Take This Rule of Thumb Quiz
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I often rail against “financial rules of thumb” for their overly simplistic view of what are often complex situations. There is far too much potential for snappy catchphrases to lead people to refuse to think and evaluate situations on their own. Rules of thumb don’t take into account individual circumstances and even the most popular ones are simply incorrect.
Kiplinger asks about the usefulness of twelve financial rules of thumb, particularly when some can be harmful if blindly followed. What do you think? Which “rules” are true and which are false?
- You should always close credit card accounts you no longer use. (See How to Best Handle Old Credit Card Accounts.)
- Save and set aside an emergency “rainy day” fund to cover at least three months’ worth of your expenses. (See Always Be Prepared: The Unexpected Job Loss.)
- The percentage of stock in your portfolio should equal 100 minus your age.
- Always go with a fixed-rate mortgage — especially when interest rates are rising.
- Save 10% of your income each year.
- Buying a car is always cheaper than leasing.
- A Roth IRA is better than a traditional IRA.
- Never buy a house that costs more than 2.5 times your annual income.
- Make sure your own retirement savings are on track before you save for your kids’ college education.
- If you carry a balance, you want a credit card with a low interest rate.
- If you need life insurance to protect your family, your coverage should equal eight to 12 times your annual income.
- With a nest egg of $1 million, you can retire comfortably. (See Does This Number Impress You?)
Some of the answers may surprise you. Leave your thoughts in the comments or take the quiz at Kiplinger.com. Also, take a look at 25 Rules to Grow Rich By.
Article comments
I’ve always liked #5, but not as an absolute of how much to save. I work on the rule that 10% of whatever you earn, from the time you start earning, should be put into long term savings – whether or not you have any idea what you will spend it on in the future. I think this makes saving something an unbreakable habit over time, and if you are also out of debt, it means you that are always living on less than you earn, which is wise. What the savings are eventually used for would differ from person to person, but I think anyone could benefit from the attitude that no matter what other savings they might forego, at least 10% savings is non-negotiable. I guess what I’m saying is that I see this rule of thumb as a useful minimum.
I think $1,000,000 for retirement would be enough if you are completely debt free. The interest from even a money market account or CD laddering would bring you close to $4,000 a month in interest. I personally plan to have much more than this. Overall good tips!
None of these are absolutes, but for they most part they seem sound. Here are some exceptions:
1) An unused card can be useful if your wallet gets stolen and you need a spare card or for traveling. Also good to use when I leave my kids with my parents to handle unforseen costs
2)3 months, why not 5 or 1? This choice needs to be based upon the liklihood of needing cash and how long it would take you to find a new job in your profession
3) I doubt that Warren Buffet has less than 30% stock holdings
4)A 3, 5 or 7 year ARM is perfectly reasonable for a young couple in their early careers who are very likely to move in that fixed timeframe.
5)10% is insufficient and is just a terrible rule of thumb. With longer life expectancies 15-20% is probably more reasonable
6)In theory leasing could cost the same as buying, if you were savvy enough and knew all of the costs involved. Economic theory tells us that financial choices with more options (i.e. when, where and to whom to sell your car) are more valuable, so buying a lease restricts your options and in theory is less valuable.
7)Only in very unusaul circumstances do I believe this to be false. The fatal flaw though is that Congress will not keep their paws off the money if everyone (or the richer people) use these too much. The pot of money is there for the taking and the chance that it will get grabbed is high in my opinion. Splitting between regular and Roth diversifies the risk (although the riask of tax rates rising is much higher than the chance of raiding Roth nmoney)
8)Not necessarily. Early career professionals can easily violate this rule with little risk. It really depends upon how frugally you live the rest of your life too.
9)OK, If your kids are going to care for you maybe it is worth it. Risky, but possible.
10)Depends on the balance and the annual fee or other costs of the card. Low balance and high fee may cost as much as a higher rate
11)10-12 may not be enough. 6 kids with a stay at home wife (no training and needing to live through retirement) could require much more (20x easily)
12)$1 Million? You have to be kidding me. This isn’t even enough for some people retiring today, planning for this for the future will kill some peoples retirement.
For most people, including me, a Roth IRA makes a lot more sense than a traditional IRA. However, it’s definitely not an “always”. I am stunned about the car leasing thing, though.
I was surprised that they did give car leasing a nod. I suppose getting a new car every three years is a lifestyle choice for which leasing is a better option… but the whole idea of needing a new car every years was propagated by auto companies … it is very profitable for them and an expensive habit for the consumer. I realize that “image” is tied into certain professions, and that’s one case when leasing might be a better option.
Toby is right – 7 is true most of the time for most people, but definitely is not ALWAYS the case. That said, if they are just “rules of thumb” that is nothing more than a quick piece of advice for someone who doesn’t know anything about the topic and has no desire to learn more about it, well then, I guess most of them work fairly well.
I disagree with 7 and 8.
They argue that a Roth IRA is always better than a Traditional IRA. That is simply not true. I agree that a majority of people will come out ahead, but for those nearer retirement, they may reap more benefit from the tax deduction on the Traditional IRA than they will on tax-free withdrawals in a few years.
And tip 8 they claim is false because you should base your decision on the monthly payment as opposed to the purchase price of the house. Perhaps if you are planning to live in a place for a short time that may be valid. But basing purchases on the monthly payment (whether it’s a car, credit card, etc.) is a horrible practice which leads to a perpetual debt treadmill. Why Kiplinger’s would suggest that you consider such a strategy for buying a house is beyond me. Also, wouldn’t focusing on the monthly payment lead you to riskier mortgage vehicles which could cause you to suddenly be unable to make your payments and then on to foreclosure and losing your house?
Oh wait! What am I talking about?…That could never happen…=P
I do have problems with a few of their tips, most notably the suggestion to go with an ARM. While technically, you may be able to play the game and come out ahead, I think the reality is that fixed rate is the better option for the vast majority of Americans.
I also have a problem with the way the one about leasing a car is phrased. They give the impression that leasing and buying a car should be valid options an equal amount of the time. Like with ARM’s I think the amount of times that leasing a car is the better option is significantly lower than the alternative.
A realize that the point of the article is simply to point out that these rules of thumb don’t always apply to everyone, but I think that some people could get the wrong idea from reading it.