When I was looking to buy our first house, back in the mid-2000s, I was surprised to learn that there were so many different types of mortgages.
I'd heard about 15-year fixed and 30-year fixed mortgages. But then you had jumbo mortgages. And adjustable-rate mortgages. And interest-only mortgages. Then FHA and HUD and VA and USDA mortgages. Then you have home equity loans and home equity lines of credit.
And that's just the type. Each one has different terms. And rules. And tons of paperwork.
This is true for almost every financial product.
And as is the case whenever there are a lot of options, there are bad options. Or more accurately, some products are only good for a certain type of customer. Then profit-minded marketers ran with it and are now sold to more than that specific customer.
With that thought in mind, I asked some financial experts what products everyone should avoid.
One of the first people I asked was Michael Kitces, author of Nerd's Eye View and proud owner of an alphabet soup of financial certifications. He reminded me that you could argue that every product could make sense for someone. Not everyone, but there existed at least one person out there where each product made sense.
OK, fair enough.
But some products and instruments make sense for very few people but are marketed to many.
These are the ones that I want to point out today so you can avoid them.
Quick Cash, Payday Loans
Will deHoo of the FoolProof Foundation shares:
Consumers shouldn't be using or buying ANY financial products or services, without acquiring proper and detailed knowledge around them first. It will be a disaster to their wallet and sanity.
‘High-interest rate loans' and ‘quick cash loans' are real budget breakers, along with the more well-known ‘payday loans' and ‘check-cashing services'. Unfortunately, consumers think they may not have financial options while (extremely) short on cash.
Consumers are marketed by the financial industry all day, every day. And these businesses know one thing: If they can get a consumer to use their financial product or service without knowing how to use it right, they know they can make big bucks.
Consumers should know, any rushed or emotional purchase, will cost them money. Don't be a fool, and become a healthy skeptic. At FoolProof, we say: “question anyone or any company that wants to touch your money or well-being. Use caution and rely on independent research… like ours.”
Skip the Extended Warranty
Michael Kitces, co-founder of the XY Planning Network, shares:
Never buy the extended warranty.
It’s tempting, especially in an age of high-priced electronics, to get a warranty that will “protect” you if the item is damaged or fails in the future. But the reality is that most electronic devices will last for their normal lifetime. If they fail fast due to a component failure, it is typically covered by the manufacturer’s warranty.
(And most credit cards double the manufacturer's warranty for up to an additional year too!)
And even if it is something that fails or breaks in a few years, electronics depreciate quickly. Which means you could probably buy a 2-3-year-old replacement for cheap.
So save your dollars on the extended warranty, and just buy a used replacement in the future if you ever have to!
Don't Mix Investing with Insurance
Todd Tresidder, former hedge fund manager and consumer advocate at Financial Mentor suggests:
Insurance is an actuarial product where the minority can win but the majority must lose to pay the salesman’s commission and leave a profit for the insurance company. It’s just a basic business truth.
That means the only valid reason to buy insurance is risk management – to insure against a loss you can’t afford to take. Simply stated, never buy insurance as an investment mixing the risk management function with investment function except in the rarest of cases.
For the vast majority, it will be a losing proposition compared to just investing the insurance premium directly. If you want to dive deep behind how this simple rule works then all the nitty-gritty details are explained in this article “Whole Life Insurance – The Complete Guide.”
Sophia Bera, founder of Gen Y Planning, is another expert who thinks whole life doesn't make sense for a lot of folks:
A lot of people are still being sold whole life insurance policies and they don't make sense for 99% of people. (The other 1% bought the policies decades ago and are using them for estate planning purposes). The fees are extremely high, the coverage of life insurance is insufficient, and the cash value also accumulates VERY slowly. It would be better for most people to buy a 20-year term life insurance policy and redirect the money they save on premiums towards their retirement accounts.
If they don't like whole life, they probably won't like whole life insurance for children.
Bill Harris, a Certified Financial Planner practitioner and co-founder of WH Cornerstone Investments, advises against variable annuities for most:
In most cases, avoid variable annuities. Fees typically are very high.
In addition to subaccount expenses, VAs have other expenses including “mortality” expenses and annual renewal charges. Some variable annuities cost 3-4% per year. Investment options typically are limited. Annuities are disadvantageous to inherit if they don’t go to a spouse, heirs miss the step-up in basis which can reduce capital gains taxes.
Annuities are complex contracts and usually, buyers and sellers have no idea what hidden in the weeds.
Liquidity comes with hefty penalties.
Neal Frankle, a Certified Financial Planner and editor of Wealth Pilgrim, says:
Most people should never buy an indexed annuity. These are annuities whose returns are typically a percentage of an index, like the S&P 500. They are touted as investments that provide participation in market upside with none of the downsides of the market. This is true – but the issue is how much will you participate in the upside, what is the cap on the participation and how long the contract lasts?
Typically, index annuities have a very complicated “participation” formula, can have a low cap (maybe 10%), and continue for 7 years or longer. My experience is that when these were first introduced, like 20 years ago, they worked well. But the insurance companies started playing with the participation formula such that investors might only get a very small return even during the years when the market does well.
My advice is: If someone tries to sell you such an annuity, ask to see a year-by-year return against the year-by-year of the S&P 500 and see for yourself. They might promise a 60% participation rate, but because of the convoluted formula, you might be credited a lot less. Also, only consider such an annuity if the salesperson can show you a 10-year history (year-by-year). Average returns don’t tell you very much.
Eric Roberge, a CFP and the founder of Beyond Your Hammock says:
Most people should never buy an interest only mortgage.
With these types of loans, the borrower only pays the interest on the loan each month, which makes the payments significantly less than they would be if they were also paying down the principal as well. Often times these loans look attractive because they allow people to afford an otherwise unaffordable home. The problem is that the borrower may get used to paying this lower amount and when it comes time to pay down the principal and interest together (usually 5-7 years down the road upon), they may not be able to make the payments, putting them at risk of losing their home.
This is not a smart risk to take. If you can't afford to make the payments for a traditional 30-year mortgage on a home, you should think twice about buying a home at that price.
“Dumb Doctor Deals”
Bo Hanson, a CFA, CFP®, and co-host of The Money Guy Show warns against this:
One financial product that most people should avoid is what we affectionately refer to as “dumb doctor deals.” This is certainly not meant to be offensive to medical professionals; rather, they are often “dumb deals” that are pitched to high income or financially successful individuals such as doctors.
These deals often have a few common traits: they are complex in their structure – often requiring separate tax reporting or business formation, they are pitched towards accredited investors (i.e. those who have a net worth that exceeds $1 Million or household income that exceeds $200k for individuals or $300k for couples), they are difficult for the average investor to understand, they can be illiquid, and they are often laden with fees and management costs.
This isn't to suggest that all private placement or private equity deals are inappropriate, but you need to make sure you have checked all your other “basic” boxes before moving to this type of investment (i.e. having healthy liquid assets spread across tax-deferred, tax-free, and after-tax accounts), keeping appropriate emergency reserves, and following the appropriate “order of operations” for your financial situation.
The biggest way to protect yourself from falling prey to this type of investment is to ask these questions:
- Do I truly understand how this investment works (i.e. could I explain it to a non-financially-minded friend or relative)?
- Do I understand exactly what the fees are (both initial and on-going)?
- Does my situation allow for the illiquidity of this type of investment?
- Am I making this type of investment in the correct sequence relative to my other financial wealth building activities?
Any Investment You Don't Fully Understand
I wanted to add this final catch-all because it really covers a lot of ground, more so than “dumb doctor deals.”
There will always be new products coming out each year. They will be complicated. They will have fee structures and schedules that don't make a lot of sense. They will be structured in a way that sounds a little too good to be true. Or too confusing to understand.
If you don't understand how it works and where it fits in with your financial plan, you must skip it. Bitcoin and cryptocurrencies were smoking hot in 2018. Bitcoin was near $16,000 a coin! It is closer to $3,600 a coin now. But none of that matters because you should not be invested in bitcoin if you don't know how it works. I have a passing idea of how it works and I wouldn't touch Bitcoin with a ten-foot pole.
Sometimes things are complicated because they're a scam. Sometimes they're a Ponzi scheme. Sometimes they're completely legit but if you don't understand it, you could be taken for a ride by more sophisticated investors.