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Do You Save Instead of Paying Debt?
| November 5, 2010 | Posted by Roshawn Watson under Uncategorized |
By: Roshawn Watson
If you earn the median income in the U.S., you will earn in excess of $2 million during your working lifetime. Will you have any wealth to show for it? One way to ensure that you don’t waste your lifetime income is by paying yourself first.1Employing this simple principle can revolutionize your finances because it forces you to make wealth-building your priority. Additionally, there is a real psychological boost to having money in the bank and increasing your liquid assets can decrease your financial risks. However, should you pay yourself first in lieu of paying off your debt?
Risk Tolerance
Eliminating your debt is the same as eliminating financial risk in your life. For example, a typical American family can easily pay well over $1000 monthly in debt payments (car note(s), student loans, credit cards). Consequently, their quality of life is much worst than someone making the same income without the debt. For example, if two families take home $4000 monthly, the indebted family would typically have at least 25% less cash flow ($4000-$1000) than the debt-free family making the same income because their expenses would likely be substantially less.
Nonetheless, I can appreciate the psychological benefits of having money saved, even before becoming debt-free. There’s comfort in knowing that money is in the bank, and it feels less risky. However, I think people discount the benefits of being debt-free. It is best for for most people in consumer debt (credit cards, student loans, and car payments) to halt saving and investing beyond a modest emergency fund, provided that they possess the ability to become debt-free relatively quickly. Here’s why: if you are debt free and have reasonable income and expenses, the struggle to build wealth lessens substantially.
Can you imagine the psychological benefit of being debt free: knowing that there’s not a cotton-pickin’ creditor who can lay claim to your money? Imagine how it feels to have years worth of expenses banked in non-retirement accounts and not a single debt in the world.
Note the average millionaire has at least 10 years expenses banked, and many could survive for much longer. This is where you are going my friend.
Are You Really Getting Ahead?
Another popular argument is that you can get ahead by playing the leverage/interest rate game. Some people believe it’s always best to get rich using OPM (other people’s money). For example, if you can get money at 0%, why wouldn’t it make sense to save or invest money, instead of paying off debts, to maximize your return.
The problem is “(d)ebt brings on enough risk to offset any advantage that could be gained through leverage of debt. Given time,… the risk will destroy the perceived returns.” (Dave Ramsey)
Additionally, most people do not pay off the debt within the specified time. For example, 88% of ninety day same as cash contracts convert to debt (typically at 24 to38% interest). Also, the interest that most of us would earn on saved money is not going to be life-changing anyway. Let’s say your bill is $2600, and you want to leave it in the bank for 2 years instead of paying off the bill because you have borrowed the $2600 at 0%. Well if you get a generous 2% interest rate, you earn a jaw-dropping $104. Instead you could just be done with the bill. Lastly, if we are the mathematical geniuses we think we are, why would any of us sign up for the debt trip in the first place? Debt builds the wealth of creditors not the debtors, so being good at math obviously had nothing to do with it.
Paying Debt is a Guaranteed Return
If a trustworthy banker (I know… an oxymoron for many) told you about a guaranteed, low-risk return, would you be interested at least? Well, such a return does exist. For example, paying debt that’s at an interest rate of 7.5% APR is the same as saving or investing that money and getting a 7.5% annual return. Consequently, in the present environment where it’s somewhat uncommon to get even a 2.5% return for savings accounts, you can certainly see the financial appeal of paying off your debt. Paying off debt can make a sizable difference to your bottom line. Don’t take my word for it though. Seventy-five percent of the Forbes 400, the 400 richest Americans, said that the best way to build wealth is to become and remain debt-free.
Net Worth
One way I conquered my natural inclination to save while I was eliminating consumer debt was to start determining my net worth. Regardless or whether you save or pay off debt, your net worth still goes up. After I began tracking my progress, my whole outlook on the process began to change. I could began to see the impact of every payment on my wealth. My lightening-fast mind began to wonder why would I want to build less wealth by holding on to debt and saving versus paying off the debt quickly and then aggressively saving and investing. It was this rationale that helped me choose the latter option.
If you are struggling between paying off your debt and saving, I encourage you to take the plunge and quickly become debt-free. If you are used to paying a lot in debt each month, you will be amazed at what happens once your cash flow is freed up. Your most powerful wealth-building tool is your income. Don’t slow down your financial independence for the sake of keeping a few extra dollars in the bank or trying to earn some more interest. There is a reason American companies are sitting on more than $1 trillion dollars in cash right now; companies, such as Ford (no bailout) deleveraged (eliminated debt) two to three years ago to decrease their financial exposure during this uncertain economic climate. If these companies were wise enough to deleverage and then increase their cash reserves, then why don’t you do so as well?
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1 popularized by George Classen’s The Richest Man In Babylon
Fabulous points. If you are unwilling or unable to get rid of your debt quickly, I would definitely suggest contributing automatically to your retirement. The time-frame is a big issue.
I think the mortgage is definitely a special case for most people. Most people are not going to get rid of their mortgage quick enough to warrant having no investments or savings. Thus, they would be better off paying down the mortgage while adequately funding retirement.
In short, I agree with every single point you made!
I also think some people don't realize how much interest they are paying every month. They see a $300 car payment, but not that a bunch of that money is going to the bank and not to paying off the car.
I hate paying interest. My think is I do a little bit of both, save for retirement and pay down debt. I put more money in debt reduction than saving though with the goal to have more to save later.
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Feeling anxious about the fact that the savings account is underfunded can be a great motivator for attacking debt. That anxiety, for many, will motivate them to sacrificially pay off debt so they will have enough positive cash flow to REALLY start saving. However, I agree with others that some savings is needed to handle emergencies before going into debt attack mode.
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I agree with you completely too. In fact, this was the impetus that caused me to move through debt repayment so rapidly. I couldn't stand the thought of being without more of a safety net. I became VERY cognizant of the precarious financial position I was in (both with the debt and without savings). It almost created a healthy desperation.
I knew there was a balance between saving and debt repayment but I didn't know that if you had the money to clear your debts, you'd play the interest leveraging game and all these complicated things :S
I'm very much in the same mindset — paying off your debt = guaranteed return.
I still think we should have savings set aside regardless (a minimum) but that's about it.
#1 establish a 6 month emergency fund #2 pay off credit card debt and stop living off your credit card. I agree this is a top priority. Unfortunately I run into many people who have a huge debt and are within 7 years of retirement with savings that are not quite what they need to retire. #3 take advantage of the 401k match.
I agree that being debt free eases the mind and is an important goal. Parents should practice this and drill it into their kids.
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Absolutely Fabulously Broke,
The leveraging game unfortunately is perpetuated by academics, often broke as can be, about the best way to build wealth. The problem is that their calculations aren't sophisticated enough to mathematically factor in risk. If they did a risk-adjusted rate of return, they would see that they are are recommending that people take unnecessary chances with their futures and will not likely get ahead financially.
Like you, I'm of the mind that you just quickly kill the debt and move on with wealth-building!
My recent post Do You Save Instead of Paying Debt
Yeah, I think parents should focus on these things. I think the problem often is kids can sense when people are not being authentic. Robert Kiyosaki often said that his "poor dad" (biological father) would have been fine if he would have actually followed his own advice.
If you are going to "preach" this stuff, you at least have to be making efforts to live this life!
My recent post Do You Save Instead of Paying Debt
100% agree Retire by Forty. Yeah, we became debt-free as well (excluding the mortgage). In fact, the only reason we kept that was because we are selling the place very soon.
I just don't like playing with dirty snakes who market a product that was designed to snare you into a lifetime of debt.
My recent post Do You Save Instead of Paying Debt
Well if they could get so rich with their fabulous theory, why aren't they millionaires then?That's where I'm skeptical about people who tell me: I can double your money in a year.If they could do it, why aren't they rich? Call me paranoid but I always think others have an ulterior motive when it comes to my money.
You are so right! That's the problem: why are they stuck purporting theories instead of being in the market dominating if they are such financial geniuses? The snobbery that they exude when discussing it is just plane insulting. Unfortunately, such brilliance can be a handicap because practicality and intuition often are superior to some of the best theories when it comes to business and investing (sorry to all my fellow academics 🙂
My recent post Do You Save Instead of Paying Debt
*LAUGHING*Agreed. I say that about SOME financial advisors too, which doesn't mean only academics are theory snobs. A lot of financial advisors have a lot of fancy graphs and whatever else to show people how to make money if they'll just invest with them… but in reality, if they shouldn't need your money to make money if they know how to be uber rich. –shrug–I am still sticking to my plan. Make money. Spend it wisely. Save it. Watch it grow.
I'm all about eliminating debt as a priority. To me, it makes sense from a financial point of view, but also from the 'sleep well at night' viewpoint. I don't want to feel like a servant to the lender, and I don't want to owe anybody anything financially. It's all about working for financial freedom.
The interest rate game is not worth playing, fundametally. Sure, there might be opportunistic situations where it could be, but my preference is to steer clear. OPM isn't for me when it comes to personal finance. Live within your means, save and invest, and avoid debt.
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Sounds like a fabulous plan to me!
I agree completely. Some financial advisers deliberately try to be confusing in an effort to deflect attention away from their own obsolescence. Not all of them are bad, but there are plenty who do not have the heart of a teacher. I'm beginning to employ another rule with regard to hired help: do your portfolio holdings mirror or exceed mine? If so, you may be qualified to give advice. I know this is a hard stance, but too many people lose their entire life savings by blindly trusting an unproven professional!
Like I said, I like your plan a lot!
My recent post Do You Save Instead of Paying Debt
Very sound advice Squirelers. Just because someone has a convoluted theory doesn't make them right!
Being debt-free can definitely help you sleep at night, and I agree there are sometimes some opportunistic situations that may prove the exception. However, I often find that most people who espouse the OPM dogma are not very wealthy. Many of them are broke and are just salesmen (often of the snake-oil variety). I can think of some exceptions, but they typically have something else going on as well (i.e. an unusually large earned income via a business or a job). In other words, they generally did not earn their wealth by using their own OPM-centric theory.
My recent post Do You Save Instead of Paying Debt
I think this was recommended in one of my favourite books — The Millionaire Next Door.One millionaire said to all financial advisors: You can handle my money if you pass my interview. Send over your net worth statements from the past 5-10 years and you'll get an interview with me.No one has taken him up on his offer yet!
I do believe that is where I first saw that recommendation as well. It was also in one of Kiyosaki's books (part of the Rich Dad series) too.
I think it is very pragmatic advice to keeping yourself from being handled by a slimy scammer.
My recent post Do You Save Instead of Paying Debt
Hey– don't slam the academics. And they do have risk adjustments– I think they're called betas. We economists at least understand the difference between a safe asset and a risky one and short term vs. long term savings vehicles. And many academic economists are very wealthy. (I'm not yet… but I'm still young.)
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Whoa! I love academics and give them way more respect than what came across in my comments. In some regards, I am one (I hold 2 doctorates), and my wife holds one. I only say this to show that there is a kinship here.
I really dislike those who perpetuate lies regarding risks though and those who talk over people heads in an attempt to appear smart. As an academic, you know that those who are the brightest possess the ability to explain things at a level so that almost anyone of reasonable intelligence can understand. In the financial industry, this simply doesn't happen, and many people end up forfeiting their life savings because of nicely packaged theories that aren't worth the paper they are written on (for many people) IMHO.
In terms of academic wealth, sure professors have a greater propensity to become millionaires than the general public, but lesser than entrepreneurs (28%), Senior corporate executives (16%), doctors (9-10%), lawyers (9%), and engineers (9%), marketing/sales professionals (7%). According to Dr. Stanley's most recent survey (not perfect), about 3% of millionaires were educators. Certainly, those with Ph.D.s or other advanced degrees often achieve higher levels of wealth by virtue of higher lifetime earning potentials. Most of the economists that I am aware of that are very wealthy make a large amount of their money from businesses that they own and speaking engagements, not from leveraged investments. However, this is not my area, so I certainly allow for the fact that I could be wrong.
My comment is specifically targeted to those who advocate for leveraging but have not proven it in the marketplace. BTW, I have every expectation that you will be building some serious wealth, and I'm so happy for you. I have devoted a serious portion of my life to academics and would hopefully never disparage a profession that I esteem so highly.
My recent post Do You Save Instead of Paying Debt
The best advice I ever received AND followed was "Earn interest don't pay it"
Simple yet effective.
It is instructive to use one of the various online calculators to determine how much you really are paying for something by financing. It can be jaw dropping. People haggle and haggle for a price reduction and search and search for the best deal then put the purchase on credit. How counter productive is that?
Well, the main reason I do both is that I don't want to miss out on the pre-tax investment opportunities with my 401K and company match. Once the year is gone I won't have the ability to retroactively go back and get it. Saving above and beyond that though doesn't make sense until I'm totally debt free.
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Great quote. I heard a version of that one too. "My goal in life is to receive more interest and dividend payments each month than bills that I have."
Like your quote, it's all about earning passive and portfolio income rather than paying for someone else's yacht.
You are right: it is very counterproductive and quite sad. Some people are going to be left with a lot of regret when they realize what they gave up so that they could have that new ____ (fill in the blank).
Thanks for the comment, and best regards!
My recent post Do You Save Instead of Paying Debt
I definitely see your point. For me, it is all about the situation. For example, if someone can conceivably become debt-free in a short period, I don't hesitate painfully halting investing. That's simply because after they are finished paying off debt, then they very aggressively invest. By aggressive, I mean investing at such a level that few are even familiar with, especially those at the same income level (i.e. at least 2-3 mortgage payments monthly). This is just a different strategy, but my experience is that people who follow through on this strategy don't end up financially behind. Alas there are many ways to do it though. This is just the method that I am familiar with.
My recent post Do You Save Instead of Paying Debt
I view this topic the same way. While you should save enough to have an emergency fund before throwing ALL of your extra cash at debt, once you have that small EF, you should attack your debt with gusto.
I don't have any debt anymore. But when I did, I split my spare cash 50/50 between paying down the debt and investing.
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Roshawn, you hit the nail on its head. When you have any form of debt besides your mortgage, especially high interest debt, your money should be working at eliminating that tumor. There is no debate around that, any form of investing can wait and the only other excuse anyone can bring up is building a modest (3mos) emergency fund.
great article, I hope you reached some listening ears out there!
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You really have to do both, unless you are going to jump on the debt and get rid of it quickly.
I don't actually (personally) know any academics who promote leveraging. There are some prominent folks who play with hedge funds, but they seem to be doing ok for themselves, but that's really in the same way that Trump does ok for himself. I don't think it's a function of them being academics.
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Agreed. It's simply and has literally worked for millions of people!
My recent post Do You Save Instead of Paying Debt
Several people have such an allocation. For me, it was just a matter of what would free up my cash flow the quickest. The good part about this though is that you are choosing between two good things: saving and paying off debt! I'm happy you are debt-free Grouch!!!
My recent post Do You Save Instead of Paying Debt
Thanks so much Mich. Yes, I hope this message is reaching some too!
My recent post Do You Save Instead of Paying Debt
That's exactly what I am suggesting, if it is possible. I guess if you have a massive amount of debt and limited income then this isn't feasible though
My recent post Do You Save Instead of Paying Debt
Very interesting point. Yes, I don't think debt leveraging is a function of being academic per se. My only problem is often academics and financial professionals are some of the few people who can argue convincingly for it. Since so many people have an inherent apprehension discussing finances to begin with, it doesn't take much for a strong person who is used to arguing to get someone to do something that may be against their better judgment.
I definitely believe there are plenty of great academics and would never impute the sins of the bad ones on the good ones. Best Regards!
My recent post Do You Save Instead of Paying Debt
Shawn, Life is much richer without any credit card debt. Sometimes it's unavoidable in case of job loss or hardship. Otherwise, debt is like a noose hanging over your head.
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Debt equals bondage in nearly every case, so noose sounds about right.
My recent post Do You Save Instead of Paying Debt
I have been hearing a lot of conflicting advice about whether I should be paying off my student loan debt. I have been out of college for 2 years, and know I will have a job for at least the next 7 months. I am currently making 38k a year, have have been putting $300-500 a month into a long-term savings account, which now has 8k. I typically spend 2k a month, but could get by on $1500. I have 3-4k in a checking account depending on the time of month, and my only debt is from student loans, about 10k, with an interest rate of around 5%. Should I start an IRA, or pay off my debt? Where can I find out more about this type of situation.
First, let me say that I think you are doing a good job handling your cash flow. Sixty-one percent of Americans live paycheck to paycheck, so by having $11-12K (savings and checking), you are already ahead.
I've been on the on the other side of this mountain, and I can unequivocally state that I am very happy that I became debt-free first. Not only is there decreased risks by becoming debt-free (penalties and fees for being late, delinquency, lawsuits, etc.), but there is increased cash flow, which is a BIG DEAL. When you no longer have debt, you can invest the money that was going to Sallie Mae and build your wealth much faster.
Looking at your numbers, a Federal tax calculator suggests that you would have a monthly take home of $2690 (not including state, property taxes and SS). If you were able to put $400/month towards your student loans, you could be completely debt-free in 25 months (a little over 2 years), since your living expenses are $2000. During this process, you would still have your EF and checking balances. The only problem is that you delay investing for two years (not ideal given the loss compounding interest but not a fatal flaw and conservative by many accounts).
Now, if you were to do this aggressively, you could do the Dave Ramsey/John Cummata approach. Temporarily, you would cut your lifestyle to nothing ($1500/mo expenses), have anemic savings to quickly pay off debt and then aggressively build wealth. In the The Total Money Makeover, Dave Ramsey recommended halting investing and emptying savings and all non-retirement accounts to $1000. All this money would go towards getting rid of the debt. Thus, with $11,000-$12,000 in your checking/savings, you could be debt free tomorrow. Your next step would be to rebuild savings back up to 3 to 6 months of expenses, then you would invest 15% into retirement, and so on. For this aggressive plan to work, one has to be committed to never going into debt again (I don't suspect that this is your problem) and to aggressively invest after debt is repaid.
If you are uncomfortable with the idea of getting rid of your savings, you can always do a hybrid: cut lifestyle to nothing $1500/mo expenses, leave savings intact, and pay $1000/month to Sallie Mae. You would be debt-free in 10 months.
In the three aforementioned approaches, you can see how you could be debt free tomorrow, in 10 months, or 2 years. The right answer depends on your risk tolerance. Since you are looking for consistent advice, I know no one whose advice is more consistent than Dave Ramsey. Borrow the Total Money Makeover from your library or buy a copy on Amazon, listen to his podcast, etc. You will learn a whole lot about getting rid of debt. Also, consider subscribing here too, as I love discussing these issues.
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Best Regards, and let me know if there is anything else I can do for you!
My recent post Do You Save Instead of Paying Debt
It really does depend on the rate of return. For credit cards and other high interest rate debt, paying off the debt is obvious. For a mortgage at 2-4%, it's not so obvious. It's really in how much security you place in paying down debt, as well as your personal time preference and if you seek to get out of the rat race by lowering expenses or if you don't mind working for some more.
It is a trade-off between risk and reward, and while I'm not about to go out and say that all debt is bad, it can be more trouble than it's worth!
Hey Kevin,
I agree with you about mortgage debt being different from consumer debt, but my rationale is somewhat different.
In this post, I was making the case for eliminating consumer debt before investing. "It is best for for most people in consumer debt (credit cards, student loans, and car payments) to halt saving and investing beyond a modest emergency fund, provided that they possess the ability to become debt-free relatively quickly." I do not classify mortgage debt as consumer debt. The main reason is that most people simply aren't able/willing to eliminate their mortgage debt quickly enough to avoid doing financial detriment. Thus, the rate of return (loss compounding, appreciation) and lack of significant savingsdoes begin to make a big difference when you factor in how many years someone is going to keep a mortgage.
In short, I think if we were both faced with the same decision, we would make the same choice: invest and pay down the mortgage. I would still not keep the mortgage for too long though, but I wouldn't halt investing entirely to eliminate it personally (unless my income allowed for the mortgage to quickly be cleared).
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There are a few blogs out there giving wrong and misleading advice ~ goes to show that free information may not be the best information. I definitely agree with you in that:
1) Save up EF Fund first for any emergency
2) Pay off ALL consumer debts first prior to investing
3) Start saving for investing/retirement etc etc
Exceptions: Loans with very low interest (eg 0%-1%) that can be deferred without penalty if you aren't earning an income… those loans can be paid with the minimum payment without being detrimental to building your wealth.
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sorry…my comment was too long…here's the second part:
Further, to your comment about paying off a 7.5% loan= 7.5% guaranteed return …. you actually need a higher interest (yield)return than 7.5% to even beat paying off your 7.5% loan because your returns are taxable income.
Example:If your tax rate is 15%, you would actually need to earn more than 8.82% return on your savings to make the option of paying off the 7.5% consumer loan NOT attractive.
It's because it's hard to actually find an investment that will yield greater than 8.82% reliably every single year – that is why it is preferable to pay off your consumer loans first – anyone telling you differently is not looking after your best interest.
Cheers x
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To rule the world education is the first tool that uses to do it. All the big civilization rules due to its knowledge and they invented numerous things that use in battle. But when they start giving less importance to the education they left behind and new civilization come to their place.