Think about the various money mistakes you have made and then ask yourself, “What was the biggest money mistake and why?”
We all make money mistakes.
We are human – there is no way to avoid it entirely; however, there are steps you can take to minimize what money mishaps you make and how frequently you make them. The first step is understanding which traps most people fall into. If you can identify the most common money mistakes and relate them to your own life, I am confident you will handle your money better.
Certain money mistakes are easily reversible; others not so much. For example, spending too much on restaurants one month can easily be corrected the next month. Buying a home that is too big and too expensive cannot. You may pay 8-10% of the sale price to reverse that decision.
Said another way, the money decisions you make lead to consequences of different magnitudes. Some are large, some small.
Establishing good money habits as early as possible is critical: getting the small decisions right can help in getting the large decisions correct.
Money Mistake #1: Not Knowing Income and Expenses
I’m amazed more people do not know what they take in as income and what goes out as expenses. Your finances should be run as a business. Can you imagine if the company you worked for had no idea how much money it made last month and how much went out? What if your company couldn’t make payroll, pay the lease, or pay a supplier? The same questions apply to your life.
I’ve previously written that you do not need to budget regularly, but you do need to have a system in place to easily look up your income and spending. Without it, you cannot make good decisions, forecast for the future, or know where to make changes as life changes.
What can you do to not make this mistake?
Look at your paystub! You see what lands in your bank account each month, but review your actual pay stub. How much goes into your retirement plan? What is deducted for disability insurance? How much is paid in federal taxes? What about state taxes? How much for Social Security? What other line items do you see on your pay stub?
After looking at your pay stub, determine what you spend each month. I use Mint to track my spending, but others use YNAB, Tiller, or other tools. It does not matter which you use; find a system that works best for you.
Look at the different categories. Is your housing expense more than 30% of your gross income? Are there other large fixed expenses that prevent flexibility in future spending? How much do you spend for food and restaurants? Does any of it surprise you?
Then, ask yourself, “Is this how I want to be spending?”
This is not something you need to do monthly, but rather, at least annually, and as you are preparing to make a change in life.
Your income and expenses affect every area of your financial life. If you do not have a good understanding of your cash flow, you are almost certainly negatively affecting other areas of your financial life.
Money Mistake #2: Not Understanding Your Time Frame
Imagine if I gave you a quest: you were about to embark on a journey and begin walking north; however, I did not tell you how long the journey would be, the terrain, or when you needed to arrive.
How in the world would you make the decision about what to bring, what method of transportation to take, or how quickly to move?
For example, if the journey is half a mile down the street to your favorite restaurant, you don’t need much. You may only need a good pair of shoes, money, and a bag to carry it home.
However, if the journey was to a remote village in Alaska and you needed to be there tomorrow, you are likely going to need a few flights, cold weather gear, extra food, and many other supplies. If you did not need to be there until next year, you may choose a slower method than flying, but you likely will still need the other supplies.
Your life is a journey and your money is supporting different mini-adventures.
You need to understand where you are going, when you want to get there, and what you need.
For example, if you want to retire in 20 years, your money needs to be working for you differently than if you are trying to buy a house in a year.
The money for the house down payment should be in cash because you know the exact amount you need and if you have less, you cannot buy the house. The money for retirement should likely be invested. Since retirement is 20+ years away, it is okay if the value fluctuates. You want the miracle of compounding to work for you.
As you can see, your money needs to provide for different journeys, which begins with understanding the time frame for your goals.
How does this translate to life?
Your emergency fund should be in cash. But, “What about the low interest it pays?”, you may be asking. Who cares? When life throws something at you, and it will throw something at you, the cash will be what gets you through it while worrying less. If I were to paint a picture of a boat (and I am not good at drawing, so I will spare you the image), the emergency fund is the life raft. It’s not interesting. It’s not fast. There is no optimization – it serves one purpose and one purpose only – to get you safely out of emergency situations. It’s there in time of need.
Your retirement accounts are the sails or engine. They will be what propels you forward to reach your goals. As such, your retirement accounts should be invested more aggressively. The aggressiveness varies depending on your comfort with risk and your need to take risk. Without the growth, you bob around in the ocean going nowhere.
Every other financial account serves a different purpose. You may have a different bucket in cash to take a sabbatical in a year. You could have a 529 plan for kids. The timeline is completely different for the 529 plan depending on your kid’s age. If college is in a year, it likely should be conservative. If your baby was just born, you have time to take more risk and invest it more aggressively.
Embedded in not understanding one’s time frame is understanding concentration risk. It’s often said concentration builds wealth and diversification preserves it. I’d also argue you can become wealthy by being diversified. It just takes more time and discipline. A good savings rate and consistent investment is likely a more consistent path to wealth than taking risk after risk hoping to hit it big. You may never hit it big.
If you did concentrate your investments and are financially secure, why concentrate and risk it from this point?
In the famous words of Warren Buffett, “Never risk what you have and need for what you don’t have and don’t need.”
Understand your time frame and the path you are taking. From there, align your money accordingly.
Money Mistake #3: Large Fixed Expenses
Most people want to live like this:
But, many people live like this:
It could be the big house, expensive car, or club membership. Everyday, too many people assume that because the bank will give them a mortgage that equals about 33% of their income, it is a reasonable amount. That’s the maximum amount they are willing to lend. They assume some people will default, and they do not care what your lifestyle looks like after the home purchase.
If your fixed expenses are large, you are giving up flexibility. You are selling your future self, often your time, in exchange for a paycheck to pay for those large expenses today.
If you buy an expensive car with a $876 monthly payment for five years at 2% interest, you have already committed over $52,000 of your future pay. If you don’t put enough down and the car depreciates rapidly like most do, you also may face a situation where you owe more than the car is worth, meaning if you sold it, you would need to pay the difference out of pocket.
For example, if the car was purchased for $50,000 with no money down and you wanted to sell it after a year when you still owed about $40,000, but the car was worth $35,000, you would need to pay about $5,000 out of pocket. In the case of a car, it’s reasonable to assume a new car will depreciate 20-30% after the first year, which means if a large payment no longer fits your lifestyle, you could be liable for even more money to undo the decision.
Homes and cars are often where people make purchases near the top of their budget. Unfortunately, it locks them into a cycle. More expensive things cost more. They need to continue earning more and more money to support their expensive choices. This prevents them from taking career risks, going back to school, taking time off, attending their children’s soccer game, saying no to projects they don’t enjoy, and the list goes on. Large fixed expenses put a claim on your future time.
If there is something you love that would bring great joy to your life, spend freely on it. I’m not one for pinching pennies. In my experience, rarely do homes or cars bring that joy.
Money Mistake #4: Waiting to Save
How many times have you heard or told yourself, “I’ll start saving more when XYZ happens?”
There are those people who truly cannot save anything, who merely are trying to survive on what they earn. This article is not for them. This article is for the folks who can save more, but who have made different decisions.
If you started saving $50 a month and earned 7% annually, how much money do you think you would have after 10 years? 20 years? 30 years? What about 50 years?
You would have $8,289, $24,597, $56,676, and $243,917, respectively.
Over 10 years, you deposited $6,000, but only had $8,289 by the end.
Over 50 years, you deposited a mere $30,000, but you had $243,917 by the end. That is the power of compounding.
That is the cost of waiting to save.
Each day that goes by is an opportunity for your money to compound and work for you. Even if it’s $5, save and invest it if you have the means. As you build the habit, gradually increase it. I’ve found many people won’t miss $20 if they set it aside the day they get paid. It’s a couple coffees or a meal or two out.
In order for compounding to work, you need time. The younger you start, the more time and power you have on your side.
What are you waiting for?
Money Mistake #5: Lifestyle Inflation
The last common money mistake people make is allowing their lifestyle to inflate. Each pay raise often comes a new standard of living. And then the next pay raise after that elevates it further. And so on.
It’s amazing how happy people are in their younger years with very little money, but feel the need to spend more money with each pay raise. The 800 square foot apartment was fine, then it needed to be a 1,200 square foot house, then 2,200 square feet, and then bigger. The used Honda Civic was great, but then a new BMW seemed deserved with a higher salary.
Before you know it, your paycheck is consumed by more and more things.
A good way to fight lifestyle inflation is to give yourself a 50% increase in spending with each pay raise. Said another way, save 50% of each raise. Following that simple rule would help prevent full-blown lifestyle inflation.
As I have previously discussed, spending lavishly on things you love is great. Spending on things just because they are nicer and feel deserved is not great.
As you earn more money, pay special attention to your lifestyle choices. Are you spending more? Is the increased spending truly improving your life?
Summary – Final Thoughts
Many people experience very similar money mistakes. Unfortunately, most people have no way of easily seeing their income and expenses. Without it, no informed decisions can be made.
Many people buy too much house. They fixate on having the best home their money can buy and end up with a large mortgage payment, which takes away their future flexibility.
These large fixed expenses often lead to people waiting to save. Remember, even an extra $20 a month can make a huge difference in your wealth after 30 years. It may not seem like it, but your future self will thank you for saving and investing anything beyond what you are doing now.
Lastly, do not be your own worst enemy. Do not fall into the trap of lifestyle inflation. A nicer home, more luxurious car, or more expensive brands will not fulfill your life. Lifestyle inflation will put you on the hedonic treadmill.
Now that you know the five common money mistakes, what will you do about it?