As a former financial planner I know that not all finance is just about the math. The truth is that earning money, spending money, and saving money is a highly emotional thing. While it is fine to suggest that people eliminate emotion when dealing with money, that’s a little bit like telling people to eliminate hunger when dealing with dieting, it just won’t work in the long run.
Is It Better to Save Money or Pay Off Debt?
One of the things that gets thrown around like a solid, no-exceptions, rocket science idea from time to time is the concept of paying off debt as a high, guaranteed return. The theory goes a little something like this:
If you pay off a credit card with an 18 percent interest rate, then that is like getting a guaranteed 18% return on your investment.
Obviously, a sure thing 18 percent return is probably the best possible investment in the world from a risk/return perspective. But, is it really that simple?
Mathematically, paying off higher interest debt is always the right move. However, that isn’t necessarily always the best move for real life, particularly if your finances are not in very good shape in the first place.
Before you go paying off debt, be sure that you are certain of being able to have a place to live. That means keeping a hold of enough cash to make a rent payment or mortgage payment or two, particularly if that has been a problem in the past. Also keep in mind any other payments or commitments where using a credit card is not an option. School tuition and day care fees often cannot be paid by card. There are ways to get cash from a credit card, but they are not cheap. The average cash advance fee is 3 percent. Even then, there are often limits to how much you can take at any one time. Using a windfall to pay down $2,000 on your Visa and then having to scramble a month or two later to come up with $950 in rent doesn’t make sense.
The idea is to first hold onto enough cash that you can cover any “cash” expenses. Then, and only then should you consider paying down debt.
Should You Always Pay the Highest Interest Debt First?
Once you’ve taken care of your cash needs, then you can start considering paying down some debt, especially if you have stable income and a budget that isn’t busted.
Most people who have actual debt, that is more debt than they can pay off all at once, have more than one account. In some cases, this is just multiple credit cards, but it can also be different types of debt including student loans, home equity loans, and mortgages. When it comes to choosing what account to pay off first, the mathematical answer is to pay off the highest interest rate account first. However, once again, in real life, there are some other considerations.
If you pay down a standard loan, such as a home equity loan or student loan, there is really no way to get that money back if something happens. For example, if you pay $3,000 on a loan, the balance goes down by $3,000 and more of each payment goes toward principal instead of interest.
But, if your water heater blows up in the middle of winter and the repair is $2,500, those loans won’t give you the money back to use, no matter how far ahead you are with your payments. However, if you made the same payment to a credit card account or a home equity line of credit, then you can just use the credit line room you opened up with your payment to cover this, or any other emergency.
When it comes to personal finance, remember that the math isn’t always the whole story. After all, the purpose of money is not to just acquire the maximum amount possible. Rather, the purpose of money is to allow you and your family to lead a good and full life. If something seems safer or less stressful than what the experts recommend, or what you read somewhere, be sure to fully understand WHY that is the recommendation. If your needs are more important than what you might achieve, listen to those first.