We hate to burst your bubble…
But here are some personal finance myths that we hear repeated so frequently that I just had to get them off my chest…
Myth #1: Paying tons of Mortgage Interest Does Not Matter because it is tax deductible.
Not quite, this is the wrong attitude. Many people seem to think that it is beneficial to have a huge mortgage so they can have a huge “tax savings”. I will lay it on the line. Having to pay interest by itself is BAD! You are being forced to pay more than something is worth just because you did not have the cash to buy it outright. Interest is paid merely for the privilege of having borrowed that money. With that said, mortgage loans can have their interest written as this interest is tax deductible.
Convenient? Sure, but a far cry from “savings.” It is more so a “discount”. You are still paying a bucket load of money to borrow for your home, but you are getting a percentage of it back as a discount or rebate. It is not a savings! However, due to the discount, mortgages and home equity loans do tend to be the cheapest way to borrow money, so if you absolutely have to borrow, then it can be the way to go. But having to pay interest is generally not the way to go. The best interest is no interest, and the best debt is no debt.
But if you must borrow, getting a low interest rate and having it be tax deductible is certainly better than a high rate that is not deductible as seen with credit cards, personal loans, payday loans, etc.
So, paying deductible mortgage interest is helpful but only because it is better than the alternatives. But, having to pay interest, i.e., thousands of dollars per year to a lender just for having to borrow, is not so fantastic.
Myth #2: Refinancing to a lower interest rate will save interest in the long term.
For the vast majority of folks this is true, but not always. The problem arises for people who have already paid down their mortgages substantially. Let us say that 5 years ago, you borrowed $100,000 at 8% interest with a monthly payment of $733 (combined principal and interest). Months when you had extra cash you had paid down the loan so now the balance of the loan is only $80,000.
Fast forward to today and perhaps you see an opportunity to get a 30-year loan on that $80,000 balance and a lower interest rate of 6.0%. Your closing costs for the loan are estimated at $2,000 and your new payment drops to only $480 per month. It would appear like a great deal, after all, the monthly payment would now be $250 lower than the previous $733.
How could that not be a great deal? Well, let’s run the numbers in a calculator. With your current loan, you would pay off the loan in 10 years and pay about $27,000 in total interest. With the new 30-year refinance, you would be paying for a new period of 30 years, and rack up over $92,000 in interest. The difference is what happens to that extra $250 per month that you would save with the new loan. If you were going to pay the loan off in 10 years, you should only look at a new 10- or 15-year loan to begin with, and you should consider keeping your payment at $733 per month anyway, if you can afford it. If you refinance to a 6% loan on the $60,000 and pay the same $733 per month, it then gets paid off in less than 9 years and costs less than $18,000 in interest.
Myth #3: You can pay no interest on a 0% car loan.
Here is another great myth. Do you want 0% financing or a $2,000 rebate? Wow, you either pay no interest, or you get a great discount! Too good to be true?
Of course it is. Look at is from the car dealer’s perspective. You have a lot full of $35,000 cars and nobody is buying them. In the old days, they did what everybody else did, they lowered prices. But now they come up with this great marketing scheme. Think of the person who buys the $35,000 car and gets a $2,000 rebate. Did he really buy a $35,000 car? No, he bought one for $33,000. So, when the next person buys the exact same car for $35,000 and walks out with a “0% loan” is he paying no interest? Nope, he just paid $2,000 in interest up front. He bought the same $33,000 car and is paying $2,000 in interest spread throughout all his payments. This is not to say this may not be a great deal, for it may well be. But do not think you are paying no interest, you are. The dealer must give a better deal to the person paying cash than to a person financing. If you were selling your washing machine and one person would pay it all in cash and someone else would be paying you in installments, to whom would you give a better deal?
Do not fall for these tricks.
Myth #4: All Variable Annuities are a ripoff.
The truth is that MOST variable annuities are a ripoff, especially the ones peddled by well-dressed insurance salespeople with lots of nice glossy brochures with pretty graphs in them. These products tend to have very high annual expenses and lots of surrender fees (if you withdraw before a specified time period). Compared to these products, it makes much more sense to just invest in no-load mutual funds. But what about no-load variable annuities that charge low annual expenses and no surrender fees? Believe it or not, they exist and can be a better idea than investing in taxable funds, for the right folks. Variable annuities allow all the money to grow tax deferred until withdrawn, meaning you do not pay taxes on them every year. They can also be moved between different asset classes. Some folks argue that mutual funds are actually better because their gains are taxed as capital gains while gains from variable annuities are instead taxed as ordinary income. Capital gains tax rates are far lower than those from ordinary income. So, for $50,000 in gains, you would likely see greater tax savings with mutual funds.
But, variable annuities being tax deferred means they should primarily be invested only in investments whose earnings would normally be taxed as ordinary income (i.e. bonds, fixed-income, REIT’s). After the recent tax cut, holding equities in a variable annuity does not make much sense anymore but holding bonds and fixed income investments still makes sense for some people. The investment can earn income and grow without paying any taxes until a withdrawal is made.
Myth #5: People who earn more money/live in expensive homes/drive fancy cars are “richer.”
No, it is the people who hold more assets who are actually “richer.” In general, people who earn more typically hold more assets, but that is not always true. You might assume the folks who live in the expensive houses and drive the expensive cars are “rich”. Many may hold more assets than you do, but many of them do not. Believe it or not, a good percentage of people you see driving expensive cars may very well hold fewer net assets than you do since they may be carrying huge piles of debt. That high standard of living certainly does not come cheap.
The best reading on this subject is Stanley and Danko’s great book The Millionaire Next Door. With auto leasing and 60- and 72-month car loans, the “expensive car” phenomenon is the most pronounced, where millionaires will drive by you in their 6-year-old Chryslers, and debt ridden but “image savvy” drivers will zoom by in newly leased BMWs and Mercedes.
Myth #6: Always hold stocks long term to reduce taxes.
Many financial advisers love to tout the importance of long-term holding to reduce your taxes, so that you only pay capital gains tax instead of ordinary income tax. Typically, holding a stock for more than one year qualifies it for capital gains tax rates, upon sale thereafter. This is true and wonderful, but not the most important thing in the world in the land of investing. Too many people hold bad stocks and for far too long just so they will not have to pay ordinary income tax on their gains. Sometimes these people end up not receiving any gains on them. Hey, you did not pay any tax though! Isn’t that wonderful?
In the past, many people held losing stocks for way too long (I am guilty too, I admit it). After racking up huge gains early 2000, we all said “this is great, but I am supposed to hold these for a whole year to save on taxes”. Then everything sank like a rock. Don’t you wish you paid those ordinary income taxes on those huge gains we had, back then? Remember the purpose of stock investing is to receive gains, and hence we have to pay taxes on them. Gains are good! Taxes aren’t so good, but you can’t have one without the other.
Do not let taxes on gains be the sole focus of your decision to acquire or hold onto a stock.
Myth #7: Taxes should be fair.
One of the big reasons politicians had fought to reduce/remove income taxes on dividends was because “it isn’t fair” to pay taxes twice on corporate income. In truth, it isn’t fair, but since when has anything about income taxes ever been fair? Is it fair that homeowners get to deduct mortgage interest, but renters do not get to deduct their rent?
Is it fair that families with children get the child tax credit and childless taxpayers do not? It is fair that someone earning $300,000 per year pays much more than 10 times as much income tax as someone earning $30,000? None of this is truly fair. However, tax laws are designed by committees of politicians, whether we like it or not, and they all compromise to try to come up with laws that they think are right but not necessarily fair for the whole country. The only truly fair tax system would be a flat tax, and that has been proposed several times but gets shot down every single time. Anyone looking for a fair tax system should look elsewhere.
Myth #8: Good investments should always beat the market.
It is truly amazing how so many people get hung up about “beating the market”. Back in the roaring 90’s when the market was returning 15-20% per year, people wanted 25-50%. After the nasty bear slump, you would think people would now be happy to just earn anything positive, but, no, everybody has to beat the average. (just like the mythical Lake Wobegon children who are all above average). So, people pay expensive fees for “expert advice”, investment newsletters, and extremely narrowly focused funds for that great ideal of “beating the market”. What is so horrible about simply matching the market? Yes, I am talking about boring, inexpensive, and unexciting broad index mutual funds and ETF’s. With their minimal expenses, you are guaranteed to not overperform the market, but instead are guaranteed to underperform the market by a small expense ratio. In reality, it has been proven that indexed securities beat the long-term performance of the vast majority of more expensive, managed investments, but most folks are willing to gamble that they will be among the lucky few who will outperform them.
A long-term return of about 10% just is not good enough for some folks, I suppose. It does not sound all that bad to me. In reality, if earning an average of 8 to 10% per year long term on your investments is not enough to guarantee ample income for you in retirement, that simply means you are either not contributing enough or that you should lower your future income goals. It does not mean that you should go on some grand search for some mythical above-market returns. It is a sad truth that most people simply do not want to face.
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