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.
This post comes from Rob Berger at partner site Credit.com.
Most 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.
The 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.
More from Credit.com:
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.
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.
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.
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