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Money & Culture

Unconventional Wisdom: Challenging Some Personal Finance Adages

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October 20, 2017
Peekaboo: Looking beyond common financial advice
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Some personal finance sayings have been around so long, many people take them as absolutes without really thinking about what they mean and whether they apply universally.

Undoubtedly, you’ve heard these nuggets: “Have six months of emergency savings in a liquid account.” “Put 20% down on your home purchase.” “Cash is king and debt is bad.”

When it comes to personal finance, Harrison Napper, product manager at TD Ameritrade, said these one-size-fits-all truisms need to be weighed against a person’s current circumstances.

“They’re in place because they’re true enough to get someone into the habit of saving who might otherwise spend the money. You need to get into the habit, not just of saving money, but of caring for the relative performance of your money and making sure you’re shaping your finances around your situation,” he says.

Rethinking Savings

“Hold six months’ salary as emergency savings.” The idea behind keeping six months of emergency savings in an ultra-low-yielding account is to provide a financial cushion in case you lose your job. These savings might also be used for unexpected expenses like medical bills or home repairs. Most people put their savings in cash-like vehicles that earn little return.

“My question is why? Liquid capital does not equal cash,” Napper says.

He says people should consider all their capital options—possible unemployment benefits, personal loans, and tapping other accounts such as retirement and investing accounts if they lose a job. Rather than keeping a big low-yield account, emergency savings can earn more money in higher-yielding accounts, and people can typically withdraw funds from them when necessary.  

To see how this might work, let's consider someone with an annual household income of $150,000 and emergency savings of $75,000. If the investor were to put this $75,000 in a savings account yielding 1%, it could potentially reach $78,825.75 after five years.

Compare that to putting the same amount into a Roth IRA and assuming the investor would have to withdraw the full amount of the savings every five years, incurring the full $7,500 penalty for the withdrawal. How much would they need to earn per year in order to make it more sensible to put the money in a Roth? That number is 2.8527%. So if the investor can find a way to make 2% over what he or she is earning in that savings account, they have the potential to come out ahead.

To put that in dollar value, let’s say the investor was able to make a conservative average annual return of 6%—a lower return than the 10-year annualized average S&P 500 Index (SPX) return of 7.44%, according to Standard & Poor's. That would leave them with $100,366.90. So even after the penalty of $7,500, they would still have an extra $14,041 over just five years. If the investor has 30 years until they need to access this capital for retirement—even if they withdraw the entire $75,000 every five years and pay the 10% penalty—if they earn that 6% on average every year, that is potentially nearly $200,000 more for retirement (or the investor could consider retiring over one year earlier); all because they put their emergency funds into something with higher earnings potential.

That said, such projections are only projections, and can't be guaranteed. Investing in securities via an IRA or Roth IRA isn't necessarily as safe as having the money in a savings account, and there's always a chance of losing money instead of gaining. Tools like the Analyze tab in the thinkorswim® platform can help you understand risk in any individual position or your portfolio as a whole, so you can make informed risk/reward trade-off decisions in these situations.

Rethinking Debt

“Put 20% down on your home purchase.” The downside of not putting down 20% for a home purchase is that the buyer gets a higher interest rate loan and must purchase private mortgage insurance to protect the lender from default. But Napper says that buyers who have the 20% down payment available should consider whether other investments might earn more than those added costs.

“Evaluate the risk and potential reward,” he says.

“Cash is king and debt is bad.” High-interest credit card debt can create quite a barrier to getting ahead financially. But using debt strategically can be smart, Napper says. Debt that allows for future growth is one example, such as paying for children's education. A growth opportunity may not necessarily be monetary, as money is just one form of value.

“If I’m taking out debt to do something that makes a difference to my family, like paying for my children’s college, that future value may be worth more than the cost of the debt. Think about what the net value will be for the future,” Napper says. 

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