Debt Dillema

As a financial planner, one of the most common questions I get asked on a day-to-day basis is, “Should I pay off my debt, or is there something better to do with my money?”  I hear this question so often that I have even coined a term for it.  I call this the “Debt-Dilemma.”  And as with almost all things financial, the answer is, ‘it depends.”  It depends on who you are, what you are trying to achieve and your specific resources and expenses.  I believe there are really two ways to look at this question.  One is statistically, and one is realistically (i.e., behaviorally.)  Let’s look at this question first from a statistical, purely numbers-based stand-point, and then from a more nuanced, behavioral or “real world” vantage point.

The Numbers

Statistically or numerically, this is actually a relatively easy question to answer.  We only need three pieces of information to figure out the “right” answer to the question: “Should I pay off my debt, or is there something better I could be doing with these dollars?”  These three data points are:

  1. What interest rate you are paying on this debt?
  2. Where will the money will come from to pay off the debt in question?
  3. What other opportunities do you have for these dollars? (In academia, this is called “opportunity cost.”)

Once you have this information, the answer, on a purely statistical basis, is this: if you have money sitting around, beyond your basic cash reserve needs, that is currently earning less and is likely to continue to earn less than the interest rate you are paying on your outstanding debt, or than you are likely to earn on the other opportunities you have for these dollars, then you pay  down the debt as quickly as possible.  Here is an example that may help to clarify this.

Example #1

Let’s say you have credit card debt that is costing you 10% per year.  In addition, you have money in the bank, beyond your basic cash reserve needs, earning basically nothing.  The only other opportunity you have for these dollars, outside of leaving them in cash or paying off your debt, is to invest them, and let’s say your investment portfolio is structured to return you approximately 7% per year.  In this scenario, if you are an unemotional and purely statistical kind of person, it is a no brainer, you pay off the debt.  Paying off the debt is a guaranteed 10% return, which is more than you are likely to earn investing these dollars and more than you are likely to earn from any other opportunities currently available to you.  If you can earn 10% by paying off your debt, why instead try to earn 7% by investing?  And, even more, why leave these dollars in cash earning even less?

Here is another statistics-based example, with a different outcome.

Example #2

Again, you have money in the bank earning basically nothing.  Now, let’s assume you have a student loan or a mortgage that is costing you 4% per year.  Once again you have an investment portfolio and strategy that is designed to return approximately 7% per year over the long run.  In this situation, without taking into account any behavioral or personal variables that may come into the equation (and which we will talk about shortly) you don’t pay off or pay down the loan, you invest.  Why would you pay off debt that is costing you 4%, when you are likely to earn 7% by investing?  If you are a robot, or a spreadsheet, you wouldn’t.

Okay, pretty simple so far, right?  Right, but here’s the rub.  You are not a robot or a spreadsheet and there is a huge difference between statistical analysis and the real world that people actually live and operate in.  The real world is filled with emotions and personal factors around money that cannot be taken into account mathematically, which is why the answer to this question is really more nuanced, and is often different from that of the more academic or statistical discussion we just laid out.

The Reality

In the real world, there are many other non-statistical and non-numerical factors to consider, in addition to the three we used in our first two examples.  For instance, many people just hate being in debt, and it gives them a bad feeling that resonates into many areas of their lives. It affects their sleep, it affects their relationship with their significant other, it is something that is always nagging at the back of their brain.  In this case, there is an emotional advantage to be earned by paying off the debt. I like to call this an “emotional dividend.”  This emotional dividend does not show up on a balance sheet, so it cannot be factored into our statistical analysis, but it is still just as important (if not more so), because it shows itself in the overall quality of one’s life and relationships.  And at the end of the day, isn’t that what is most important?!?  If it causes you angst, or you lose sleep over having debt, then to some degree the statistics go out the window.  The emotional advantage gained by paying off the debt may well be worth more than the joy you get from knowing you’re following the “correct” statistical path.  As such, there are times when the statistically-correct choice, is not the behaviorally-correct choice for you as a living, breathing, emotional being.

There are some other instances where relying purely on statistics may not be the right choice.  If you’re the kind of person who just doesn’t feel comfortable investing for the long run, or you do not need to invest any more money to meet your financial goals, even though you may have an opportunity to earn more by investing, it still may not make sense to do so.  There are those who, for whatever reason, just don’t like or don’t trust the stock market, and as such are highly unlikely to leave money invested for the long run, through the significant upside and downside volatility that will come. For them, the statistics, once again, don’t really matter.  The upside potential of investing is only likely to work to your advantage over the long term, so if you are unable or unwilling to stay invested for the long run, then our statistics go out the window.  In this scenario, it might make perfect sense to pay off your 4% debt, rather than invest, as you are unlikely to earn the portfolio’s statistical long term return of 7% (or whatever rate your portfolio is designed to provide), because you are probably not capable of staying invested for the long run.  This is a case where it is of utmost importance to truly know yourself.  Everyone seems happy to be an aggressive investor these days, because the markets have been doing so well, but what will you do when things inevitably turn south? 

The last example of when reality trumps numbers, involves a scenario we all hope to find ourselves in.  Perhaps you have worked out your financial plan, and you have realized that you have more than enough money invested to meet all of your financial goals. Here again, it may make perfect sense not to invest more, and to instead pay off or pay down your debt, even though the numbers say you could likely do better.  The question here is, better than what?  What are you investing for?  If you are a robot, and your primary goal is to maximize your net worth, then you invest.  If you are human, and your primary goal is to maximize your quality of life, and you have already attained the financial wealth you need, then the answer may well be different.  After all, why keep playing the game if you have already won?




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