February 7, 2023
When it comes to financial products, we’ve all heard stories of people who bought something they never should have. They wake up two, ten, or even twenty years later, lamenting their decision because it cost them money, time, or freedom. So how does this happen, and more importantly, how can we avoid it?
Great Example: The 15-Year Fixed Rate Mortgage
Let’s use the 15-year fixed-rate mortgage as an example. Homebuyers and homeowners regularly contemplate whether to have one and they’re regularly misused. The 15-year fixed-rate mortgage is a home loan with a fixed interest rate for 15 years.
If you borrow $500,000 at 7% for 15 years, you would pay $4,494.14 each month for 180 months until the loan was paid off. The total interest paid on this loan over 15 years is $308,945.68.
This loan is typically compared to the 30-year fixed-rate loan. Those loans are fixed for 30 years. The interest rate can be .25% to 1.5% higher. If you borrow $500,000 at 8%, you would pay $3668.82 each month for 360 months. The total interest paid would be $820,779.07.
As with all amortizing home loans, the interest owed on this product is front-loaded – that is, the first payment is more interest owed than principal and the last payment will be mostly principal and little interest.
Based on this information, it seems like the choice of mortgage might be obvious. But the following examples illustrate how it’s not and how the wrong reasons caused someone to choose the wrong financial product.
The Salesperson Was Convincing, Funny, Articulate, Charming, etc.
We’ve all met that salesperson who made a compelling presentation. The salesperson of the 15-year fixed-rate mortgage might have highlighted the increased interest paid over time and made a case for taking the 15-year fixed rate mortgage.
For all you know, they’ve memorized the company scripts, toed the company line, or is winning a trip to Hawaii because they sold the most 15-year fixed-rate mortgages that month.
But imagine if….
- The extra $825.32/month was more than your cash flow could comfortably allow?
- You didn’t have the savings to make that payment if you lost your job. Do you ruin your credit because you can’t make the payment?
- You had unexpected expenses that made that payment challenging to make?
- You planned to refinance the house to do home improvements in less than five years. Then why pay down the house when you could be saving for the remodel?
- You had to sell in less than five years?
- Having that bigger mortgage payment made it hard to meet other savings goals like retirement or a kid’s college education?
Did you know that if you take the 30-year fixed-rate loan, you can still make payments such that you can pay off the loan in 15 years? Then, if you can’t make the larger payment, you always have the option to make the regularly scheduled one.
Did you know if that if you take the difference between the payment on the 15-year fixed-rate mortgage and the 30-year fixed-rate mortgage, saved and invested it, that you’d have two assets at the end of 15 and 30 years – the house AND the investment account?
Would you really give up flexibility and options and greater wealth to save 1% in interest rate? What was truly the better decision here?
Just because the salesperson was convincing, funny, articulate, charming, etc., doesn’t mean that you’ve made the best financial choice for you and your family’s future.
(Out of respect for my favorite sales trainers, please note that I did not say that the salesperson did a “great job” by being charming and toeing the company line. A great job would have meant listening to you as a client and putting you in the right product.)
We all love a good return on investment or a guaranteed payout, but sometimes investors can’t let go of sexy numbers.
Let’s face it, it’s more fun to say you have a 7% interest rate on your mortgage than 8%. It’s more fun to say you will have $3,000/monthly guaranteed income for life than to talk about how your 401k just lost 20%.
Don’t lose sight of the potential downsides or risks inherent in a product just because you like sexy numbers that are fun to talk about at cocktail parties.
Failure to Plan
This is probably the most common mistake when it comes to financial products. The adage goes that people spend more time planning a vacation than their retirement. The same applies to financial products. You wouldn’t install the electrical system in a house without putting up the framing first, so why would you buy a financial product without a plan?
The 15-year fixed-rate mortgage might work in one’s plan, but it may not allow for the most flexibility and freedom. Imagine:
- Getting the 15-year fixed-rate mortgage and paying the fees to refinance it five years later when rates go down or to get the 30-year fixed-rate mortgage because it is more affordable. Most people are doing something with their mortgage every 5-7 years and rarely keep them for 15 years, let alone 30.
- Having to sell a house sooner than anticipated. Sure, the balance of the mortgage is less, but all that cash was stored in the house making no money elsewhere.
- Paying off the house, only to refinance and take cash out to send a kid to college. That mortgage interest is now not tax deductible, and instead of borrowing from the house, the difference in payments could have been saved for college. The lack of a mortgage might have also made it harder to qualify for need-based or merit-based aid.
- Wanting to remodel the house after 10 years and having all this equity in the house but being unable to access that equity because of financial life changes that made borrowing impossible (identity theft, lowered credit rating, job loss, etc.).
Life happens. Planning that provides the most flexibility to accommodate life’s twists and turns and choosing strategies and products that provide the most options gives you the greatest opportunity for financial success.
Impulsiveness and/or Laziness
Another common mistake is not doing one’s homework, taking advice from friends or family who don’t know your situation well, or not asking good questions. Or, deferring to someone else’s judgment, like the 30-year-old asking Dad what to do and him saying “take the 15-year fixed-rate!” when someone in their 30s has very different needs, challenges, and obligations than someone in their 50s.
Marketing, Hype, FOMO
Humans are pack animals and we like to move in groups and follow each other. Our brains are biased towards seeing what supports our decision, rather than what might be a good reason not to do something. We fear missing out (FOMO) on the next best thing, and we want to keep up with our friends, neighbors, or favorite movie stars.
Examples of this include seeing an ad for the 15-year fixed-rate that has someone with your demographics in it and you choose that loan for no other reason.
How to Avoid Buying the Wrong Product
Plan: The first and most important step in avoiding buying the wrong financial product is to plan. This means taking the time to understand your financial goals and needs, as well as considering your current and future financial situation. It’s essential to know what you’re looking for in a financial product and to have a clear idea of what you want to achieve.
Do your research: Researching different financial products is crucial in avoiding buying the wrong one. Look at different options, read reviews, and compare the pros and cons. It’s also important to understand the fees, risks, and potential returns of each product.
Ask good questions – of everybody: Don’t be afraid to ask questions, especially to experts in the field. But also don’t forget to ask questions of yourself, like how you’ll feel about this decision in one month, one year, or ten years.
Watch your bias: We all have biases, and it’s essential to be aware of them when making financial decisions. Be mindful of any emotional or cognitive biases that may be influencing your decision.
Take your time: Don’t rush into a decision when it comes to financial products. Take the time to consider all options and make sure you’re comfortable with your choice.
Make a decision and sleep on it: Once you’ve made a decision, it’s a good idea to sleep on it before finalizing. This will give you time to reflect on the decision and ensure that it’s the right one.
Life happens and even the best-made decisions can be the “wrong” ones later on. The goal here is to make good, conscious decisions as best you can so that even if you don’t like the outcome five years from now, you can look back and say “we made the best decision at the time.” That’s going to feel a heck of lot better than thinking “ah, that was really stupid, I should have seen that coming.”
If you want to talk about a pending financial decision, please reach out.
Lanning Financial Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.