Most of my professional career was spent helping people manage their money, ranging all the way from advising them on specific income tax or investment problems to overseeing all their financial affairs. Because many of them came to me only after getting into financial difficulty, I’ve probably seen every mistake ever made in personal financial planning and the consequences thereof; I’ve compiled a list of the ten most common.
By “most common” I mean the mistakes that are made most often by most people, and that’s the order in which I’ll present them – the order of frequency, not the order of devastation, because the degree of devastation depends entirely on a person’s particular circumstances. What might be just a small dent in one person’s finances could easily put someone else into bankruptcy, and vice versa.
Another important point about these mistakes is that people at all levels of wealth and income make them. The same mistakes cause financial difficulties for the millionaire and the blue collar worker alike. The only difference is the number of zeroes involved.
Number 1: Buying Too Much On Credit
The most common personal financial mistake made most often by most people is buying too much on credit. More people, rich and poor alike, get into financial difficulties because of buying too much on credit than for any other reason.
The key words here are too much. It’s rare to never have to borrow money or buy something on credit. For example, few people can buy their first house, or even their first car, for cash. The mistake is to overdo it. Don’t buy a Cadillac when an Impala is all you can really afford, and don’t take out a mortgage for a four-bedroom, two-storey house when a starter bungalow is all your salary can sustain. By the time the debt and interest from buying on credit are paid off, the total cost often doubles or triples, often using up money that’s needed for other purposes thereby compounding the mistake.
In these days of unsustainable low interest rates the temptation to make this mistake is probably greater than it’s ever been. You may be able to afford that 4.9% mortgage now, but what if the rate doubles or triples over the next few years?
A good rule of thumb is to borrow only for what you need, wait until you can afford the things you simply want.
Number 2: Borrowing At The Wrong Place
I don’t mean that one financial institution is better than another. What I mean is you should borrow where the loan is going to cost you the least by the time it’s all paid off.
You not only have to compare interest rates, but you also need to determine how often the interest is going to be compounded, which means how often is the interest going to be calculated and added to the amount you owe. For example, in the first year of a $5,000 loan with 10% interest, compounded quarterly, the total interest would be $519.07. If the interest rate was 10 ¼%, but compounded annually, the interest would be only $512.50. So, a rate of 10% compounded quarterly is an effective annual rate of 10.38%, which over the long life of a large loan can make a big difference.
Another point to always check out when borrowing money is to determine all the costs, many of which may be disguised as something other than interest, such as administration fees, registration fees, repayment bonuses, renewal fees and whatever else the particular institution is able to come up with.
What has to be compared is the total cost of paying off the loan at one institution compared to the total cost of paying it off at another.
Number 3: Not Paying Off Debts As Quickly As Possible
This applies particularly to charge accounts and credit card balances. People often forget, or overlook, that if you don’t pay off the balance in full every month, it’s the same as borrowing that amount at an incredibly high interest rate. Because not paying off charge account and credit card balances in full each month is the most common form of borrowing at the wrong place, you’re also committing mistake number 2. Credit cards and charge accounts are meant to be substitutes for cash, not substitutes for borrowing. When used as substitutes for cash they’re wonderful; when used as substitutes for borrowing, they’re disastrous.
In addition to the unbelievably high interest rates on unpaid credit card and charge account balances, there’s another reason they shouldn’t be used as substitutes for borrowing rather than substitutes for cash, and that is that there’s absolutely no discipline employed in taking out the loan – you don’t have a set payment schedule and you have no idea how much it’s going to cost you. If you apply for a consumer loan you’re going to have to come to grips with the amount of the monthly payments and exactly how long it’s going to take you to pay it off, which might keep you out of mistake number 1 as well as numbers 2 and three. And speaking of consumer loans, if you can’t pay off your credit card and charge account balances in full, you’ll be much better off to obtain one to do so.
You should also pay off your mortgage as fast as you can. If you paid off a 10%, $50,000 mortgage over 15 years rather than 25 years, you would save almost $40,000! And to accomplish this you would have to increase your monthly payment by only $84. Many people spend more than that on coffee. Another thing to remember is that dollars saved are whole dollars. Earn an extra $40,000 and you have to pay tax on it, but save $40,000 and the money is all yours.
Number 4: Renting Your Living Accommodation Rather Than Buying It
Now don’t stop reading yet! I know there are lots of you who would far rather rent than own, and that’s a lifestyle decision I’d never argue against. I also know that there are many of you who haven’t accumulated enough money for a down payment on a residential purchase. I know, too, that there are a number of people outside of Canada who read my material, so I hasten to add that the following comments, and this rule itself, may not apply to you. But for Canadians, from an economic standpoint, over the long term, it’s a mistake to rent living accommodation if you can buy.
There are several reasons for this. First and foremost, your home is the only investment you can sell for a profit and pay absolutely no income tax whatsoever. Second, residential real estate in Canada is as good a hedge against inflation as you can find – especially over the long term. Third, your home is one of the very few investments you can make that also fills an absolute need; everyone needs a roof, four walls, and a place to go to the bathroom. Last, and certainly not least (but most often overlooked), your home provides enormous potential for continuous enjoyment. With the increased use of cable, satellite dishes, internet, large screen TVs, PVRs, video games, and other recreation facilities such as swimming pools and home gyms, this factor continues to increase in importance.
A common mistake people make in this area is to put off buying a home until they can afford their dream house. Get into a starter home as soon as you can so that benefit from increasing real estate values rather than falling behind on the sidelines while paying rent to someone else.
Number 5: Not Budgeting For Non-regular Expenses
People, who don’t budget for once-a-year expenditures such as insurance premiums, vacations, subscriptions, lump sum retirement plan contributions, and even Christmas, are making this mistake. You’re also making this mistake if you don’t budget for even less regular outlays, such as trading the car and major repairs or renovations.
The danger in making this mistake is that it usually ensnares you in mistakes 1, 2, and 3 – the borrowing problems.
Number 6: Not Budgeting At All
People shy away from personal budgeting for a number of reasons: they think personal budgets have to be very formal documents; they think they’ll become slaves to record-keeping; and, they think budgets will cramp their style. None of this is true.
Personal budgeting simply involves comparing your planned expenditures with your income over, say, the next year. The budget itself is the only document that you need add to your records. And, rather than cramp your style, having a budget will help you decide what you can afford and when you can afford it, thereby keeping you out of mistakes 1, 2, and 3.
Every person I know who has tried personal budgeting swears by it.
Number 7: Buying On Impulse
This is not about buying a blueberry pie when you just needed a quart of milk. This refers to big ticket items, like cars, jewelry, furniture, appliances and, in some cases, even houses.
On big-ticket capital items that you expect to own and use for a long time, the more expensive, high-quality item is very often the cheapest in the long run. I’ll never forget the advice I was given by a very wise clothing store owner, Max Gold, when I bought my first clothing after starting work. He said, “When you buy a cheap outfit you’ll be happy when you buy it but unhappy every time you wear it. When you buy a quality outfit you may be a bit unhappy when you buy it, but you’ll be pleased every time you wear it.” This advice applies to all major purchases.
Another thing to remember is that you can negotiate price on almost any big-ticket item. Always shop around and look for the best long-term deal.
Be especially wise when making a really large purchase because it sometimes takes years to overcome the negative financial effects of one major, bad impulsive purchase.
Number 8:Trying To Make A Quick Buck When Investing
The real meaning of “investing” excludes trying to make a quick buck. Trying to make a quick buck is always speculation. Unless you’re using money that you can clearly afford to lose, it’s always better to opt for a lower but surer return.
When faced with two seemingly identical opportunities but the rate of return on one is much higher than on the other, the chance of losing your money in the one with the higher return is always greater than with the more conservative option.
Then there are the “hot” stock market tips from inexpert people. You’d be better advised to go to the race track. At least you’ll have the fun of watching the horses run.
Number 9: Making Investments That You Can’t Really Afford
This one is really quite easy to avoid. If you have to borrow money to make the investment then you can’t afford it. If you borrow to buy stocks, mutual funds, or a condo to rent out, sharp increases in interest rates, significant drops in the market, or the need to get your cash back for other purposes could all force you into panic moves prompting you to sell at a loss. And in these cases the loss is usually significant. On the other hand, if you could really afford the investment you could wait out such financial storms.
Number 10: Thinking The Future Will Take Care Of Itself
It never has and it never will.
We have to plan prudently for long-term requirements such as children’s education and our own retirement. We also have to prepare as well as we can for emergencies such as the death of a breadwinner, the collapse of a business, the return of high inflation, or spiralling interest rates.