4 Common Personal Finance Tips That Will Actually Fail You
Christy Bieber, The Motley Fool
Updated
When it comes to money, there's a lot of advice out there that's repeated over and over. While some of this advice is great, there are also situations where the conventional wisdom is wrong. Unfortunately, if you rely on myths to make important choices about your money, you could end up in a very bad situation.
It's important to research financial decisions carefully and to question the status quo to make sure you do what's best for you. In particular, there are four pieces of common financial advice you likely don't want to rely on because they're probably wrong.
Broken piggy bank with coins spilled out.
Image source: Getty Images.
1. Save 10% of your income for retirement
You've probably heard many times that you should save 10% of your income for retirement. Sadly, when you actually do the math, you'll discover this is likely to leave you with far too little income to sustain your lifestyle after leaving work.
Saving 10% of income simply isn't enough to provide the funds you need as a senior. Say, for example, you start saving at the age of 30 when you're earning $35,000. If you get 2% annual raises, invest 10% of income, and earn a 7% return on investments as a pre-retiree and a 4% return on investments during retirement, you'd end up with $440,827 saved by age 62. If you needed to replace 90% of pre-retirement income and receive an estimated $21,883 in Social Security benefits, you'd run out of money by age 75, assuming a 2.9% inflation rate.
Having a higher income won't help. Assuming all the same parameters, having an income of $60,000 at age 30 and a Social Security benefit of $30,848 at 62 would leave you running out of money by 73. You'd run out of money sooner because you'd have a higher income to maintain post-retirement and, as your salary increases, Social Security replaces less of your pre-retirement income.
To make sure you've got sufficient savings, it's best to aim to save at least 15% of income for retirement, but more is always better.
2. The 4% rule means you won't run out of money
Conventional wisdom also says you're safe to withdraw 4% of your income from retirement savings during your first year and then increase withdrawals based on inflation each year.
But research from Morningstar Investment Management conducted in 2013 found that with bond yields below historical averages, the 4% rule only provides a 50% probability of success. In other words, it's 50-50 whether you'll run out of cash if you follow it. To have a 90% chance of not running out of money, you'd need to follow a 2.8% rule instead.
The Center for Retirement Research also warned against following the 4% rule and suggested an alternative that bases your withdrawal rate on your age and Required Minimum Distribution (RMD) tables from the IRS. RMD tables are made by the IRS to show required withdrawal rates from traditional 401(k) and IRA accounts after you turn 70 1/2. The table below shows the amount you could withdraw, based on RMD calculations.
As you can see, if you follow this guidance, you'd start by withdrawing 3.13% from savings if you retired at 65 and your withdrawal rate would be below 4% until age 73, when you could withdraw 4.05%. While you may decide you'd prefer to be more conservative and use the 2.8% rule instead, there's one thing both CRR and the Morningstar report have in common: They make clear that withdrawing 4% of your money is a risky strategy -- so you need to think twice around basing your retirement security on this old rule.
3. Buying a house increases your net worth
Owning a home has long been a part of the American Dream. After all, if you own a home, you can build equity, benefit from increases in property values, and stop wasting money on rent. It's a sure path to riches -- right?
If you're still buying into this myth, ask anyone who bought their home at the height of the real estate bubble in 2008 how that worked out for them.
Buying a home can make sense, if you're financially ready for it, and if you don't buy in a bubble. But if you buy at the top of the market or if you purchase a home you can't really afford and end up compromising other financial goals, you'll be much worse off for it. Timing the real estate market can be a challenge, but there are metrics you can look at -- such as pricing trends in your area, months of new supply, and home prices relative to wages -- to get an idea of how the market is doing.
You also need to make sure you have a down payment and an emergency fund before your purchase and that your housing costs don't exceed 30% of your income. Unless all these things are true, renting likely makes more sense for you rather than becoming a homeowner.
4. Paying down debt should always be a priority
Debt freedom is touted as a top financial goal by many financial commentators, some of whom argue you should never borrow. And, indeed, there are times when you should work hard on paying off debt -- like when you owe money on credit cards, payday loans, or high-interest medical or personal loans.
But it doesn't make sense to pay off all types of debt early. Mortgages and federal student loans, for example, typically have very low interest rates. And you're able to take a deduction for student-loan interest (regardless of whether you itemize) provided your income isn't too high, as well as a deduction for mortgage interest if you itemize on your taxes.
If you pay off a mortgage at 4% interest, your return on investment is 4% at best -- or less if you're forgoing a tax break you'd have otherwise claimed to defray interest costs. If you could reasonably expect to earn 7% or more in the market, it makes no sense to forgo higher returns and put extra cash toward paying down your home instead of investing.
To decide if you really should focus on debt pay-down, always consider opportunity cost. Don't give up the chance to get more value from your money just because you've heard how great it is to be debt-free.
Don't just follow financial advice
As you can see, if you followed these four common pieces of financial advice, you could end up in a really bad situation with a house you can't afford, too little retirement income, and money allocated the wrong way that doesn't maximize returns. Instead of buying into the conventional wisdom, take the time to think about your own financial situation to make sure you're really making the right choice for you.
