Now is not the time to pay off debt faster

Now is not the time to pay off debt faster

I’m sure there’s a politician somewhere who can spin the information to arrive at a different conclusion, but most of us are dealing with the following financial realities:

• Property values are down.
• Interest rates are down.
• The stock markets are down (then up for a while, and down some more).
• The US dollar is down – and the cost of living (especially fuel) is up.
• Our US economy is down (due largely to the real estate and financial crises).

As a result, many Americans are worse off than they were a year ago. Given these negative financial circumstances, where many people have less money and are less inclined to takes risks with it, I am reading commentary from financial “experts” saying the prudent thing to do now is to re-direct saving and investment dollars to pay off debt.

I’m all for eliminating debt. Debt is a financial millstone around the necks of most Americans, and it is debilitating, financially and psychologically. But while I’m sure many of these financial experts are well-intentioned, I would argue now is not the best time to pay off debt. Rather, now is the time to save money. Let me explain:

The argument that most pay-down-your-debt advocates make goes like this: If you don’t think you can earn above-average returns in stocks, and interest rates are low in guaranteed vehicles (like Treasury instruments, Bonds, CDs and Money Market accounts), then why not use your investment dollars to pay off high-interest (and usually non-deductible) debt? After all, if your credit card company is charging you 15-18%, making extra payments on the balance is “like earning 15-18 %.”

Superficially, this argument makes sense. Mathematically, you can “prove it.” But while this strategy is logical, it neglects some of the financial realities. Let’s use a hypothetical “real-life” example to illustrate.

Suppose you decide to follow the advice of the pay-down-your-debt gurus. Instead of saving or investing in your 401(k) or some other accumulation vehicle, you commit an additional $200 each month to paying off credit card debt.

If you make an extra $200 payment on the credit card, will you still have a payment due next month? Yes. Will the monthly payment be significantly less than the month before? Probably not. There may be some decrease, depending on the size of the balance, but especially if your balance is high enough that it would take a year or more of extra $200 monthly payments, the monthly decrease isn’t going to be that great. So while you technically “earned” the interest you saved, you don’t have more money in your pocket, and you still have a financial obligation next month.

Let’s inject a little more “reality” into this scenario.

Assuming you have used your “extra” $200 for the past few months to pay down your credit card balance, how will you pay an unexpected but necessary expense, such as an $800 automobile repair? If you don’t have any liquid savings, most likely you’ll end up using the credit card. If you do, your outstanding balance is goes back up, and so does the interest charge.

Here’s another “reality” situation. In the next few months, what happens if you lose your job, or have to take a pay cut? If you don’t have as much income (or no income) and no liquid savings, the likelihood is there’s not going to be a payment to the credit card company. And more than likely, one late payment will trigger a higher interest rate (along with fees) on your card – and your credit score is going to take a hit as well.

One of the reasons most people have high-interest credit card debt in the first place is because they haven’t learned the discipline of saving. They haven’t developed the habit of living below their means and paying cash for big-ticket purchases, vacations, emergencies, etc. In fact, the only saving many people do is through their retirement plan, where money is withheld from their paycheck. Thus, their default budgetary model is “if it’s in the account, I can (and will) spend it.”

Of course, this approach is ill-equipped to deal with unexpected expenses or large purchases, so borrowing becomes the other default action in their financial lives. There’s always the intention of paying the credit card off next month, but a few years later, unpaid credit card balances are a permanent part of their budget. Five years later, the monthly payments are putting a strain on current expenses. Consolidation may temporarily relieve cash flow pressures, but because the underlying behavior hasn’t changed, it isn’t too long before the balances are going up again.

If you really want to fix your debt problems, start saving and stop borrowing. Building a pool of savings (call it your emergency fund, rainy day fund, save-to-spend account, whatever) will keep you from going back to the lending trough. Having savings will keep you from missing payments if your employment situation changes. Having $10,000 in a liquid, safe account will change your life.

By the way, even if you already have $10,000 or more set aside, and have a very secure employment situation, I would still recommend saving instead of extra payments on debt, even credit card debt. The better approach is to make the scheduled payments each month until your savings balance is large enough to pay the outstanding debt in full.

Part of this is a matter of control. If Visa is satisfied with $100/mo., why send them $300? Keep your money under your control, and when it suit you, pay the balance in full.

The other reason for saving instead of paying off debt is that the math isn’t as favorable as you might think – even if there’s a significant different between the rates of return on your savings and the interest charged by the credit card company. For an eye-opening illustration, check out this article on www.worksaveown.com.

Saving money is not the same as paying off debt. Saving money is a behavior that leads to financial control and freedom. Paying off debt, even at a faster pace, may help relieve some financial pressure, but it doesn’t move you forward. If you don’t establish the saving habit, you will always be at risk of going back into debt. Bad habits not only need to be avoided, they need to be replaced.

With all the uncertainty surrounding the present economic situation, the best financial decision is to save.