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5 financial tips that can lead you astray

Money rules aren't one-size-fits all, and following them isn't always the prudent thing to do; it's better to consider individual circumstances and temperatments.

By Credit.com Dec 19, 2013 12:43PM

This post comes from Rob Berger at partner site Credit.com.


Credit.com on MSN MoneyMost of us tend to like cut-and-dried answers to our financial questions. How much house can I afford? There’s a rule of thumb for that. From the order you pay off your debt to the amount you should withdraw in retirement, there are a number of financial guidelines available to help you make better financial decisions.


Crystal ball © Randy Allbritton, Getty ImagesThe problem with rules of thumb, though, is that they don’t ring true for every situation. Personal finance is, of course, personal. This means that, while a rule of thumb is a good starting point, it isn’t the final word for your finances.


With that in mind, here are five financial rules of thumb that can lead you astray if you follow them blindly.


1. Pay off your smallest debt first

Paying off consumer debt is one of the first steps toward financial freedom. It’s also one of the hardest. For those getting out of a debt, a common question is which debt should be tackled first. The rule of thumb often cited is to start with your smallest debt first.


The rationale behind the smallest-debt-first approach is one of motivation. By quickly paying off a small debt in full, many find they are motivated to continue their climb out of debt. As important as motivation is, however, it’s not the entire story.


The problem with this approach is that you could end up paying more money in interest over time. Your smallest debt might not have the highest interest rate. As a result, some could find themselves working on their smallest debt first, all the while paying more interest on larger debts.


Mathematically, it makes more sense to start with the debt with the highest interest rate. By tackling high-rate debt first, one can get out of debt faster and with less interest charges. For those who really need the psychological pick-me-up of getting rid of the smallest debt first, though, any debt reduction plan is better than nothing.


2. Withdraw 4 percent a year during retirement

How much can one withdraw from savings each year in retirement without the fear of running out of money?  What is an extremely complicated question is often answered with the 4 percent rule. This common rule of thumb tells us to withdraw 4 percent of our money in the first year of retirement, and then increase the withdrawal amount each year by the rate of inflation. The thinking is that if your portfolio has annualized returns of 7 percent and inflation averages 3 percent annually, you’ll be able to live on 4 percent and reinvest the remaining amount to keep up with rising prices.


The problem with this rule of thumb is that a large stock market event near the beginning of your retirement can wipe out a lot of value. If you withdraw at a rate of 4 percent during such a time, you could easily dip into your capital, lowering your returns overall, and resulting in the possibility that you will run out of money before you run out of retirement years.


Instead of relying on this rule of thumb, it’s important to check conditions, and determine whether it makes more sense to withdraw a little less, or put off withdrawing (if you can) until the market recovers.


3. Stocks return 10 percent annually

One rule of thumb that continues to persist is the idea that stocks return 10 percent annually. While this has been true for some periods, the reality is that your stocks -- even if you invest in index funds -- probably won’t return that in “real” terms. From 1926 to 2012, the total annualized real return (after inflation) for the S&P 500 (including capital gains and reinvested dividends, and accounting for inflation) was less than 7 percent.


4. An 'affordable' mortgage payment is 30 percent of your income

When deciding how much mortgage you can afford, many experts cite the 30 percent rule. If you can keep your mortgage payment to 30 percent of your monthly income, you should be able to afford the house you are contemplating.


There are several potential problems with this rule. First, it focuses on qualifying for a mortgage.  The better consideration is what potential homebuyers can comfortably afford -- not what they can theoretically obtain. Second, it doesn’t account for other debt consumers may have. The mortgage process will look at all debt, not just the home loan. Finally, it can lead some borrowers to obtain mortgage products, such as interest-only or variable rate loans, that are not in their best interest.


The key is to buy a home with a payment that you are comfortable with, not one that merely conforms to a rule of thumb.


5. Buy a used car, not new

Finally, one of the common rules of thumb is to avoid buying a new car. The theory is that the depreciation on a new car once you drive it off the lot is significant, suggesting that a used car is a better deal. While a used car may indeed be a good deal depending on the circumstances, it isn’t always.


This rule of thumb doesn’t take into account, for example, the repair costs you might pay on a used car. It also doesn’t consider costs related to fuel efficiency or insurance. Most importantly, it misses arguably the most important factor when it comes to the cost of owning a car -- how long you keep it. Buying a new car and keeping it for 10 years will be a better deal than buying a “new” used car every three years.


Rules of thumb can provide you with guidance as you work out how to best organize your finances. However, it’s important to take a step back and evaluate your situation. Chances are that you are better off tweaking the rule to fit your specific circumstances.


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47Comments
Dec 29, 2013 9:10AM
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I bought a 1986 Toyota pick-up new and drove that sucker until 2002.  Never let me down.  It was paid for in 1990 and I kept making payments to myself, about $180 a month into a muni bond fund.  Will never have to worry about car payments again. 
Dec 19, 2013 2:56PM
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I don't know what world you live in, but have you seen the price of a new car? Replacing my truck with a new closest equivalent, would cost almost as much as I owe on my house. And you forget mention that a car loan is another form of debt on a depreciating investment.  Sorry- buy used, pay cash and do as much work on it as possible yourself. Another thing that is becoming impossible on new cars.
Dec 29, 2013 8:29AM
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In June, 1994, I bought a new 1995 Chevy Monte Carlo.  New car on the market then and I had to pay top dollar for it (nearly window sticker).  I'm still driving it to work daily and it's been the cheapest car I've ever owned.  My dad paid cash for a new car every 8 to 10 years when cars lasted 80,000 miles and had no value after that.  If I want a new car today, I'll buy it and pay the cash I didn't use on used cars, the tires and battery it probably needs right away, transmission problems it caused by possible abuse and neglect created by the original owner who knows he has a warranty to cover his problems.

Buy a new car, take excellent care of it and drive it till it won't go any further.... put the cash in the bank for your next one.

Dec 29, 2013 2:28PM
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You know what you can afford. Just be smart.
Dec 29, 2013 5:28PM
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I'm 61 years old and retiring next year. All is paid off and I always (except 1 time about 20 years ago) buy a 1 to 2 year old used car. You can get much more of what you want and after a couple of years all is the same anyway. Everything said in these investment ideas are good if used within your situation. Pay off your bills and house. Always save. GIVE BACK, we are rich compared to most . YES you can afford to give back you just don't want to. Don't buy everything you want , you fool! Instead of buying a new electric dog polisher, put the money in your child or grandchild's college fund and give some to your church. I'm not a rich guy preaching. I'm a guy who has worked over 40 years in 2 different industries and 2 jobs the last 8 years to build for retirement. When I retire next year I go to a 20 hours work week (home based business) and that will be retirement compared to 60 hours I now work. WORK, pay off your debts, save, give back and quit whining. This is America and we are still #1 some of us just don't act like it.
Dec 29, 2013 12:41PM
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Although “Pay off your smallest debt first” contains valid points, my experience indicates that motivation is more important than the author believes.  I have worked with several people who needed to pay down debt, and those debts were the result of impulse or frivolous buying.  These people need quick and constant positive motivation or else they fall back into their old habits.  Yes, they could end up paying more money in interest over time.  But if these debtors quit the program then they will still pay a lot of money in interest.  And it is harder to convince them to go back to budgeting.

 

Prudent budgeters can attack their highest interest debts first without needing so much encouragement.   But they are also less likely to pile up so much debt in the first place.
Dec 29, 2013 1:57PM
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Just make sure you don't out live your MONEY,try to enjoy the ride  Happy 2014 BYE
Dec 29, 2013 1:56PM
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The most important financial advise to remember is, the value of a dollar has never risen.
Dec 29, 2013 10:57AM
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I agree with everything except the car theory.  I always bought used vehicles and ended up with problems.  They are a 'sinkhole' for money because you never know how they were maintained before you owned them.  Buy new and keep your vehicle for 10 years or more.  You regulate the care of the vehicle.  You keep the maintenance records.  You keep the repair records.  You have complete knowledge of what transpired with the vehicle from the time it was manufactured until you drove it off the dealer lot and took it home.  No previous owners to deal with.  No previous anything to deal with.  It's just you and your vehicle.  Depreciation does not matter because you are going to have this vehicle for a long time.  I accomplished this with my present truck and in September it was 10 years old.  It looks brand new because I've kept it up without spending a lot of money doing it.  It has actually saved me a lot of money by doing this.  Best decision I ever made.  Does it take effort?  Yes it does, but it has been worth it.
Dec 29, 2013 8:41PM
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Imagine that.  Money management is all about math.
Dec 29, 2013 2:01PM
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Funny how MSN says "buy a new car", when another says a new car isn't one of the things to buy new. I think one of the top money tips to ignore should be "don't listen to MSN Money".
Dec 29, 2013 11:58AM
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the thing on the car, they never consider how long you plan on keeping it.

If less than say 5 years ok buy used.

But if you are like me and get 9 years out of a vehicle and keep up the maintenance and don't beat it go buy new

when I retire I plan on a NEW small pickup 4wd so I can carry a 4 wheeler to go places to ride.

I will not beat the truck and wont be drving it to work each day, and when the weather is bad and being retired I can stay home for the one or two days till the roads are cleared.

Dec 29, 2013 2:33PM
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Maintain your own counsel.  Stop putting credence in these MSN Money articles and reprints from other sources.  They are page fillers,  that's it.
Jan 11, 2014 1:39PM
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There's no reason you can't buy a used car and have it around for 10 years either. 

And when paying off debt, interest rate shouldn't matter if you are really focusing and getting rid of everything in a few years. The way to really buckle down?...get motivated by getting rid of some smaller debts and feeling how good it feels to be done with them! The math might work out on attacking high interest rates, but people aren't as logical as calculators and our behavior takes some motivating to go in the right direction and not get burned out. 
Dec 31, 2013 3:57PM
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Why is the rationale behind paying off the smallest debt first is always stated as one of motivation, it is actually about cash flow.  Paying off the small ones doesn't just free up cash for the bigger debts but also frees up cash for emergencies so that you don't have to charge them and can get out of the debt cycle.
Jan 17, 2014 2:40PM
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I love all the people that are adament about buying new. Keep at it. You are making the prices of used cars even cheaper for me.
Jan 17, 2014 1:50PM
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As far as cars go, I buy what I want, when I want. I'm barely on the middle-class ladder, but still have money to put into *two* credit union savings accounts.
Jan 17, 2014 3:39PM
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Pertaining to rule # 1 in paying off debt. If we were doing math, you would know that having debt in the first place is mathamatically stupid. Finances are 80% behavior and 20% math. I agree with point 2,3 and 4. As far as point 5 goes, as long as you have the money to pay cash and not finance the car, buy whatever you want.
Dec 29, 2013 6:59PM
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New cars and trucks cost more than your home if you are not careful, buy a new one every two or three years.....insurance and maintenance are up there too, if you have to pay parking there goes another chunk. It is best to share a car with others if possible.... 
Dec 30, 2013 12:22AM
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I will never buy a used car again.  However  I keep my car way longer than the loan. Have that warranty at the beginning is good as well 
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