We ran across an article a few days ago that left us shaking our heads.
Let us explain.
If you have read any of the posts on this blog you’ll know that we do our best to provide good information about debt, debt relief and personal finances.
The article we found talked about financial rules of thumb that the author felt should not be followed blindly. While they can make things simpler when it comes to financial decisions this writer felt that some of these rules of thumb were wrong in many instances and could lead to serious financial problems. The rules of thumb he took exception to were:
Pay three times your annual income for your house
Here’s a rule of thumb that makes house buying almost drop-dead simple. You just multiply your income by three and that will tell you how much you could afford to pay for a house. For example, if your family’s total income is $70,000, you could buy a home for $210,000. Actually, this rule can be helpful. If you have a decent down payment and reasonably good credit you should be able to qualify for a mortgage of 2 1/2 to 3 times your income. However, that doesn’t mean you should do this. If you spend too much on a house you could become what’s known as “house poor,” which can leave you feeling suffocated and unable to do some of the other things you would like to do in life such as take vacations.
A better idea is to save for a longer period of time so that you can put more money down. Try to keep your housing costs to no more than 1/5th of your total income. Citylab.com, published an interesting report that tells us how much you should be earning to afford a 2-bedroom house in every state in the country. For instance, you need to earn at least $25.67 per hour if you want to live in a nice home in New York. In North Carolina and South Carolina, you can live in a 2-bedroom house even if you only earn $15 an hour.
And remember, if you ask a mortgage company broker how much you should pay for a house it’s much the same as asking a car salesman how much you should spend on a car.
Snowball your debts by paying off the smallest one first
The idea of snowballing your debts originated with the financial expert Dave Ramsey. However, doing a “debt snowball” isn’t really about the order in which you repay your debts. What it really means is that you should pay the same amount of money every month as your minimum payments go down. If you do this, you will get out of debt much faster.
The idea behind paying off your smallest debt first is that it’s supposed to motivate you to continue paying off your debts. And, this can be true – for some people. The downside of this strategy is that it can cost a lot depending on your other debts and their interest rates. Rather than thoughtlessly following this strategy without paying attention to what it would cost, you should stop and determine what exactly this would cost. There are online calculators available like unbury.me that would help you do this. But here’s the bottom line. When you do the numbers your answer will almost always be to pay off the debt that has the highest interest rate first as this will almost always save you the most money.
When you stop to think about it does this just make common sense? Do you really want to spend years toiling away to pay down debt while ignoring your retirement fund? If you have a lot of consumer debt it can definitely create a financial hardship. And it is important that you do get out of debt. TheSimpleDollar.com revealed that the average household owes more than $15,000 in credit card debt alone. With the rising interest rate, you know that you need to get rid of this fast.
However, if you ignore all of your other financial goals in the process this is hardly ever the best option. A better option is to protect your credit score, refinance your debt to the lowest interest rate you can, and then begin saving for retirement. And if your company offers a 401(k) with matching funds you need to sign up immediately and have as much of your income automatically put into your 401(k) as you can afford.
Credit cards will cause you to spend more
One of the tried and true axioms of personal finances is that if you pay for things with plastic you’ll spend more than if you paid cash. There have been numerous studies that prove this, plus it just sort of makes sense. The truth is that yes, some people will spend more money on more things when they pay with a credit card than they would otherwise. If you fit this description then by all means put those credit cards away and pay cash as much as you can. However, the fact is that not everyone spends more money just because they use credit cards. As an example of this if you use a credit card for gas and then drive until your tank is almost empty and then fill up again this is really no different than if you paid with a debit card or cash. The same is especially true for groceries and your utilities.
Own bonds in a percentage that’s equal to your age
The biggest asset allocation you will have to make in saving for retirement is how much money to put in bonds and how much in stocks. The goal of this rule of thumb is to help you create an investment strategy. If you follow it and are 30 years old you would put 30% of your investment in bonds and 70% in stocks. Then when you reach age 50, the amount you invest in stocks would go to 50% and in bonds 50%. The problem of this investment approach is that stocks historically have returned much better returns than bonds. Plus, whether you’re 30 or 50 your investing horizon isn’t really much different. You would still have more than 10 years before retirement.
If you’re a long-term investor with 10 years or more before retirement a better option would be a portfolio that tilts more heavily towards equities or stocks. For example, if you have 70% of your portfolio in stocks this could be a good starting point so long as you stick to this even during bear markets.
The net/net here is that regardless of what people might recommend never follow a rule of thumb blindly. One of these rules might be a good idea, depending on your circumstances, while another might lead to serious financial problems. Sit down, think things through, use some common sense and you’re bound to make good financial decisions.