Identifying common financial misconceptions

[GoodStash BadStache]

Hey all,

I was reading a Case Study on the "Ask a Mustachian" board a few days ago and one of the replies indicated that when you go into the next federal tax bracket that all of your income would be taxed at that higher rate, which isn't correct.  I mentioned this to a financially responsible co-worker of mine expecting to get a laugh, but instead got a "You mean that's not how it works?" response.  Aside from the convoluted nature of the US tax system, I found it hard to believe that fiscally engaged people didn't know how their federal income taxes are calculated and may be making bad fiscal decisions based on misconceptions.

I wanted to see if anyone else had examples of financial misconceptions they've come across in order to help out people who are getting their Mustachian financial education.  I'll kick it off with this one:

US Federal Income Taxes are Graduated (Progressive):  You don't pay your highest marginal tax rate on all of your income, only the portion within that highest tax bracket.  Don't pay any more income tax than you need to, but having income that moves you into the next tax bracket won't result in a massive tax jump.

[MDM]

Misconception:  That, for the same tax rate, there is a difference between investing small amounts in traditional vs. Roth accounts.
Truth:  Roth = A * (1 - T) * (1 + i)^n
            trad = A * (1 + i)^n * (1 - T)
A = amount invested
T = tax rate
i = annual investment return
n = years invested
Either way, the amounts are identical.

Misconception: That, for maximum contributions, there is no difference between traditional vs. Roth accounts, even for the same tax rate.
Truth: In this case, Roth is better.  See http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758 (among others) for details.


One may have to read the above items carefully....

[RichMoose]

Here are 2 very common misconceptions for Canadians:

RRSP's (Registered Retirement Savings Plan) are a 'Financial Instrument': I bang my head against the wall every time I hear someone talk about "cashing out their RRSP's". They have no clue that an RRSP is a savings plan like a 401(k) that can hold a long list of eligible investments. The RRSP itself is not an investment, it's just a name for a tax-deferred account.

TFSA's (Tax Free Savings Account) are just high interest savings accounts offered by local banks: The TFSA is the Canadian version of a RothIRA. You can invest in just about anything, earn (hopefully) great returns, and never pay tax on those again. Problem is banks in Canada heavily advertise TFSA's throughout the year as a special type of regular savings account and along with that will offer a "generous" 1.5-2% return. So instead of Canadian's using their TFSA's to invest in stocks, they earn a pitiful amount of interest that is even a bit lower than inflation. This, of course, completely wipes out the biggest benefit of the TFSA.

[Undecided]

Misconception:  That, for the same tax rate, there is a difference between investing small amounts in traditional vs. Roth accounts.
Truth:  Roth = A * (1 - T) * (1 + i)^n
            trad = A * (1 + i)^n * (1 - T)
A = amount invested
T = tax rate
i = annual investment return
n = years invested
Either way, the amounts are identical.

Misconception: That, for maximum contributions, there is no difference between traditional vs. Roth accounts, even for the same tax rate.
Truth: In this case, Roth is better.  See http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758 (among others) for details.


One may have to read the above items carefully....

Misconception: That a comparison that assumes that a traditional IRA is deductible is universally applicable.

[Posthumane]

Here are 2 very common misconceptions for Canadians:

RRSP's (Registered Retirement Savings Plan) are a 'Financial Instrument': I bang my head against the wall every time I hear someone talk about "cashing out their RRSP's". They have no clue that an RRSP is a savings plan like a 401(k) that can hold a long list of eligible investments. The RRSP itself is not an investment, it's just a name for a tax-deferred account.

TFSA's (Tax Free Savings Account) are just high interest savings accounts offered by local banks: The TFSA is the Canadian version of a RothIRA. You can invest in just about anything, earn (hopefully) great returns, and never pay tax on those again. Problem is banks in Canada heavily advertise TFSA's throughout the year as a special type of regular savings account and along with that will offer a "generous" 1.5-2% return. So instead of Canadian's using their TFSA's to invest in stocks, they earn a pitiful amount of interest that is even a bit lower than inflation. This, of course, completely wipes out the biggest benefit of the TFSA.

I hear these sometimes as well, but in addition a few more Canadian ones I've heard:
-Myth: RRSP only defer your tax payments rather than reduce them because people spend as much in retirement as before. In reality in order to pay the same amount of tax when withdrawing from RRSPs as you saved by contributing to them you would have to withdraw a lot more per year than you made during your working years. For example, if a person in Alberta is making 100k gross, anything deposited into an RRSP is deducted at their marginal rate of 36%. In order to be taxed at 36% AVERAGE rate on their withdrawls they would need to take out (or have a combined income of) over $400k/year.
-Myth: You should get married so that you can split your income to save on income tax. There is no general income splitting between working couples in Canada, with a couple of exceptions. One is if your spouse is not making a significant amount (below $10k or so) they can be listed as a dependent and you can have a deduction for that. The other is the new legislation being put in place for couples with dependent children, which I haven't really read about yet.

[GoodStash BadStache]

I was reminded of another one that has lead to more than one frustrating/heated discussion:

Social Security won't be around when I retire:  Social Security will need to have some adjustments made to it, but assuming there isn't a global catastrophe that dwarfs anything we've seen in modern times, it will be there.  If no changes were made up to the date when the "trust fund" runs out in the 2030's, approximately 75% of benefits could be paid out by the revenue taxes being collected at that point.

[Eric]

The idea that it's normal to have (a lot) of credit card debt.

There seems to be a common perception that "most" people have credit card debt and therefore it's normal.  I think this is because lots of rudimentary financial articles mention that the average American has *$10,000 in credit card debt.  But what this number actually represents is those Americans with CC debt and completely ignores those without debt when calculating the figure.  But even then, average is a terrible way to measure, as it's completely skewed by a handful people that are in way over their head.  The median is closer to *$2,000.  But again, that's only people with CC debt, whereas the majority of people have none.

*Numbers made up, but the point is the same

[RunningWithScissors]

Good points TuxedoEagle. 

I also love the common confusion of net vs gross income.  So simple, but many people think they're able to spend their gross income, and don't understand why there's always a shortfall at the end of the month.

And the one about marginal tax rates is good too...many online retirement calculators don't clarify what rate needs to be input.  Putting in your top bracket % instead of the averaged rate skews results.

[seattlecyclone]

Misconception: the fact that the stock market is at an all-time high means you should not invest new money until the next crash.

[samburger]

Misconception: the fact that the stock market is at an all-time high means you should not invest new money until the next crash.

And the inverse: You should get out of the market when it crashes to preserve the money you have left.

[retired?]

Misconception:  That, for the same tax rate, there is a difference between investing small amounts in traditional vs. Roth accounts.
Truth:  Roth = A * (1 - T) * (1 + i)^n
            trad = A * (1 + i)^n * (1 - T)
A = amount invested
T = tax rate
i = annual investment return
n = years invested
Either way, the amounts are identical.

Misconception: That, for maximum contributions, there is no difference between traditional vs. Roth accounts, even for the same tax rate.
Truth: In this case, Roth is better.  See http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758 (among others) for details.


One may have to read the above items carefully....

That T(at investment) = T(at retirement)

[MDM]

Misconception:  That, for the same tax rate, there is a difference between investing small amounts in traditional vs. Roth accounts.
Truth:  Roth = A * (1 - T) * (1 + i)^n
            trad = A * (1 + i)^n * (1 - T)
A = amount invested
T = tax rate
i = annual investment return
n = years invested
Either way, the amounts are identical.

Misconception: That, for maximum contributions, there is no difference between traditional vs. Roth accounts, even for the same tax rate.
Truth: In this case, Roth is better.  See http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758 (among others) for details.


One may have to read the above items carefully....

That T(at investment) = T(at retirement)

That T(at investment) = T(at retirement) may or may not be a misconception in general.  For the quoted post it was more like a blatant assumption. :)

[EDSMedS]

MISCONCEPTION: Non-profit organizations don't make money and folks that work for them are poor.

"The organization must not be organized or operated for the benefit of private interests" - http://www.irs.gov/Charities-&-Non-Profits/Charitable-Organizations/Exemption-Requirements-Section-501(c)(3)-Organizations

It is possible to be well compensated by a non-profit.  Very much like for-profit pay structure, the more responsibilities you take on, the more you will be paid.  A regional non-profit manager should make more money than a regional for-profit underling.

[KMMK]

That renting is always "throwing money away". Because home ownership has no lost costs - it's pure profit/savings, didn't you know?

[KMMK]

And also that the cash vs credit (what makes you spend more) is a fair or useful comparison. The comparison is not cash vs. credit. It's about limits. Typically cash is fairly limited, whereas the credit is not, or has a much higher limit. If you think you spend more if you use credit compared to cash, try walking around with $5000 of cash in your wallet (or whatever your credit limit is) and see how you spend then. The more you have to spend, regardless of method, the easier spending is. If you need a clear limit in order to spend less money, then go for it - use a small amount of cash. But don't buy into the myth that it's the payment method that is helping here.

[Mr. Frugalwoods]

Myth: Credit Cards are universally terrible

I hear this a lot from people who are just getting their financial lives in order.  Just because they can't handle having a credit card doesn't mean the rest of us shouldn't use them responsibly to rack up the rewards.

I've been chided about using credit cards by someone who I know is in much worse financial shape than I am.  I smiled and kept my mouth shut.  But come on!

[TeresaB]

And also that the cash vs credit (what makes you spend more) is a fair or useful comparison. The comparison is not cash vs. credit. It's about limits. Typically cash is fairly limited, whereas the credit is not, or has a much higher limit. If you think you spend more if you use credit compared to cash, try walking around with $5000 of cash in your wallet (or whatever your credit limit is) and see how you spend then. The more you have to spend, regardless of method, the easier spending is. If you need a clear limit in order to spend less money, then go for it - use a small amount of cash. But don't buy into the myth that it's the payment method that is helping here.

So what about people like me, who will quickly blow through their (limited) $20 cash, but not waste $20 of their $2,000 credit limit? For some people, the method DOES make a difference.

[Kaspian]

I don't know if this is myth or real, but people tend to think:  Not carrying credit card balances will hurt your credit rating.  What in the name of fuck?  If you had no debt, what the hell do you care about your credit rating for?  What logic is going on here?  "I should pay mad interest monthly so that I can borrow even more in case I ever need it?" 

Whenever the bank tells me that voluntarily lowering my credit limit (that is, I'm asking for them to put it back to sane $5000 levels because they keep jacking the limit), it could 'hurt my credit rating',  I answer, "I don't owe anything and don't plan on doing so. What do I care if it 'hurts' it?  Stab that bastard in the guts for all I care."

[skunkfunk]

And also that the cash vs credit (what makes you spend more) is a fair or useful comparison. The comparison is not cash vs. credit. It's about limits. Typically cash is fairly limited, whereas the credit is not, or has a much higher limit. If you think you spend more if you use credit compared to cash, try walking around with $5000 of cash in your wallet (or whatever your credit limit is) and see how you spend then. The more you have to spend, regardless of method, the easier spending is. If you need a clear limit in order to spend less money, then go for it - use a small amount of cash. But don't buy into the myth that it's the payment method that is helping here.

So what about people like me, who will quickly blow through their (limited) $20 cash, but not waste $20 of their $2,000 credit limit? For some people, the method DOES make a difference.

Hear, hear! I see I have $20 left in a budget category on mint, I'm not likely to spend it. If I have that $20 in my pocket, eh, whatever, it's already a sunk cost in my budget software - at least, that's what happens to me.

[KMMK]

And also that the cash vs credit (what makes you spend more) is a fair or useful comparison. The comparison is not cash vs. credit. It's about limits. Typically cash is fairly limited, whereas the credit is not, or has a much higher limit. If you think you spend more if you use credit compared to cash, try walking around with $5000 of cash in your wallet (or whatever your credit limit is) and see how you spend then. The more you have to spend, regardless of method, the easier spending is. If you need a clear limit in order to spend less money, then go for it - use a small amount of cash. But don't buy into the myth that it's the payment method that is helping here.

So what about people like me, who will quickly blow through their (limited) $20 cash, but not waste $20 of their $2,000 credit limit? For some people, the method DOES make a difference.

Hear, hear! I see I have $20 left in a budget category on mint, I'm not likely to spend it. If I have that $20 in my pocket, eh, whatever, it's already a sunk cost in my budget software - at least, that's what happens to me.

You're right. I was generally thinking about the reverse "myth" that people spend less if they use cash. In my own life, I'm usually the same as you two - cash is easier to spend

[Gone Fishing]

You can't touch your retirement accounts before 59.5 without a penalty!

Debt is evil!

Mortgage interest no big deal, because it is deductible!

Home equity loan is a great way to finance a vacation!

Cars will cost you an arm and a leg in repairs after 100k miles!

A top school is worth the money!

Whole life insurance is a great investment!






 

 

[jka468]

Hey all,

I was reading a Case Study on the "Ask a Mustachian" board a few days ago and one of the replies indicated that when you go into the next federal tax bracket that all of your income would be taxed at that higher rate, which isn't correct.  I mentioned this to a financially responsible co-worker of mine expecting to get a laugh, but instead got a "You mean that's not how it works?" response.  Aside from the convoluted nature of the US tax system, I found it hard to believe that fiscally engaged people didn't know how their federal income taxes are calculated and may be making bad fiscal decisions based on misconceptions.

I wanted to see if anyone else had examples of financial misconceptions they've come across in order to help out people who are getting their Mustachian financial education.  I'll kick it off with this one:

US Federal Income Taxes are Graduated (Progressive):  You don't pay your highest marginal tax rate on all of your income, only the portion within that highest tax bracket.  Don't pay any more income tax than you need to, but having income that moves you into the next tax bracket won't result in a massive tax jump.

I would guess that 40-50% of Americans don't understand the basic idea behind a progressive tax system. I've been shocked at how many convos I've had like yours, where someone looks at me like a deer in headlights when I explain it to them.

[James]

I have a co-worker who is desperate to take off the rest of his vacation days before this year ends. He is having a hard time getting the days off because he waited until the last minute. He doesn't mind working, so I asked why he doesn't just work the days and get a bonus for having worked extra days at the end of the year. He could retire earlier, or do whatever with the bonus. His reply was that "taxes eat up all the additional pay", so it didn't make any sense to take the pay for those days...


This is based on what happens when you get a big bonus in a particular paycheck. More taxes are withheld so it doesn't look like you got much of a bonus, but the effective rate on the additional pay is simply your highest tax rate based on income, you can easily figure out that rate and know how much the bonus is worth after tax. But he would rather just assume he doesn't get any additional pay from working those days based on the simplistic observation that his "paycheck doesn't seem that much higher after a bonus."

[jka468]

I have a co-worker who is desperate to take off the rest of his vacation days before this year ends. He is having a hard time getting the days off because he waited until the last minute. He doesn't mind working, so I asked why he doesn't just work the days and get a bonus for having worked extra days at the end of the year. He could retire earlier, or do whatever with the bonus. His reply was that "taxes eat up all the additional pay", so it didn't make any sense to take the pay for those days...


This is based on what happens when you get a big bonus in a particular paycheck. More taxes are withheld so it doesn't look like you got much of a bonus, but the effective rate on the additional pay is simply your highest tax rate based on income, you can easily figure out that rate and know how much the bonus is worth after tax. But he would rather just assume he doesn't get any additional pay from working those days based on the simplistic observation that his "paycheck doesn't seem that much higher after a bonus."

He very well may have a point here. Depending on where he lives, his deductions and current tax bracket, it very well may make sense for him to have additional time off rather than pay a 40-50% tax on that additional income. It's all about utility.

[Eric]

Home equity loan is a great way to finance a vacation!

This cannot be a common thing, can it?  [shudders]

[RichMoose]

Home equity loan is a great way to finance a vacation!

Duh, of course it is. The bank said it would only cost me like $45 per paycheck (over 10 years) to take my $10,000 once in a lifetime vacation. YOLO!

[SporeSpawn]

That investing means "playing the stocks." I've seen this cut two ways.

First, it drives lots of people (usually the poor) off from investing because they think there's too much risk or that you have to be smart and cutthroat or just that "stocks are bad, like in the movies."

Second, it can lead to people doing what they think "playing the stocks" entails, only with their otherwise perfectly good mutual funds. My father works with a bunch of factory men who buy and sell their retirement mutual fund shares, chasing after market fluctuations like they're digging for snipes.

Investment is saving money in a way that let's it grow. Not going to Reno and putting it all on black and not stuffing it under the mattress.

[Gone Fishing]

Home equity loan is a great way to finance a vacation!

This cannot be a common thing, can it?  [shudders]

Not like it was around 2005, this is how it usually happens:

HELOC is put in place for "emergencies"
Now emergency money can be used for vacation
Roof leaks, HVAC breaks, and now the vacation is on the HELOC.

Talk to anyone who is bad with money for 15 minutes and at least once, maybe twice, the following words will come out of their mouth, "The ____ broke and I didn't have any money so I HAD to put it on the credit card, take a payday loan, etc" like it was some fateful event vs something they should have been prepared for.

[NoraLenderbee]

I don't know if this is myth or real, but people tend to think:  Not carrying credit card balances will hurt your credit rating.  What in the name of fuck?  If you had no debt, what the hell do you care about your credit rating for?  What logic is going on here?  "I should pay mad interest monthly so that I can borrow even more in case I ever need it?" 

Even if you do care about your credit rating, this is a myth. No one ever needs to carry a balance to improve their credit score. Paying in full every month will boost your credit score just as well. (BTDT, got the FICO.)

[brooklynguy]

Not like it was around 2005, this is how it usually happens:

HELOC is put in place for "emergencies"
Now emergency money can be used for vacation
Roof leaks, HVAC breaks, and now the vacation is on the HELOC.

Talk to anyone who is bad with money for 15 minutes and at least once, maybe twice, the following words will come out of their mouth, "The ____ broke and I didn't have any money so I HAD to put it on the credit card, take a payday loan, etc" like it was some fateful event vs something they should have been prepared for.

Yes - because money is fungible, anyone who makes any expenditure while they have debt outstanding can be thought of as having financed that expenditure with that debt (even if it was not incurred for the express purpose of funding that expenditure).  So if you pay for a vacation at a time when you have an outstanding HELOC balance, you have financed your vacation with the HELOC.

[Bikesy]

I think one of my favorite misconceptions is that of the tax deduction.  Heard someone at work say "just bought a new laptop, but I'm a student and its deductible so I'll get that money back!"  Yikes!

[Poorman]

I think one of my favorite misconceptions is that of the tax deduction.  Heard someone at work say "just bought a new laptop, but I'm a student and its deductible so I'll get that money back!"  Yikes!

Actually a laptop can be used to qualify for one of the education tax credits which are "above the line" and essentially reduce your taxes dollar for dollar.

[lakemom]

Good points TuxedoEagle. 

I also love the common confusion of net vs gross income.  So simple, but many people think they're able to spend their gross income, and don't understand why there's always a shortfall at the end of the month.

And the one about marginal tax rates is good too...many online retirement calculators don't clarify what rate needs to be input.  Putting in your top bracket % instead of the averaged rate skews results.

This has been a biggie for nearly the whole 30 years of our marriage.  Dh will say But I make X amount of money why can we only save y amount of money.  Me....ummm we only TAKE HOME z amount of money, our expenses are A leaving only B to save NOT y!  Its only been in the last 6 or so years that its FINALLY  sunk in with him

[ChrisLansing]

Hey all,

I was reading a Case Study on the "Ask a Mustachian" board a few days ago and one of the replies indicated that when you go into the next federal tax bracket that all of your income would be taxed at that higher rate, which isn't correct.  I mentioned this to a financially responsible co-worker of mine expecting to get a laugh, but instead got a "You mean that's not how it works?" response.  Aside from the convoluted nature of the US tax system, I found it hard to believe that fiscally engaged people didn't know how their federal income taxes are calculated and may be making bad fiscal decisions based on misconceptions.

I wanted to see if anyone else had examples of financial misconceptions they've come across in order to help out people who are getting their Mustachian financial education.  I'll kick it off with this one:

US Federal Income Taxes are Graduated (Progressive):  You don't pay your highest marginal tax rate on all of your income, only the portion within that highest tax bracket.  Don't pay any more income tax than you need to, but having income that moves you into the next tax bracket won't result in a massive tax jump.

I would guess that 40-50% of Americans don't understand the basic idea behind a progressive tax system. I've been shocked at how many convos I've had like yours, where someone looks at me like a deer in headlights when I explain it to them.

I would guess it to be more like 70%.    I don't know why this is such a common misconception.   

[MrsSmitty]

"The market is at an all time high, therefore it's about to crash." Meaning, it's going to crash tomorrow and we'd be stupid to invest today because we'd just lose it all. This is one my husband has. He doesn't get that while he's waiting for the crash, he's losing opportunity to grow investments.

If you put in $100 now, earn $50 over a couple years, and then lose $25 in a "crash", you're still up $25! Yes, it's possible you'll put in $100 and then immediately lose $25, but it's still going to go back up to $100 and higher eventually. I don't think we're going to see the economy completely crash and burn in some horrible doomsday scenario in the next couple decades. Chill out.

[Señora Savings]

Misconception 1: Inflation doesn't exist, so if I invest $100 in the bank, in 30 years I'll still have $100 worth of buying power.

Misconception 2: I am the first person to ever realize that inflation exists, so every plan that anyone else ever made does not account for inflation.

[infogoon]

Myth: Credit Cards are universally terrible

I hear this a lot from people who are just getting their financial lives in order.  Just because they can't handle having a credit card doesn't mean the rest of us shouldn't use them responsibly to rack up the rewards.

I've been chided about using credit cards by someone who I know is in much worse financial shape than I am.  I smiled and kept my mouth shut.  But come on!

This one drives me nuts. It's usually someone digging out from under a huge pile of credit card debt, and saying "nobody should use credit cards" comes right before they start advocating for putting cash into a bunch of different envelopes to budget.

[Bikesy]

I think one of my favorite misconceptions is that of the tax deduction.  Heard someone at work say "just bought a new laptop, but I'm a student and its deductible so I'll get that money back!"  Yikes!

Actually a laptop can be used to qualify for one of the education tax credits which are "above the line" and essentially reduce your taxes dollar for dollar.

Learned something new today! 

[retired?]

RE progressive taxes - I didn't realize that a decent number of people thought that as you cross into a new tax bracket that the rate applies to the full income.  That would be horrible of course and a true disincentive to work, or at least game the system.

It should be that earning an extra $ always leaves you 'post tax' with more money.......perhaps (1-tax rate) x extra.  But, at the lower levels of income, there are several tax credits that have a 'cliff type' of application.

For example, the EIC/EITC has a limit on investment income for it to apply.  $3300, I think.  The thought being that if have that much in investment income, you cannot really be hurting.  These are 'refundable' tax credits in that the govt will pay you if your actual tax is less than the credit. 

So, an extra $ in investment income, for a family with two kids, can cause one to lose over $4k in credits.

Tax code be screwy, man.

[BZB]

The idea that if you buy something on sale you have "saved money" when in fact you just spent money.

[Dictionary Time]

It's been mentioned, but I can't get over people and their deep and abiding love of their mortgage interest tax deduction.

I sent $20K to the bank.  Then I get to deduct the amount over the standard deduction, (depending on what else you have) $15K.  Now I save 20% on that amount ... $3K.  Free money!

Yes, sign me up!

[iris lily]

It's been mentioned, but I can't get over people and their deep and abiding love of their mortgage interest tax deduction.

I sent $20K to the bank.  Then I get to deduct the amount over the standard deduction, (depending on what else you have) $15K.  Now I save 20% on that amount ... $3K.  Free money!

Yes, sign me up!

this. As if the standard deduction doesn't exist. And frankly, friends my age who argue for this shouldn't have big mortgages anyway at this late stage in life, for god's sake.

[GoodStash BadStache]

Related to the topic of mortgages, I was reminded of the biweekly mortgage payment plan.

Misconception:  Using a biweekly mortgage payment plan saves you money due to the partial payment being made before the full payment is due.  Almost all of the reduction in time to payoff of the mortgage is because by paying biweekly you're making 13 payments per year (52 weeks/2 = 26 biweekly payments*0.5 mortgage payment = 13 mortgage payments per year).

It may still be a useful way to pre-pay your mortgage if it's easier to match up with you pay period, but you'd get almost all of the benefit by making one extra mortgage payment at the end of the year.

[MrsStubble]

"I'm not going to pay extra towards my mortgage because it's locked in at 3%"

i feel like i'm constantly explaining amorization to people who think that 3% interest is constant over the life of the loan and they are paying 3% interest with each payment.  I have pulled out mortgage tables over and over to actually show people when their 3% is actually 3% of their payment. 

[MDM]

i feel like i'm constantly explaining amorization to people who think that 3% interest is constant over the life of the loan and they are paying 3% interest with each payment.  I have pulled out mortgage tables over and over to actually show people when their 3% is actually 3% of their payment.

Could you explain it to me?

I've been under the impression that each mortgage payment includes the interest rate times the principal remaining, plus some amount (equal to the monthly payment minus the amount of interest paid that month) of the principal.  Thus the interest rate is constant over the life of the loan.  What am I missing?

[xenon5]

i feel like i'm constantly explaining amorization to people who think that 3% interest is constant over the life of the loan and they are paying 3% interest with each payment.  I have pulled out mortgage tables over and over to actually show people when their 3% is actually 3% of their payment.

Could you explain it to me?

I've been under the impression that each mortgage payment includes the interest rate times the principal remaining, plus some amount (equal to the monthly payment minus the amount of interest paid that month) of the principal.  Thus the interest rate is constant over the life of the loan.  What am I missing?

Let's say you have a loan for $100,000 @ 3% in $500 monthly installments.  After month one your balance is $100,250.  On your first payment of $500, you pay $250 in interest and $250 in principal. 

What he's saying is that some people assume that only 3% of that $500 payment is interest - so $475 principal and $15 interest every month.

[MDM]

i feel like i'm constantly explaining amorization to people who think that 3% interest is constant over the life of the loan and they are paying 3% interest with each payment.  I have pulled out mortgage tables over and over to actually show people when their 3% is actually 3% of their payment.

Let's say you have a loan for $100,000 @ 3% in $500 monthly installments.  After month one your balance is $100,250.  On your first payment of $500, you pay $250 in interest and $250 in principal. 

What he's saying is that some people assume that only 3% of that $500 payment is interest - so $475 principal and $15 interest every month.

Wow, that is some misconception - didn't even occur to me that's what it was.

The only time the interest amount in the monthly payment equals the monthly interest rate is the final payment. 

For people who confuse the annual vs. monthly interest rates, the only time the interest amount in the monthly payment equals the annual interest rate is ~12 months prior to the final payment. 

[Copperwood]

Related to the topic of mortgages, I was reminded of the biweekly mortgage payment plan.

Misconception:  Using a biweekly mortgage payment plan saves you money due to the partial payment being made before the full payment is due.  Almost all of the reduction in time to payoff of the mortgage is because by paying biweekly you're making 13 payments per year (52 weeks/2 = 26 biweekly payments*0.5 mortgage payment = 13 mortgage payments per year).

It may still be a useful way to pre-pay your mortgage if it's easier to match up with you pay period, but you'd get almost all of the benefit by making one extra mortgage payment at the end of the year.

you sure this is correct?

[Le Barbu]

Here are 2 very common misconceptions for Canadians:

RRSP's (Registered Retirement Savings Plan) are a 'Financial Instrument': I bang my head against the wall every time I hear someone talk about "cashing out their RRSP's". They have no clue that an RRSP is a savings plan like a 401(k) that can hold a long list of eligible investments. The RRSP itself is not an investment, it's just a name for a tax-deferred account.

TFSA's (Tax Free Savings Account) are just high interest savings accounts offered by local banks: The TFSA is the Canadian version of a RothIRA. You can invest in just about anything, earn (hopefully) great returns, and never pay tax on those again. Problem is banks in Canada heavily advertise TFSA's throughout the year as a special type of regular savings account and along with that will offer a "generous" 1.5-2% return. So instead of Canadian's using their TFSA's to invest in stocks, they earn a pitiful amount of interest that is even a bit lower than inflation. This, of course, completely wipes out the biggest benefit of the TFSA.

CW (about TFSA): I prefer to hold some stash in my TFSA then repay my mortgage at 6.25%*
Me: Why? Does your TFSA is getting more than 6.25% or is it for a safety-net purpose?
CW: Well, first for safety, and anyway, a TFSA gives 3.5%
Me: 3.5%? depends in what it is invested
CW: Not really, a TFSA get 3.5%
Me: What do you mean? What is your holding, I mean your investments, CD's, Bonds, EM stocks????
CW: It's a T-F-S-A, I just told you
Me (now 100% sure CW is clueless): Ok then
Me (still bugged by the 6.25% mortgage): When did you get this mortgage
CW: mid-2012
Me: and what is the term?
CW: 4 years
Me: ........................

How come for god sake can you signed for a 4 years @ 6.25% by mid-2012, in Canada? I got a 5 years @ 3.49% in that same period and still have the feeling to be fooled a bit because I know the best rate available was 3.10% 

[Le Barbu]

-Myth: You should get married so that you can split your income to save on income tax. There is no general income splitting between working couples in Canada, with a couple of exceptions.

Now (2014) couples in Canada can split incomes for tax purpose. Don't have to be "married" do.