Whenever we make decisions, we make certain assumptions. This is true when making decisions about money. We make financial projections based on assumptions about how things will go with our money. It’s also common to make personal finance decisions based on economic assumptions.
Unfortunately, our assumptions don’t always bear out. In fact, sometimes our assumptions can lead to financial decisions that can be downright devastating.
Here’s how to avoid the most dangerous financial assumptions:
1. Debt will remain cheap
We’ve seen low interest rates since the financial crisis, which means cheap debt. I know I’ve taken advantage of it; I financed a car in 2011 at 1.9% APR.
The problem is it’s easy to fall into the trap of assuming debt will always be this cheap. What if you get used to buying on credit, rather than saving up? Plus, what if you have a relatively low variable rate on a loan now, but interest rates rise?
You can’t assume that today’s low rates are sticking around forever, whether you are looking at a variable-rate mortgage or special rate on your credit card. In fact, some Federal Reserve insiders think that additional rate hikes are coming.
That means more expensive debt down the road. Now is the time to tackle your debt – before you get slammed by higher interest charges.
Also, don’t get used to buying on credit. It can be tempting to use cheap debt to leverage your lifestyle. The right approach can be beneficial, but it’s a good idea to save up for what you want. That way, even if you use cheap debt to make a purchase, you can pay it off quickly if rates start to rise.
2. You’ll get 10 percent annualized returns on stocks
When making financial projections about your portfolio growth, it’s common to assume stocks will get you 10 percent annualized returns. This is a dangerous assumption for planning to build your portfolio.
MoneyChimp’s compound interest calculator offers an illustration of how devastating that assumption can be over a period of 30 years: If you invest $450 a month, you’ll end up with $977,094.49. That’s a pretty good chunk of change, and might actually get you through retirement.
But what if you’re wrong? What if you only see an annualized return of 7.9 percent? It doesn’t seem like a big deal, but over 30 years it adds up. Now you only end up $648,069.80.
MarketWatch points out that the S&P 500 had an average compound return of 9.8 percent from 1928 to 2015. But during one 40-year period within those 87 years, the return was only 8.9 percent. Your actual annualized returns depend on what happens during the time you build your portfolio.
There’s a good chance that you will come out ahead if you stick to a dollar cost averaging strategy. However, you might not get the returns you assume.
Instead, base your financial projections on a lower rate of return, like seven percent annualized. It means you’ll sock more away in the long run, or start saving earlier. These are not bad things. You should probably be doing both anyway.
3. Basing future expenses on today’s costs
One of the worst things you can do is assume that in 20 years things will cost the same they do today. Inflation will kill your finances if you make these assumptions.
The year-over-year inflation rate for the all-items index released by the Bureau of Labor Statistics was 2.1 percent in December 2016. Historically, the inflation rate hovers right around three percent. That’s why it’s often used as a rule of thumb.
According to the SmartAsset inflation calculator, it would take $243 in 2047 to equal what you could get for $100 today.
While inflation varies each year, the bottom line is that prices rise. You need to plan for it by investing in assets with higher potential returns. On top of that, just setting aside more than you think you’ll need can help you combat the ravages of future inflation.
4. Government benefits will always be there
Originally, Social Security was designed to supplement income in old age. However, when it was implemented, expected lifespans were much shorter. Just since 1950 life expectancy has risen.
According to the Centers for Disease Control, the average life expectancy was 68.2. In 2007, it had risen to 77.9. Someone who made it to age 65 in1950 was only expected to live another 13.9 years. In 2007, someone who made it to 65 could expect to perhaps live another 18.6 years.
As a result of changing demographics, economic projections, and longevity, there are concerns about Social Security. In fact, there’s already talk about changing Social Security benefits. Other government benefits like Medicare might also change.
Instead of planning on government benefits to help you meet your retirement income goals, set aside more now. If you get the benefits, it will be gravy.
5. Everything’s just fine
The world probably isn’t coming to an end, but many of us think things are fine when they aren’t.
The reality is that, according to the Federal Reserve, less than half of Americans have three months’ worth of expenses set aside. On top of that 46 percent of respondents to the Fed’s survey indicated that it would be challenging for them to come up with $400 for an emergency.
Your financial assumption that you are fine might be based on the fact that you aren’t dealing with an emergency right now. If you’re living paycheck to paycheck and not setting aside money for savings, everything is not fine.
Recognize you might encounter a hardship. The Fed data indicates that a significant number of people can expect to face financial hardship at some point:
Begin building a rainy day fund immediately. Don’t assume that just because you can handle your bills that you are in a good place. This is a dangerous financial assumption to make.
In the end, we have to make some assumptions as we plan our financial projections. However, we are better off erring on the side of things being slightly worse than we expect; you can plan for the worst while hoping for the best.
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|Lender||Rates (APR)||Loan Amount|
|* = includes AutoPay discount|
|4.77% – 14.24%*||$5,000 – $100,000||Visit SoFi|
|5.25% – 12.00%||$2,000 – $50,000||Visit Earnest|
|5.75% – 16.24%1||$5,000 – $50,000||Visit Citizens|
|5.67% – 29.99%||$1,000 – $50,000||Visit Upstart|
|6.20% – 19.75%||$3,000 – $25,000||Visit Pave|
|8.00% – 25.00%||$5,000 – $35,000||Visit Payoff|
|9.95% – 36.00%||$1,000 – $35,000||Visit Avant|
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