5 Financial Rules You May Need to Break
March 15, 2012There are certain guidelines that we financial planners tell people to help keep them out of trouble. Most of the time, they’re right on. But there’s almost always an exception to the general rule. Here are some of those rules, why they usually make sense, and when they might not.
Pay your credit card balances off in full
Why it usually makes sense: Not paying off your credit card balances off in full means that you’ll have to start paying interest to the credit companies at an average rate of 14%. That’s high but you could be charged a lot more than that, especially if your credit isn’t too great. Have you seen those calculations that show how the magic of compound interest can grow your savings over time? Well, when you have credit card debt, that same magic of compound interest is actually working against you. Pretty soon, you could find yourself paying more in interest than you spent on the original purchases. Some will even have to file for bankruptcy…and it all started with carrying that first balance.
Except: There are two opposite situations that I can think of in which carrying a balance can make sense. The first is if you have a very low rate and are better off investing the money than paying down the balance. In this rare instance, your credit card debt actually becomes good debt like a mortgage or student loan. In fact, I wrote a whole post about how you can make money off zero rate credit card offers. However, that post actually came with a warning from our CEO because you have to be very disciplined to make sure that you save that money and that you keep track of when the low interest rate offer expires so you can pay it off beforehand. The second situation is when you’re in such financial difficulty that you’re having trouble paying your mortgage or your car payment. In that case, make sure those bills are paid first because as much as you don’t want to pay interest or fall behind on credit card payments, you don’t want to lose your home or your car even more.
Aim to have 80% of your income in retirement
Why it usually makes sense: First, any target is better than none. In fact, our research shows that most employees aren’t confident they they’re on track to retire comfortably and have never even run a calculator to see how much they need to save. 80% is a good starting place because people tend to need less income when they retire since they won’t be saving for retirement or paying into Social Security and may have their have kids out of the home and their mortgage and other debts paid off.
Except: The key word there was “tend.” Your situation may be different depending on the lifestyle you want to have in retirement and how your various expenses may change. For example, you may want to spend a lot more on travel while someone else may prefer to stay close to home and spend more time with the grand kids. Look at what debts will be paid off but don’t forget to add in the costs of retiree medical insurance and possibly long term care insurance. In short, some people will need a lot less than 80% and some will need a lot more.
Start contributing to your 401(k) as soon as possible
Why it usually makes sense: The earlier you start saving for retirement, the better off you’ll be. The longer you delay, the more you’ll have to save or the later you’ll have to retire. In other words, your future self won’t be very happy that you had other “priorities” with your money. Plus, if your employer offers you a match, you don’t want to leave that free money on the table.
Except: There are three reasons why you might want to delay contributing to your 401(k). One is to focus on paying down high-interest debt. This is because high-interest debt can cost you more than you’re likely to earn in your 401(k). Just make sure that you make up those lost contributions once the debt is paid off. The second reason is to build up an emergency fund since your future emergency may not qualify you for a hardship withdrawal and even if you are eligible, you could be subject to a 10% tax penalty. You might be able to borrow from your plan but only up to half of your balance, which may not be enough. The final reason to delay is to save for a home purchase. After all, owning a home could be part of your retirement plan too. Once again, just be sure to make up for those lost contributions after you throw that house warming party. (One final note is that you can save for emergencies or a home with a Roth IRA since the contributions can be withdrawn tax and penalty-free at any time for any reason and the earnings can also be withdrawn tax-free for a first-time home purchase as long as the account has been open at least 5 years. The advantage is that anything you don’t use can grow tax-free after age 59 ½ so you’re still saving for retirement too.)
Don’t borrow from your 401(k)
Why it usually makes sense: Speaking of 401(k) plans, too often people use them like an ATM. Since the interest you pay just goes back into your account, it can seem like a cost-free loan. However, you’re missing all the earnings that your money would have earned if you hadn’t borrowed it. Meanwhile, the loan payments you’re making could have been additional contributions. If you leave your job for any reason, you may also have to pay the outstanding loan balance back within 60 days or it would be considered a taxable distribution and subject to a 10% penalty if you’re under age 59 ½.
Except: I’ve seen situations where people have used their 401(k) to pay off high-interest debt and get themselves out of severe financial distress. That’s because there’s no credit check and low interest rates mean that the 401(k) loan payments could be a lot lower than the credit card bills. The key is that this needs to be part of a long-term strategy to get and stay out of debt. The worst thing you can do is find yourself back in debt but with a much lower retirement account balance. Also, don’t raid your retirement account if you’re thinking of declaring bankruptcy since it’s a protected asset.
Don’t borrow from your home either
Why it usually makes sense: In short, you’re putting your home on the line. Lots of people did this during the housing boom, expecting to pay off their loans with rising property values only to find themselves underwater and struggling to make the payments.
Except: If you have a comfortable amount of home equity and you’re confident that you can afford the payments, a home equity loan can be a tax-deductible and low-interest alternative to more expensive sources of credit. Just be careful of variable rates and balloon payments that can make that loan not so affordable in the future.
As they say, rules were made to broken. But that doesn’t mean they should be broken lightly. If you’re unsure, talk to a qualified financial professional first. After all, you don’t want to learn the hard way why the rule was created in the first place.