Risk and Everyday Decisions

As humans, we are amazingly bad at properly assessing risk.

Whether it’s playing the lottery or (especially for me) a fear of flying, humans can’t really judge the chances of a particular event occurring.

People purchase lottery tickets everyday, with the hope and dream of winning millions of dollars, despite the fact that the odds of winning are… well, let’s say they are really, REALLY slim (for the Powerball, as of the publishing of this post, it’s roughly 1 in 292 million). To put it another way, for every 292 million Powerball tickets sold, only 1 will win. The odds are so low, that the lottery is commonly referred to as a “math tax” (or more derisively as a “stupid tax”).

The odds of a plane crash are incredibly low and flying has never been safer. Yet, for thousands upon thousands of people, flying can be one of those stressful things you could do. I know this because I have a fear of flying. Many avoid flying altogether out of fear of being on the next flight that crashes.

Another area in our lives where we fail to to judge risk properly is when it comes to our finances. Consider the following scenarios:

1. You and your partner decide that renting is “throwing away money” and decide to buy a house. You have little to put down and not much in savings afterwards but you are able to qualify for a mortgage, effectively fixing your monthly payment.
2. You buy a brand new vehicle with nothing down and finance it for 72 months without any GAP insurance. Oh and when you bought the vehicle, the dealer rolled the difference from the previous loan into the new one.
3. Seeking to make repairs & upgrades to your house and lacking savings (or desiring to preserve savings for “emergencies”) you decide to take out a loan against your 401k based on the reasoning that it’s a loan where you are “paying interest to yourself”.

In each scenario, you are taking on a big risk, with the expectation that life will continue to be smooth sailing. You can absolutely do any or all of the above (and more) and not have any financial troubles… lots of people buy houses with small down payments, car loans at 72-months are slowly becoming the norm, and 401k loans can be a cheaper way (in the short-term) to access quick cash. We assume that we can easily make the payments or repay back any debts quickly.

However, we often fail to even consider something I’m gonna to refer to as “Life Happens”. “Life Happens” is any circumstance out of your control that causes financial hardship or money issues. I hear it from time to time and it’s most often used as an explanation as to why a person is having problems with money. However, rarely do I ever see or hear of it used as a reason to plan.

Consider the following examples again and how “Life Happens” can occur, beginning with the house:

1. A few months in, after buying a house, you and your partner discover an issue with the HVAC system. With a small (or no) down payment, you have very little equity to pull from for a HELOC or Home Equity Loan. Because you and your partner have no savings, there is no way to immediately fix the issue without taking on a personal loan or running up existing (and new credit cards). These latter options are bound (potentially) to high higher interest rates. Maybe you and your partner decide to take out a 401k loan…
2. A year after buying your car, you either lose your job or are laid off and go on unemployment. Because you’re making much less than you were when you bought the car, you seek to get out of your current car and into something cheaper. However, there is too much negative equity (owe more than the car is worth) and the lender will not let you trade-in for a cheaper car. At this point, your options are very limited.
3. After taking your 401k loan, you decide to quit your job due to X (X = any reason). Now, the balance of the 401k loan becomes due at tax-time the following year or it will be treated as a withdrawal, subject to penalties and taxes. If you don’t have much in savings (or wish to preserve it) will you have enough time from the day you quit to tax day the following year to pay off the balance?

I could go on and on, but the gist here is that what might seem like a low risk and “easy” short-cut could expose you to a lot of trouble down the road. Even if the chances feel remote, it’s definitely a great idea to take a quick step back and imagine what could or might happen with each major (or minor) financial decision we make. It could better prepare you for “Life Happens”.