Science magazine just published a study that found that, if you’re poor and also mismanage your money, it’s possible that you might be able to make good financial decisions but more than likely you’ve trapped yourself into a vicious circle and can’t. Problems caused by being poor are more than likely having an effect on your judgment which means that you’re going to be even worse off because of the bad decisions that you’re poverty is forcing you to make.
While it may not help a whole lot to know that you’re not alone, today we put together a blog for those people who are struggling financially. It’s not exactly going to show you what to do to get out of the poor house but rather will explain how 3 things that most people do, including buying a house, a car and their retirement plan, while they seem like good ideas, are not being handled correctly by most people with severe financial problems.
Buying too much house. While few personal-finance experts will tell you that buying house is a bad idea, most will advise their younger clients that it is possible to buy one too early, before you’re ready, as well as buying a house that’s just too big.
The fact is, the romantic notion of owning a home drives many people to make bad decisions and take out mortgages that are much too big for their wallets. Having a nice house but not having either the money to pay the mortgage or money left over to pay anything else are both causes for trouble.
Many people don’t know how to use or simply don’t have a budget when they buy their house, one “red flag” that really says that they aren’t yet financially ready. Not being able to put down at least 20% or not having a 6 to 12 months emergency fund already set aside is another reason to put off buying a house but, unfortunately, many people don’t realize this and rush in with great intentions but bad financial ability.
Buying an expensive, new car. Probably more than houses, people make huge mistakes when buying cars, especially because the payments might not seem all that expensive. For example, extending a 3 year loan to 6 years will lower the cost on an $18,000 car from $531 a month to $282 a month. While this might seem like a “bargain” it obscures the fact that those extra three years will end up costing you an extra 20% on your car.
Even worse, if your interest rate is 4% (the average these days) you’ll be paying nearly $1200 more in interest alone. If you have good credit it might be worth doing this to get the lower payments but, if your credit isn’t so good, you’ll probably be paying an interest rate closer to 18% which will raise your interest costs to just about $5000 or 320% more over 3 years. Spread that loan out over 6 years and your interest claims to a whopping $11,000! What that means, numbers wise, is that you’re going to be paying $29,000 for an $18,000 car.
Most financial experts will tell you that you should never buy a car that costs more than one 10th of your gross annual income. What that means is that, if you make $60,000 a year, you shouldn’t spend it more than $6000 on a car. While that’s not exactly realistic based on today’s new car prices, it’s certainly a good point to start from. While $60,000 a year might be a lot for a young, single person, for a family of four it’s actually not all that much.
Withdrawing money for anything else but your retirement from your retirement plan. Times definitely are tough but, unless you’re in an extremely dire financial situation, withdrawing money from your retirement account like your 401(k) or Roth IRA is possibly one of the worst mistakes that you can make with your money. The US Department of Labor even coined a phrase for people who take money out of their retirement accounts to pay for other expenses. They call it “leakage” and, like a water bottle with a hole in it, you can lose a lot of money before you realize that it’s gone.
Here’s a great example of how bad a decision this actually is. Take a 25-year-old man and say that he wants to buy a $5000 motorcycle. Since he’s in the 20% marginal bracket the penalty for taking money out of his IRA will be 10%. He’ll actually need to take out just under $8100 to pay for the motorcycle and the taxes. Doesn’t sound so bad, right?
Had that young man left the $8100 in his IRA and had it earned an average of 8% return, by the time he reached 65 he would’ve had over $195,000! That, in our opinion, is one very expensive motorcycle.
All three of the financial mistakes above can, in most cases, be easily avoided if you make and keep a budget, spend frugally and try hard not to keep up with the Joneses. In the long run the money lost will be substantial and, in most cases, the gratification will have long been gone by the time you realize just how money you’ve lost.