner’s insurance policy.  And, oh yeah, enjoy that well-deserved vacation!

A Wild Ride

Dear Dr. Per Cap: I am turning 18 next week and will be getting my Minor’s Trust payment.  I am psyched!  I am thinking of getting a Cadillac Escalade or may just a Land Rover.  I was wondering what color do you think I should get it in – black or gunmetal grey? 

Signed, Built For Speed

Dear Built for Speed,

Whoa there!  Let’s take a step back here and take a deep breath.  You have a lot more to think about than the color of your car. You’re about to receive a large amount of cash, and you want to make sure that money lasts longer than the new car smell. Otherwise it is just “easy come, easy go.”

This is a once in a lifetime opportunity, and you should make a plan for what you are going to do with your money before spending one dime.  The plan doesn’t have to be complicated either.   Maybe write a paragraph describing how you intend to spend your money over the next few years; or draw a pie chart with wedges that represent expenses and savings.  A good rule of thumb for a young person is to save at least 50%, but don’t be afraid to sock away more.  Then put your plan somewhere where you’ll see it every day; like your refrigerator door, bathroom mirror, or even the inside of your locker at school.

Now let’s talk about car buying. But I’m gonna have to apply the brakes here, too. Getting a new car can be fun, and a car is also a necessity for many people. But keep a few things in mind. First: a car is not an investment because it actually loses value, or depreciates, over time.   In fact, some brand new cars can depreciate by as much as $2,000 the moment you drive them off the dealer’s lot!  So don’t assume your car will hold its value if you ever need to sell it.

Next, remember the words a wise man once told me: “You start paying for a car after you buy it.” (Would you believe the wise man was actually my high school wrestling coach? Yep!)   And my coach was right because as soon as the ink dries on your sales contract, and you’ll be spending more money on stuff like insurance, gas and maintenance.

The third thing to think about is that those car dealers are smart, and know how to separate people from their money – they are good at their job. So be a savvy shopper and maybe take an experienced friend or family member with you when you are looking around for the perfect car, to make sure the car salesman doesn’t take you for a ride.

Ok, so now that you have the road map in front of you, and you have your plan, think about what car best suits your needs – do you need good gas mileage, a big truck bed, or is reliability the most important thing?   Next, if your budget can afford it, you can think about your wants too – a kickin’ stereo, rims, sunroof, tint, etc. Then shop around, and take your time. And before you know it, you’ll be zooming around town in your dream car – and still have money in the bank for later. So sit back, relax, and enjoy the ride!

PS: Oh, yeah, and I vote for the color red.

Stock Market Jitters

Dear Dr. Per Cap: Last summer I opted into my tribe’s 401-K plan.  Everything was going great until February when the stock market started freaking out.  One day the market is up and the next it feels like stocks are going to come crashing down.  My account balance is down for the year and I’m worried it’s going to keep dropping.  What should I do?

Signed, Stressed in Lapwai, ID

Dear, Stressed

First off step back, take a deep breath, and relax.   I know it’s hard to watch your money rise and fall like a Tilt-A-Whirl at the state fair but remember unless you suddenly decide to sell or liquidate the investments in your 401-K you’re only looking at unrealized paper losses.  You didn’t mention your age but I’m guessing you’re still a few years away from retirement.  Meaning you’re a long term investor who won’t need to start withdrawals any time soon – more reason to relax.

The volatile market we’re in has a lot of investors worried right now and everyone has an opinion about what’s going on – rising interest rates, fears of a global trade war,  overvalued stocks coming back to earth – take your pick.  As of early April 2018 all major U.S. stock indexes are down for the year with technology stocks taking an especially hard beating.  That’s a wake up call considering  high flying tech stocks like Facebook, Apple, and Google parent company Alphabet, driving forces in last year’s strong overall market gains, have collectively lost over $300 billion of market value since mid-March.  How do they protect that data!

Another concern is that bonds, often a shelter in times of stock market turbulence, aren’t performing any better than stocks these days.  So where should an investor put her money?

I’ll respectfully dodge that question by recommending that an investor first come up with a view of where you think the bull market is heading.  A bull market can be described as a prolonged period in which stocks or other investments increase in value.  And the current bull market in stocks just celebrated its tenth birthday having officially begun in March of 2009.  To put things in perspective they were still putting cassette players in new cars when this thing started, making it the second longest bull market since the end of World War II.

So the real question is how much longer can it last?  If you think this year’s volatility is just a speed bump on the road to higher stock market gains you’ll probably want to stay the course, maybe even increase your monthly retirement contributions to buy on the dips.

On the other hand if you think the bull market is riding into the sunset like a cowboy in a George Strait ballad it might be time to re-balance.  So if you’re less than ten years from retirement consider shifting your 401 K holdings away from stocks and into U.S. Treasuries, high quality low risk securities issued by the federal government, or a cash equivalent money market fund.  Bear in mind you won’t earn much return with a money market but you also won’t lose any principal – your original investment.

If you’re not sure which way the market is heading understand that most folks currently fall into the second camp.  In fact according to the American Association of Individual Investors, only 31% of individuals expect stocks to go up over the next six months.  Yikes!  And remember what a wise person once said:  “Life is like a roller coaster.  It has its ups and downs.  But it’s your choice to scream or enjoy the ride.”

It’s YOUR Money

Dear Dr. Per Cap: It’s tax time and I have a lot of money coming to me. I was thinking of taking out a loan against my tax refund because why should I wait if I don’t have to?

Signed, Tired of Waiting

Dear Waiting: How you would feel if you loaned someone $2,000 and they waited a year to pay you back? Then, to make matters worse, they only gave you $1,700?

Sound ridiculous?  Most of us would probably think so, but if you’re like millions of Americans who pay to have their taxes prepared every year, this might be what is happening to you.  Here’s how.

The refund you receive after filing your tax return often comes from having more money withheld from your paychecks throughout the year than you actually owe in taxes.  And for many, this over payment of tax amounts to thousands of dollars.  Now you might prefer overpaying to avoid owing the IRS additional money at the end of the year.  That’s fine as long as you understand that your refund is not free money or a bonus, as some mistakenly believe.  But rather, money (that belongs to you) that the government “holds” during the year and then pays back the following year.  It’s really like giving a loan to the U.S. government … but Uncle Sam does NOT pay interest on it. 

I made the mistake one year of taking out a loan against my tax refund so I could my money sooner. When all the dust settled, I figured out I had paid $400 to someone just to get my money one week faster. Those tax preparation fees and loan fees really add up!

So watch out for those high fees that many tax preparation businesses charge to complete fairly simple returns (close to $300 in some cases).  If you choose a high-interest refund anticipation loan that promises a faster refund than direct deposit, then you’ll pay even more. 

Does this sound like free money to you? 

If you don’t like people getting a cut of your free money, consider consumer friendly tax-preparation options such as Volunteer Income Tax Assistance (VITA).  VITA sites serve many Native communities and will prepare your taxes for free if you meet certain income requirements.  And finally, stay clear of those loans against your tax refund. With direct deposit or the IRS debit card, you’ll get your money quickly in 5-7 days anyways. You shouldn’t have to pay extra to get at your free money!