The 3 Biggest Money Mistakes You Can Make
|October 26, 2009||Posted by Roshawn Watson under Uncategorized|
Borrowing on Your Home Equity
Perhaps this is a mute point for most due to the mortgage crunch; however, real estate is showing signs of recovery. The $8,000 tax credit is prompting many to take the plunge into home ownership for the first time. Additionally, home prices are returning, which is great news. However, in the midst of the celebration, the old admonishment still holds true: leave that equity in your home alone. By far, one of the most common reason to tap home equity is to “pay off” consumer debt through a debt consolidation loan. For the vast majority of those with consumer debt, the debt is not the problem but rather a symptom of poor financial management (or an emergency that wasn’t prepared for). Sure that’s a hard stance, but it is also true. What’s important is that we realize that one generally cannot borrow his way out of financially trouble. The debt only makes the problem worse. That’s exactly what happens with home equity lines of credit (HELOCs).
Lenders tout HELOCs as a way to pay off credit cards, student loan debt, and other consumer debt. Even some personal finance journalists promote these loans stating that you can get these loans at a lower interest rate than other loans, plus the interest you pay is tax-deductible. Americans have bought the goods too. According to SMR Research and Freddie Mac, we have cashed out more than a whopping $2 trillion between 2002-2005. It is always surprising how many people will borrow on their homes to pay Visa, Mastercard, and American “Excess.”
Unfortunately, there is a catch. Brittain associates reports that nearly two-thirds of people who borrowed against their homes to pay for credit card debts had run up more debt in two years. Instead of solving the problem, the HELOC consolidation only served to move the debt from an unsecured loan (i.e. credit card) to a loan secured by your home.
I wouldn’t even set up a HELOC for “emergencies.” Instead, I would use an emergency fund: three to six months worth of expenses in a money market or savings account. It wouldn’t be horrible to go up to eight months. Sure this is boring, but it is also responsible. Additionally, many people don’t realize that many lenders will close your HELOC at the first sign of financial trouble (i.e. missed payment), so it’s not a good financial buffer anyway since it can be closed precisely when you need the cash.
Borrowing on your 401K
Another big mistake is borrowing on your 401K. At some point, we all need to retire. If you tap your account, not only will your money not grow, but you can be subject to severe penalties and taxes. Over eighty percent of American workers with 401K accounts have the option of borrowing on their retirement account, and twenty percent of participants do just that according to the Investment Company Institute.
Many of those who do borrow on their 401K accounts consider themselves pretty savvy. After all, the interest paid back to the account is their money, so they are effectively paying interest to themselves. The problem arises if they cannot pay the money back, for example if they get fired or lose their job. Often one will have to repay the money within weeks or the loan is counted as a “premature distribution.” In this case, one would have to pay taxes on the money withdrawn from the 401K at their present tax bracket, which for many is about 25% plus get a pretty hefty penalty. For many people, they end up losing 40% of the money. That’s obviously a bad deal. Also, by borrowing, they’re putting their retirement at risk. It just not worth it unless you are facing bankruptcy or foreclosure.
Stretching to Buy A Home
Perhaps this is the most difficult not to partake in because purchasing a home is such an emotional purchase for so many people.
It is almost as if the lender and real estate broker conspire against you, so that you will purchase a home that costs more than you can afford. Of course, when you purchase a more expensive house, the real estate agent gets a bigger commission and the lender racks up more interest and fees. Indeed, 40% of homebuyers are overextended. This means that the sum of the principal, interest, taxes, and insurance exceed 28% of your gross income. This is particularly troublesome because this means that there is less money for investing for retirement, college funds, vacations, eating out, giving, maintenance on the house, etc.
Don’t mortgage your future by becoming house poor. That dream home will become a nightmare once Murphy comes to visit you.
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Copyright 2012, Roshawn Watson, Pharm.D., Ph.D. All Rights Reserved.