Most of us tend to like cut-and-dry 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 always 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.
(Editor’s Note: If you want to track your debt progress, the free Credit Report Card can help you track the impact paying off debt has on your credit scores.)
2. Withdraw 4% 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% rule. This common rule of thumb tells us to withdraw 4% 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% and inflation averages 3% annually, you’ll be able to live on 4% 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% 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 or not it makes more sense to withdraw a little less, or put off withdrawing (if you can) until the market recovers.
3. Stocks Return 10% Annually
One rule of thumb that continues to persist is the idea that stocks return 10% 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%.
4. An “Affordable” Mortgage Payment Is 30% of Your Income
When deciding how much mortgage you can afford, many experts cite the 30% rule. If you can keep your mortgage payment to 30% 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 a potential homebuyer can comfortably afford; not what they can theoretically obtain. Second, it doesn’t account for other debt a consumer may have. The mortgage process will look at all debt, not just the home loan. Finally, it can cause some to obtain mortgage products, like 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.
Image: Zoran Zivkovic