Five Money Missteps
State Farm Insurance recently published “Five Money Missteps to Avoid” in their monthly magazine. (Thanks for sending this, Jay!)
I’m a sucker for short lists that help you succeed one sound bite at a time. They’re a quick read, they’re easily compared to your own practices, and you don’t feel as if you’re slogging through a personal-finance marathon. The trick is applying them to your own situation, which frequently requires thinking about your own values and then analyzing the math.
Along with the article’s text, here’s a more in-depth discussion of these mistakes from a military family perspective:
1. Tapping into your retirement account early.
Good: Easy money! A quick solution for spending emergencies.
Bad: Higher income taxes plus possible penalties on the withdrawal. Once the money’s taken out of the retirement account, it’s no longer compounding for your retirement. 401(k)s can be tapped for a loan (you’re repaying yourself with interest), but if you lose your job then the loan is either immediately due or classified as an early withdrawal.
It’s possible to take a loan from the Thrift Savings Plan. If you must tap a retirement account then this one will probably have the lowest interest rate: whatever the G fund yields. That rate will be fixed for the life of the loan (1-15 years). You might even be able to arrange the loan without having to tell your chain of command, which is perhaps more attractive to some servicemembers than requesting advance pay. However the loan effectively busts your TSP account’s returns down to the rate of the G fund without any compounding benefit.
Don’t borrow from your retirement account. Consider the following options:
- Roth IRA contributions can be withdrawn any time.
- A Roth IRA can also be tapped for a first-time home purchase or educational expenses.
- A long-term way to tap into a conventional IRA before age 59½ is a series of “substantially equal periodic payments” based on IRS tax code rule 72(t). Although this method works well for early retirees, it’s exceedingly complex.
Again, although these withdrawals may not be penalized, they’ll be subject to income tax and won’t be compounding away in your retirement account.
2. Paying too much for your mortgage. (Both the payment amount and the interest rate.)
Good: “Gosh, we can live in a great house/location!”
Bad: You won’t spend much time in your great house/location because you’ll be working to earn the money to make the payments. If the housing market drops then you may even owe more money than your home is worth.
Really bad: Active-duty military may have to transfer on short notice, resulting in extra house/mortgage expenses that could lead to foreclosure or even bankruptcy.
A generation ago, mortgage lenders used to limit the payment to 28% of your after-tax income, while limiting total debt (house, car, student loans) to ~36%. This was conservatively based on decades of payment statistics because the lender was probably going to keep your loan on its books instead of selling it to Wall Street for “creative financial engineering”.
Even with today’s record-low interest rates, mortgage balances have been rising. In “The Two-Income Trap”, Elizabeth Warren claims that two-income couples have spent the last 30 years bidding up the prices of homes in good neighborhoods with good schools. This is especially problematic for active-duty military because they’ll transfer so frequently that they’ll rarely profit from real estate appreciation. Equity gains (if any) will be spent on the transaction costs and unreimbursed moving expenses.
The only time to keep a mortgage with a higher interest rate is when you’re aggressively paying it off early. Do the math: the total difference of the higher monthly payments should be less than the refinancing costs. In most cases this difference will be just a few years of higher payments.
While you’re on active duty it’s almost always safer to rent (or to live on base) than to own. After you leave active duty there will be plenty of time to find a good home and make a fortune in real estate.
3. Confusing sticker price with affordability. State Farm says “Being able to make a monthly payment doesn’t necessarily mean you can afford a purchase. If you want to buy a car but can’t also manage the insurance, gas and maintenance expenses, you can’t truly afford the purchase.”
Good: “Wow, look how much money I can borrow!!”
Bad: Eventually you’ll have to pay it back.
The root of this misstep is the retailer’s dream: shopping based on how much you can (probably) pay, not on how much value you’ll receive. Every car sales rep knows that buyers are much more susceptible to maximizing their monthly loan payment than they are to assessing how much that vehicle (and the loan) will cost them.
The best approaches?
- Save up the cash to buy the car.
- Try to choose housing and work locations that minimize the commute.
- Use alternate transport (public transportation, carpools, bicycling) as much as possible.
- Buy a used vehicle in a model with a high reliability record.
4. Saving for your child’s college education instead of your retirement. State Farm says: “Many families opt to fund college accounts before contributing to their long-term savings. But experts agree that while there are affordable college loans, there aren’t comparable loans to cover basic retirement expenses– so pay yourself first.”
Good: Nothing about this is good for you. It might not even be good for your college student.
Bad: You’re sacrificing your retirement future in the hope that your kids will get a good return on your investment. This is problematic.
5. Not protecting your income. State Farm says: “If you suffer a disability and can’t work then every person who relies on your income will be negatively impacted. Disability insurance can protect your family against the loss of a paycheck by making up a sizable chunk of that lost income.”
Good: When you’re on active duty, your disability benefits are far more affordable than the civilian equivalent.
Bad: Most of the military’s occupational hazards tend to be deadlier than civilian careers.
When you’re leaving active duty, pay close attention to your medical & dental records to make sure that any potential disability issues are evaluated and assessed. This is tedious and time-consuming, so start at least six months early and don’t be dissuaded by the bureaucracy. As hard as it may be, it’s far easier to complete this process on active duty than after you’ve left the service.
If you pursue a bridge career after the military then buy disability insurance. It’s just as essential as life, home, vehicle, and liability insurance.
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