Common Financial Mistakes
Another great question David Chilton, The Wealthy Barber, asked me on his podcast is what big financial mistakes I see people making. I’ll discuss two mistakes I see mainly among working-age people and two more specific to retirees.
Buying expensive cars and trucks
Paying $1000+ per month on car loans for the rest of your life isn’t a sensible financial move for most people. You might need a car, but you don’t necessarily need such an expensive car. In a moment of weakness and excitement, you sign the papers on that great car. That sets up a cycle that’s hard to break. You’ll be rolling one car loan into another. The debt will keep growing and last for decades.
I used to tell people to pay cash for cars. I still think this is good advice, but people just blink now when I say it. At the very least, think about the life burden your car payments will create and choose a car that fits your budget.
Buying a house that is too expensive
This is an emotional subject. Young people aren’t to blame for the huge increases in house prices that have recently started to reverse. But young people are the ones feeling the pain. The number of forced sales is starting to increase. The people who bought thinking they had to jump in or prices would just run away from them are learning that house prices can drop.
Taking on a mortgage you can’t handle and hoping to refinance as your home appreciates only works as long as prices keep rising fast enough. This plan is certain to blow up eventually. At some point, you have to be able to make mortgage payments without the help of additional loans. Keep this in mind before you buy.
People renovate too much. Necessary repairs are one thing, but fancy new kitchens and bathrooms are expensive and unimportant. Dated fixtures and cabinets work as well as new ones will. A carefully thought out plan to improve function can be sensible, but going into debt to make things prettier is senseless.
Retirees overspending
The retirees who overspend tend to be those with modest pensions and savings. They want to continue to live life as they’ve always lived it in the same home, but they don’t have enough income and assets to get by for the long term. They’re fine most of the time paying the bills that come in every month. But less frequent costs make them dip further into their savings. It might be a car repair, home maintenance, helping an adult child, or some other demand. That $100,000 they started retirement with quickly becomes $50,000, and keeps dropping.
Maybe they’ve got a small workplace pension that isn’t indexed to inflation. Prices keep rising. At first there isn’t enough money to make bigger home repairs, but it gets worse. They don’t want to leave their homes, but there just isn’t enough money to stay. They can see that they’re in trouble. They’re worried and embarrassed.
I've painted a picture where the problems don’t seem like the retirees’ fault. But the truth is that they needed to see this coming sooner to put the brakes on spending before it was too late. Some people really do face unforeseeable challenges, but for many, the path is predictable. If you’re going to have to make a lifestyle change or move to reduce spending, it’s better to do it sooner rather than later.
Retirees underspending
The retirees who underspend tend to be those with substantial savings (perhaps $500,000 to a few million), but they fear that they’re in the overspending camp. They were good at saving their whole lives, and they’re not good at reversing course and spending their money.
This is the type of retiree good financial advisors see frequently. The fact that they have a lot of money is what made them desirable clients. Overspending retirees are less visible to advisors and the financial media. It’s the good savers who interact with online financial content, and so that content caters to them.
Good savers often retire with big RRSPs, maxed-out TFSAs, some non-registered assets, and perhaps some sort of pension. They used to have working income, and now they see a substantially reduced income. They’re comfortable spending the dividends from the non-registered assets, and perhaps the non-registered capital, but they can see this isn’t enough. They take CPP and OAS as soon as possible, but the income still isn’t enough.
They try to live as frugally as possible to leave the RRSPs and TFSAs for later. They don’t realize it, but they’re living small now so they’ll be rolling in cash when their forced RRIF withdrawals start. They’ve got everything backwards. When I try to explain the idea of spending some RRSP money in their 60s to have a decent lifestyle for their whole retirement, they look horrified. They’re not doing that.
When I try to explain that they should delay taking CPP and OAS until they’re 70, all they hear is that they should live even smaller. The RRSP meltdown strategy that increases spending for their whole retirement just sounds crazy to them.
Every situation is different, but the common theme of living small early in retirement and making the wrong moves with RRSPs, CPP, and OAS, plays out every day. These people need to take a long-term view of their retirements and consider all the options for which order to spend assets.
"...At the very least, think about the life burden your car payments will create and choose a car that fits your budget...."
ReplyDeleteI agree with the general principle, but I think the “burden” of a car payment needs to be considered relative to both income and net worth.
For someone still accumulating wealth, the usual income-based rules make sense because a large car payment can materially reduce savings and investment.
Once you've accumulated substantial assets, however, I think a better rule of thumb is to look at the annual cost of the vehicle as a percentage of investable net worth since it also could help address the retirees who underspend.
As a rough personal guideline, I might think of it this way:
Above 1% of net worth per year: material
0.5–1%: noticeable
0.25–0.5%: relatively small
Below 0.25%: increasingly immaterial
Below 0.1%: essentially a rounding error
For example, consider your $1,500-per-month lease, or $18,000 per year. At $1 million of net worth that's 1.8% annually and potentially a meaningful expense. At $2 million it's 0.9%. At $5 million it's 0.36%. At $10 million it's just 0.18%.
Same cars, same payments, but a completely different financial burden.
The better question is: What percentage of your financial resources are you willing to devote to transportation, and does that spending interfere with any of your other financial objectives?
At some point the decision stops being primarily an affordability question and becomes a consumption choice: is the enjoyment or convenience worth what you're spending?
Your analysis is sensible for those with meaningful net worth. The problem I see is with people buying their first car. They bury themselves in car loan debt before they have any meaningful savings. When it comes time to get a second car, they're once again looking at a large load with minimal down payment, or even some of the first loan unpaid.
DeleteYes, that's true, and it's an important distinction. I certainly wasn't leasing expensive vehicles when I was trying to build my net worth. I drove my share of clunkers and junkers well into my 50s because keeping money invested was far more important to me than what was sitting in the driveway.
DeleteMy argument about leasing really applies once you've accumulated meaningful net worth and have the capital to buy the vehicle outright. At that point, the question becomes how you want to deploy your capital. That's very different from someone with little or no savings borrowing $50,000 or $60,000 for a car and then repeating the process every few years. In the wealth-building stage, avoiding large car payments and putting that money toward investments probably did far more for me than any clever financing strategy ever could.
The main problem with leasing is that few people can do a meaningful comparison of costs for leases, because of the added complexity. As a result, the lease terms offered tend to favour the dealership more than purchase terms. A wealthy person might reasonably say, "I don't care if I'm paying more -- I just want the convenience."
DeleteIt was interesting to read the "retirees underspending" section. Good to know I'm not the only one. Do you have any rules of thumb for non retirees underspending? I'm 40, so quite far from retirement, but I've always had trouble spending money, where other people had an entertainment budget to limit their spending, I had one during college years to encourage myself to spend it... and would come in short most months.
ReplyDeleteI now have 2 properties (in Toronto, which is one of the most overpriced RE markets around), half a mil in registered accounts and a good salary and yet I end up living quite frugally. Any rules of thumb for invest vs live life?
My wife has always been frugal. It was necessary when she was younger and is unnecessary now. I used to be much more frugal than she was, because it was necessary. I've changed my spending as my means have changed, and she has changed much less. What changing she's done has come from repeatedly going over the numbers (she's an engineer). I have no great psychology insights for you. Keep reminding yourself of how much you can spend safely. Then when you're buying anything, recognize your tendency to steer away from the item you really want to get a cheap version. The more I remind her of how she can improve her life by buying better things or paying a company to mow the lawn, etc., the more she starts to do this naturally.
DeleteI'm an engineer too... and I have a detailed excel record of all my spending since high school (when it was necessary), when I created the system. I can tell it didn't help me as I'm still living well below my means.
DeleteI appreciate your view on this though.