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Three Popular (But Dumb) Money Moves
Wednesday, 31st January 2007 (by J.D.)This article is about Choices
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Liz Pulliam Weston — one of my favorite professional personal finance writers — has a warning regarding the three worst money moves you can make.
Sound financial advice doesn’t change much from year to year. Bad money management ideas, however, seem to mutate and flourish with each passing season…Ultimately, it’s up to you to resist bad advice and protect your own financial futures.
She writes that the three pieces of bad money advice currently en vogue are:
Use a home equity loan to pay off credit-card debt
This is tempting because home equity rates are lower than credit card rates and the interest is tax deductible. But if you make this move without ditching the credit cards, you risk digging yourself into a deeper hole. “Nearly two-thirds of the people who borrowed against their home equity to pay off credit cards had run up more card debt within two years,” writes Weston.
I’m one of the minority: when I moved my debt to home equity, I destroyed my personal credit cards. I’ve been lucky. There were certainly times I was tempted to take out new credit cards and acquire new debt. Those urges are gone now, and seemingly for good.
Cash out your retirement
Weston’s article discusses borrowing from a 401(k). This is a poor move, she says, because it puts your retirement at risk. People often find it difficult to repay the money borrowed from a 401(k). Worse, if you’re not able to re-fund the retirement plan on schedule, that investment is lost to you forever.
My family’s business offers its employees a profit-sharing retirement plan. When an employee leaves the company, she may cash out the portion in which she is vested. To date, every employee who has left us has done this. When they withdraw the money, it is taxed as a lump-sum and is subject to penalties. One employee cashed out $50,000 early, but sacrificed nearly $20,000 to do so.
Overextend to buy a home
Real estate agents, mortgage brokers, and banks are all anxious to get you into an expensive home. Even friends and family sometimes join the act. Don’t take the bait. A high house payment can be a soul-crushing experience. Weston notes:
Buying too much house could mean giving up other things you want: vacations, eating out, a college fund for your kids, a sufficient retirement kitty. Or it could mean ever more debt, as you borrow to try to maintain your lifestyle.
When we bought our first house in 1994, we were told that our regular housing expense — principal, interest, taxes, and insurance — shouldn’t total more than 28% of our pretax income. When we bought again in 2004, that number had risen to 33%. This difference may seem small, but it can make a huge difference. Many experts recommend ratios as small as 25%. After thirteen years of homeownership, I’m inclined to agree — for our new house, we aimed for a payment less than 20% of our pretax income.
(JLP has a recent post on determining how much house you can afford. Also, Mapgirl says that you know that you’re ready to buy a house “when you’re ready for the responsibility”.)
These three moves can be very tempting — they promise quick and easy money. It’s the lure of a wonderful today at the expense of a miserable tomorrow. Be careful.
[MSN Money: The three worst money moves you can make]
15 Responses to “Three Popular (But Dumb) Money Moves”
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January 31st, 2007 at 7:40 am
Our mortgage is at 13% of our gross income and 20% of our net (after savings, giving, etc.). We’ve been concentrating all our funds at our debt which, thankfully, we just finished paying off this month.
(Thanks to Get Rich Slowly for keeping me on the straight and narrow!)
Now my wife and I are trying to pay off our current house or move to something a little nicer. I’m torn, but I’ll enjoy my low mortgage in the meantime!
January 31st, 2007 at 7:56 am
Our housing expense (15 year fixed- principal, interest, taxes, and insurance) is at 17% of our pretax income (base pay, not counting overtime or bonuses, etc). 25-33% is just too high - there is no way we could afford retirement investments if we doubled our home expenses! And this means we also get to keep less in our emergency savings, which equals more money to invest or spend. It’s really not that hard to do - spend just a little bit less on your mortgage and you’ll reap tons of savings in insurance rates and taxes.
January 31st, 2007 at 8:00 am
Exurban Jon - Congrats on paying off your debts this month!
January 31st, 2007 at 8:09 am
I don’t brag much about my financial acumen, but I’m very proud to say that I’m zero for three on this one.
The one that scares me the most is the home equity line. The thought of losing my house just to buy a new sink or pay off credit card debt makes me break into cold sweats.
January 31st, 2007 at 8:17 am
Regarding cashing out your retirement, there’s one situation where this might make sense: using a Roth IRA toward a first-time home purchase. I have two small (around $5,000 each) Roth IRAs that I can’t contribute to anymore because I moved permanently to another country. I’m planning to cash out both of those to help with the downpayment on my first home. You can use a Roth IRA for this purpose with no penalty, and you don’t need to pay it back. And according to the IRS, your first home can be anywhere (in my case, Canada). If my IRAs were more substantial I’d probably leave them alone, but these two small ones are not growing much and represent onlly a small percentage of my total retirement savings.
January 31st, 2007 at 8:57 am
Thanks for the link JD! I firmly believe that a person has to be ready for the responsibility first and foremost, otherwise the headaches of homeownership will get in the way of enjoyment. (Life isn’t always about the money!)
January 31st, 2007 at 9:15 am
Thanks MM!
January 31st, 2007 at 10:09 am
When an employee leaves the company, she may cash out the portion in which she is vested. To date, every employee who has left us has done this.
That’s pretty alarming.
Along similar lines: I find it boggling that people treat tax refunds as “free money” to blow on a car, a holiday, or whatever.
A big refund may be a nice surprise, but what it really means is that you’ve been managing your money badly: you’ve been overpaying the IRS, and now they’re giving it back with no interest paid. Better to adjust your withholdings and save the surplus into something that’ll actually give you a return on your investment, no?
And as for “refund anticipation loans”: *boggle*. Now you’re paying interest on money which was yours to begin with!
January 31st, 2007 at 12:31 pm
The first one is kind of a bait and switch. The idea itself is not bad. It’s the lack of follow-through with something entirely unrelated that’s that problem. Consider the alternative of continuing to build up credit card debt at enormous rates. This advice really boils down to “don’t live on credit” which is obviously a good idea.
As for your family-owned company’s profit-sharing plan, that’s really odd. I don’t know of anyone that’s ever cashed out their 401k plan when they moved their job. It makes me wonder if there’s a difference between your profit-sharing and a 401k. Perhaps people are not educated in the consequences. Or perhaps people fear that if they don’t pull the money out of the plan now, it could disappear if the company goes out of business. Or perhaps people are worried that it could disappear like many companies’ pension plans.
January 31st, 2007 at 2:17 pm
One thing to keep in mind is that in many “hot” parts of the country, you simply cannot buy a house with a mortgage that’s under 25% of your monthly income. Maybe it’s better to rent in those areas, but if you want to buy a home, good luck. And trading a huge commute with its associated expenses for a more expensive home is only fooling yourself.
January 31st, 2007 at 3:24 pm
This is what I call creepy math. Where I live and work, I can’t rent an apartment OR buy a home for less than 28% of my monthly income.
Not only does this condition make saving for a downpayment difficult, but even with a healthy downpayment, at many banks I can’t qualify for a mortgage that would result in monthly payments hundreds of dollars lower than my rent has been every month for the last decade.
The best I can do is use my modest apartment as a work space and claim a portion of the rent for a tax benefit, concentrate on retirement savings, and prepare to skip town for a more affordable metropolis so I can actually have some breathing room someday.
February 1st, 2007 at 8:42 am
We purchased our first house a year ago for only $75,000. Luckily it was all we could afford. Our housing payments, including property taxes, are less per month than the rent we paid at our previous place. Plus, we bought before the recent real estate boom in our city, and I estimate the value of our house has doubled (considering the price of an average house locally by the end of this year will be over $200,000).
The house is only 798 sq ft, which is pretty small for our family of five. we manage though and when our term is up in four years, we will be able to use the equity to not only pay off our mortgage, but have enough to pay a very substantial down payment on a much bigger house.
February 1st, 2007 at 8:47 am
FTR, my housing payments are 14% of my gross and 19% of my net.
February 6th, 2007 at 8:24 pm
We were saving around $1500 a month and hadn’t planned on buying a house. We were going to pay cash for a better car once we had enough. Until we found the perfect house. We consulted a realtor we knew personally and a lender he trusted. We got a 100% financed mortgage, which I was wary of, but which is still affordable. Meanwhile, all the money we saved for the “down payment” went into moving expenses, furniture, etc. We re-budgeted and discovered we could still save just under half of what we were saving before we took on the expense and still make extra-large payments on my student loan.
After all that, I was surprised last month with a mid-year raise. It’s really an adventure when you are saving money. Now we only have two debts; the mortgage and my student loan (luckily my wife got one of those “free rides” everyone talks about) We pay cash for her grad school tuition.
I consider myself lucky that we are not wealthy and we are able to live comfortably. The trick is if you marry someone who is ultra-budget-conscious, do whatever she says! It will pay off in two or three years…
March 14th, 2008 at 3:17 am
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