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.

“I, Pencil” – A Free-Market Classic

The inspiration for this post comes from a December 9, 2006 “Evenings with FEE” speech,  by author George Gilder. FEE, the Foundation for Economic Education, posts “classics” in the sidebars of its daily “In Brief” commentaries on current events.

As prologue to his speech, Gilder made reference to the writing that most influenced him to embrace libertarianism and Austrian economics. It was I, Pencil, written by Leonard Read.

Gilder called this short work of fiction about the making of a pencil “the single most important essay of liberty ever written,” and “an inoculation against Socialism.” He added that once you read I, Pencil “you just can’t believe in massive government planning…it becomes evident that people who imagine that whole economies can be planned are just imbeciles.”

Gilder is right. I, Pencil is a brilliant piece of writing. The logic is tight, and so are the conclusions.

For a short, yet effective dose of free-market clarity to counter the fog of government-think, click to here to retrieve I, Pencil from our reading room.

Why You Need To Meet Murray Rothbard

Question #1. Ever heard of fractional banking?Question  #2.Did you know a bank can legally lend up to 10 times more money than it has in deposits?Question  #3. Did you receive a government-sponsored “public” education?(Best guess: If you answered “no” for Questions 1 and 2, you answered “yes” for 3. If you answered “no” to 1, 2 and 3, you probably over-paid for your private education.)

The ignorance of the general public about the negative economic impact of fractional reserve banking is enough to make one seriously consider whether public education isn’t some form of mind-control conspiracy. When what would be considered theft or fraud in any other business transaction is completely ignored simply because it bears the stamp of government approval, you have to wonder if the absence of outrage isn’t due in part to a deliberate campaign to obscure or hide the truth.

Which is why I love Murray Rothbard and his book The Case Against the Fed (Click here to purchase it). In 150 pages, Rothbard takes a subject (banking) that is almost unintelligible to the average American and makes the essential elements crystal clear. And when the scales drop from your eyes, two items stand out:

1. Fractional banking isn’t much different than counterfeiting. The government gives one institution (the central bank) the authority to print paper money – out of thin air – and then requires that it serve as “legal tender” for all financial transactions.

1. Governments cannot help but love fractional banking because it gives them economic power over the citizenry. The first party to obtain the use of counterfeit money is the government, and the government is the only party that benefits from the introduction of it into the economy. After that, all others suffer because the excess paper money creates an imbalance between the cost of goods and services and money that can be used to purchase them. This inflates prices. Real people, working for real money, must now pay more for the same loaf of bread or automobile.

 According to the bio on the back of his book, “Rothbard (1926-1995) was dean of the Austrian School of economics and America’s foremost scholar of central banking.”

America’s foremost scholar of central banking. There’s an obscure distinction. (Who would want to put “scholar of central banking” on their resume? The fact that we would ask that question is indicative of how little we know or understand about how central banking distorts every economic action in the United States.)

But read this brief comment from Rothbard:

“…if the public knew what was going on, if it was able to rip open the curtain covering the inscrutable Wizard of Oz, it would soon discover that the Fed (i.e., the Federal Reserve Bank, the central bank of the United States), far from being the indispensable solution to the problem of inflation, is itself the heart and cause of the problem.”

Got that? The Fed, now led by Ben Bernancke, formerly under the direction of Alan Greenspan, is the cause of inflation. And because the Fed is the cause of inflation – which progressively diminishes the purchasing power of our hard-earned dollars – it can never be the solution.

The irony is that 170 years ago, the citizens of the United States understood the impact of a central bank – and they voted to close it. The first “Fed” was called the First Bank of the United States (catchy title). It was authorized by Congress in 1791 and “retired” 20 years later when Congress declined to renew its authorization. A Second Bank of the United States was chartered in 1816, but 20 years later, its charter was not renewed either. From 1836 to 1913 the United States did not have a central bank.

A major plank of Andrew Jackson’s presidential campaign in 1832 was his opposition to the re-chartering of the Second Bank of the United States. Can you imagine a sound byte today from McCain or Obama or Hillary that promised to “rid us of the scourge of central banking?” (Hmmm…that sort of sounds like Ron Paul, doesn’t it?)

Two final comments:

Every citizen who cares about their financial future should understand fractional reserve banking and the role of the Federal Reserve in the economy. Rothbard’s book is a good place to start, but any education would be helpful.

The opposition to central banking and the economic abuses that result is not new. As far back as Biblical times, Solomon warned that “dishonest scales are an abomination to the Lord, but a just weight is His delight.” (Prov. 11:1). Government-authorized counterfeiting might be legal, but it is dishonest – every new piece of paper distorts the value of our work and our assets.