5 Popular Rules of Thumb That Can Wreck Your Finances

Before you go, we thought you'd like these...
Before you go close icon
I'm worth way more than that! Unhappy woman with banknote
iStockphoto/Getty Images
Financial rules of thumb have their place. They can help remove the complexity from financial decisions we have to make. Relying on them blindly, however, can be a costly mistake. In fact, some rules of thumb are flat out wrong in many cases.

Here are five of them to watch out for as you make your next big financial move.

1. Pay off debt before saving for retirement. I cringe every time I hear this one. It's sad to see families toiling away for what can be years paying down debt while ignoring retirement savings. Watching them is like watching a movie where everybody but the heroine knows the bad guy is lurking behind the door. And If they are foregoing a company match with their 401(k), they might as well just peek behind that door and get it over with.

Debt, particularly consumer debt, creates financial hardships. And getting out of debt is an important goal. But ignoring all other financial goals in the process is rarely the best option. Instead, guard your credit score, refinance debt to the lowest interest rates possible, and begin saving for retirement as part of a comprehensive, holistic approach to your finances.

2. Spend three times your income on a home. It's been said that you can buy a home that costs roughly three times your family income. This rule of thumb is generally accurate. With reasonably good credit and a down payment most can qualify for a mortgage of 2½ to three times their income. But that doesn't mean it's a good idea. Being house poor feels as suffocating as a packed elevator stuck between floors. Trust me, I've been there.

Rather than going "all in" with a house, save a bit longer for a bigger down payment. Scale back your desire for a McMansion and work to keep your housing costs at no more than 20 percent of your income. And remember, asking a mortgage broker how much you can afford is like asking a barber if you need a haircut.

3. Pay off your smallest debt first. This old chestnut has sometimes wrongly been referred to as the "debt snowball." The debt snowball has nothing to do with what order you pay off your debts. Rather, it refers to paying the same amount each month even as your minimum payments go down. By doing so, you get out of debt faster than if you paid just the monthly minimum payments. Be that as it may, many now refer to the debt snowball as paying off your smallest debt first regardless of the interest rate.

The theory is that paying off one debt quickly will help motivate folks to stay on track. There may be some truth to this for some people. The problem is that it can be very costly, depending on your other debts and interest rates. Rather than mindlessly paying off the smallest debt first regardless of the interest rate, figure out just how much this approach will cost you. It's easy to do with a free calculator such as unbury.me.

Armed with actual numbers, you can then make the best choice for you. (Spoiler alert: it's almost always paying off the highest interest rate debts first.)

4. Own your age in bonds. This rule of thumb is intended to help investors create an investment strategy. The most significant asset allocation decision one makes is how much to invest in stocks and how much in bonds. With the "own your age in bonds" rule of thumb, a 30 year old would stash 70 percent in stocks and 30 percent in bonds. At age 50 the bond allocation would rise to 50 percent. I'm not sure what the centenarians among us would do (perhaps leverage a 100 percent bond portfolio).

This investment approach is easy to apply, and that brings to an end the good things we can say about it. The problem is that stocks have historically returned significantly more than bonds. Further, the investing horizon of somebody who is 30 isn't significantly different than somebody who is 50. They both have more than a decade before retirement.

A better approach for long term investors (10 years or more) is a portfolio tilted toward equities. A portfolio of 75 percent equities or more is a good starting point, so long as you can stick to the plan during bear markets.

5. Credit cards cause you to spend more money. I've heard it repeated over and over again that paying with plastic causes you to spend more money. This conclusion is drawn from a number of academic studies, and it has some intuitive appeal. Applying it mindlessly to everybody for all purchases, however, is a mistake.

Here's the truth. Paying with a credit card causes some people to spend more on some things than they otherwise would. If that's you, by all means don't use a credit card for those purchases. But not everybody spends more simply because they use plastic.

I don't spend more on gas because I pay with credit. I drive my car until it nears empty and then gas up. It would be no different if I paid with cash or a debit card. Same is true with groceries and my monthly Netflix subscription (does Netflix even take cash?).

As another example, I didn't spend more on my daughter's college tuition by paying with a credit card. I did, however, nab 2 percent cash back. In fact, since getting my Citi Double Cash card last year I've earned $1,674.19 in cash back. The vast majority of these purchases weren't influenced by the use of plastic.
Read Full Story

Sign up for Finance Report by AOL and get everything from business news to personal finance tips delivered directly to your inbox daily!

Subscribe to our other newsletters

Emails may offer personalized content or ads. Learn more. You may unsubscribe any time.

People are Reading