Seven Financial Traps That Make Poor People Poorer (and Rich People Richer)
“America is a place where the luxuries are cheap and the necessities are expensive” — Joseph Cohen, 2014
Why do the poor get poorer while the rich get richer? For some of us, no matter how hard we try, our bank accounts don’t seem to get any fatter. Sometimes it feels like mysterious forces are trying to pry our money from us at every turn.
But on closer examination, there’s really no mystery there. The American lifestyle has built-in traps that target our poorest citizens while the wealthy easily avoid them. So what are some of these traps that are keeping us poor?
Your Emergency Fund is Too Small (or Too Big)
An emergency fund is a cornerstone of a strong financial portfolio, but it’s subject to the Goldilocks Rule. A proper emergency fund should be neither too small nor too large, but just right.
If your emergency fund is too small, a sudden loss of income or a surprise expense could leave you unable to pay short term expenses like a mortgage or utilities. This can force people to pay late fees or tempt them into credit card debt to fill the gap. This can quickly spiral into a cycle of poverty. The less diversified your income streams are, the bigger your emergency fund needs to be. If a family’s sole breadwinner loses her job, the family may need to have three to six months of income stored away until a new job can be found. However, if the family has two or more income streams (and a high savings rate), only a small emergency fund may be needed because the family can adjust to a temporary drop in income.
This highlights the other trap that low and middle-income people can fall into: having an emergency fund that’s too big. If all of your savings are stored in your bank account, you’re missing out on opportunities to invest that money for a higher rate of return. Your bank’s savings account is unlikely to to protect you from inflation, which can eat away at the value of your money year after year. That’s why it’s important to judge how much money you’ll need in case of an emergency, because being too risky and too risk-averse can both cost you.
Insurance is Gambling, So Play Like a Pro
If you were rich, you wouldn’t need health insurance, auto insurance, or life insurance because you could pay for life’s occasional expenses and leave your family with plenty of inheritance if you died. Buying insurance is an expense that you have to pay when you can’t afford the worst case scenario.
Insurance is gambling where the goal is to lose as little money as possible. If you buy the best health insurance plan and are perfectly healthy for the entire year, you’ve paid high premiums for nothing. If you don’t buy insurance and experience severe health problems, then you may not be able to afford the medical bills. By the way, the odds are stacked against you, because insurance companies hire armies of actuaries to estimate how much you’re going to cost them, and they structure their fees to make it more likely that you’ll pay in more than you get out. How else do you expect them to make a profit?
If you don’t understand how insurance companies make their money and you don’t understand the thick policy manuals for your plans, you’re likely to lose the gamble to the insurance company. Like emergency funds, insurance is subject to the Goldilocks Rule: having too much or too little can cost you. Also like emergency funds, you can reduce your dependence on insurance by having a high savings rate.
Fees Are For Poor People
Banks generally require new customers to keep a minimum balance in their savings and checking accounts, because banks use the money in your account to make loans to other customers. Recently, more and more banks have offered “free” checking accounts with no minimum balance. “How nice of the banks to do this!” you might think. But in reality, free checking accounts serve as a trap to very poor people, because banks rely on the poor to make mistakes so that the bank can make money.
Banks are happy to charge fees for overdrafting accounts, in addition to low balance fees, convenience fees, and debit card fees, which disproportionately affect the very poor. It seems unfair that the less money you have in the bank the more your bank charges you, and it’s just one more way that people pay extra for not knowing how to manage and build their wealth.
Credit card fees are another example of this phenomenon. If you carry a balance on your credit card, you are allowing credit card companies to charge you for being bad with money. In contrast, if you have a good credit score you can qualify for rewards credit cards that pay with cash or discounts on services if you pay your statement in full each month. It’s nice when credit card companies pay you, and these credit card rewards disproportionately go to wealthier folks.
Once again, bank and credit card fees can be avoided by maintaining a high savings rate.
The Taxman Cometh for the Poor
Which gets taxed at a higher rate? Income earned through labor (i.e. “earned income”) or income earned from owning things like stocks and rental property (i.e. “passive income”)? You guessed it, the government wants the working man’s money more than money earned by the idle rich. The poor get the majority of their income from taxable wages while the wealthy have portfolios that are designed to minimize tax burdens and compound their profits.
Penny Wise, Pound Foolish
People with very little money can’t afford high-quality goods, so they can’t benefit from the buy-it-for-life philosophy. Buying cheap products that degrade quickly adds up in the long run. A new coat that costs $200 and lasts ten years is a much better investment than a $50 coat that you have to replace yearly. Often the poor do their best to look for “good deals,” spending lots of time to save a dollar here and there, rather than looking at the bigger financial picture.
The Rich Have the Home Field Advantage
Which is better — buying a house or renting? That contentious debate won’t be solved here, but there are certain advantages to owning a home. Homeowners who are mortgage-free generally have lower annual costs than people who rent a comparable house. Homeowners can also rent out rooms or sell their house if they feel a financial squeeze. Even homeowners with mortgages benefit from tax breaks that renters can’t exploit.
Moreover, renters tend to move around a lot, and this leads to money spent on application fees, deposits, and moving fees. These are yet another cost imposed on people who can’t afford to own a home, or at the very least, can’t afford to stay in one place for a long period of time.
Live or Die by Your Reference Group
Behavioral psychology suggests that we are most influenced by people who are similar to us, or whom we admire. Imitating the financial choices of your family and friends and following their advice can be a risky proposition. If your friends are conspicuous consumers, you’re more likely to spend money to impress them. If you hear enough people talking about their auto loans, you might think “I guess an auto loan is a normal thing that I should get” even though it’s definitely not.
Take time to think about your reference group and whether they’re the best role models. You might want to stop taking financial advice from friends and relatives, because if they’re living a middle class consumerist lifestyle, you’ll end up like them too if you follow their advice. Remember that it’s tough to judge someone’s finances from the outside, and people who look and act rich are often a lot poorer than people who live more modest lifestyles. Educate yourself and read books by successful people whom you want to emulate.
Step 1: Be Rich. Step 2: Don’t Be Poor.
There are many more examples of how lacking wealth and the financial knowledge necessary to acquire it costs people heavily. Principles of personal finance aren’t difficult to understand, but they are often non-obvious and counterintuitive. What you may think is important (wow, he can afford a huge house) is often not (…or a huge mortgage at least). Meanwhile, the things you don’t even think about (what is my savings rate?) can make or break you financially.
If you want to avoid the traps that the American lifestyle has laid out to keep you poor, you have to learn to identify them and to turn the financial odds in your favor. At Monte Largo, we add value by conducting this detective work. A good financial planner can spot spending habits or lifestyle choices that seem innocuous but have lasting consequences on your life. More money is rarely the answer to your problems. You have to learn how to play the game more intelligently than the game plays you.
Nathan is the CEO of Monte Largo Financial Advisors LLC.