Thursday, June 25, 2009

Reduce Debt or Save

saving By Ronny Miller

One of the most common questions we receive from credit union members sounds something like this,

“Should I pay off my credit card (car loan/mortgage/personal loan/etc) or should I save the money instead?”

A simple mathematician would tell you to pay off the debt. You are paying an average of 4% more on the debt than you are earning on your savings. It’s simple! Right? Maybe…maybe not.

Simple Math

You have a $100 mortgage charging 7%. That costs you $7 per year. So if you paid off the mortgage you would have an extra $7 to spend.

Your other option is to invest the money instead and earn a rate of return of 3%. This provides income of $3 per year. Now you would have to pay taxes on that. (Let’s assume marginal tax rate of 30%). That means, after taxes, you have an extra $2.10 to spend.

A difference of $4.90. So, mathematically it almost always makes sense to pay off the debt first.

In a perfect world we would all pay off higher interest debt first, but that fails to take into account many important factors.

1) Building an emergency fund which may save you from acquiring more debt later on.

2) Piece of mind in knowing you have a nest egg on which to rely.

3) Waiting too long to start saving may be the worst mistake of all.

The Psychological FactorPsychology

How would you answer this question?

“I want a debt reduction plan to pay off my credit cards. How should I go about paying these off?”

Most people would recommend listing the balances from highest rate to lowest rate and start paying extra on the highest rate card. This is excellent advice, but not what we would recommend.

First we say “Save!” If you are truly putting together a debt reduction plan, the best thing you could do to set yourself up for success is to have an emergency fund. Without question you will have an emergency at some point during your effort to pay off debt. A lot of people depend on credit cards to fix these emergencies.

Imagine just starting a debt reduction plan and then having to go into more debt due to a medical problem, car repair, or other emergency. How frustrated would you be? For most people this is all the reason they need to give up on the plan and go back to their old ways.

This is a great example of when you should save first to pay off debt second.

The time value of money

You can’t afford to wait. The power of compounding interest is a miracle of personal finance and the sooner you start the more benefits you can reap. Actually, the benefits are exponential. This is the reason Albert Einstein referred to compounding interest as “the 8th wonder of the world”.

So, how does this apply to debt reduction? If you are choosing not to save in order to pay off a mortgage in 20 years instead of 30, you are losing 20 years of compounding interest. You cannot afford to lose that time.

Compound Interest Equation equation

P = C (1 + r) t

    P = future value
    C = initial deposit
    r = interest rate (expressed as a fraction: eg. 0.06)

    t = number of years invested

The “t” is the exponential part of this equation and it makes all the difference. Let’s look at two examples:

Let’s say you are 20 years old with 45 years to retirement. Saving $1200/year (100/month) and you average a 10% rate of return. You’ll retire with $948,954.38. Who knew $100 a month could almost make you a millionaire.

Now, let’s say you are 50 years old with 15 years to retirement. Saving $_________/year and you average a 10% rate of return. How much would you need to save to get your million dollar retirement? Go ahead, take a guess.

The answer: $28,000 a year. ($2,333/month). Ouch.

By the way, if you just saved $100/month for 15 years you would need to earn a rate of return of 45% to hit the millionaire zone. Not very likely.

The Bottom Line

Paying off debt is never a bad idea, but sacrificing long term saving to pay off debt is. Look at your personal situation and ask for help if you need it.

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