From a pocketbook standpoint, there are two ways to look at the Federal Reserve Board’s decision to raise interest rates in August.
1. Borrowing got more expensive, particularly if you are about to take a mortgage.
2. A “risk-free investment” in paying off your debts got a lot more attractive.
It’s the second, less obvious answer that should have most consumers rethinking some of their personal financial strategies, particularly if rates rise again this year.
Most financial experts harangue consumers into feeling as if they must pay off all debts as soon as possible, but the reality is much different for the average consumer.
The statistics show that millions of Americans carry credit card balances, car and mortgage loans, education loans, home-equity loans and every other manner of financing.
While we frequently hear the horror stories of people whose debts are overwhelming, those tales actually are in the minority. Much more common is the consumer who is balancing saving for retirement, college and other long-term goals with paying down his debts.
In these cases, the consumer is saddled with his own liability, carrying the debt burden while, hopefully, moving forward on all financial fronts.
“The rule of thumb that says `Pay debt off first’ does not necessarily apply to everyone,” says Stephanie Tower Keating of Financial Education Resources, a Rhode Island advisory firm. “People see debt as a bill, an expense to be paid rather than part of the picture of how to use their financial resources. . . . They have to look at where they get the best return for their money, and they must be honest about their spending and paying habits.”
Obviously, anyone on the road to a personal bankruptcy must first address his debt problems. But for people who have manageable debts, the decisions aren’t so clear-cut.
About the only two things financial advisers uniformly agree on is that tax-advantaged retirement savings programs get first priority for savings, and high-rate debts such as credit card bills are the first things that should be paid off.
“You’re trying to accomplish two different goals, and you probably have to do both at the same time,” says Cynthia Delia Coddington, director of the financial planning group at David L. Babson & Co. in Cambridge, Mass. “You punish yourself in the future if you don’t put anything into retirement, and you punish yourself with a high cost of money now if you don’t pay down the debts. So most people need to make retirement savings and debt reduction the highest priorities.”
Once the high-rate debt is being serviced and basic retirement money invested, the decision often boils down to the stock market, which many people now view as a sure thing, versus cutting the debt, which guarantees a “return” in the form of interest payments you will never have to make.
Obviously, the higher the interest rate, the bigger the risk-free gain when you pay ahead.
But personal preferences, investment needs, financial goals, risk tolerances and spending habits all play a part in deciding whether to throw more money at debt or savings.
Here are the key questions to consider when deciding how to split your cash flow between debts and savings.
– What is the asset allocation of your investments? This is a good starting point, especially if you are considering whether to pay ahead on a mortgage.
If the home, for example, represents the biggest portion of your net worth, plowing more money into the real estate portion of your assets doesn’t make much sense.
Conversely, if all of your money is tied up in stocks, the guaranteed return of paying ahead on debts can act like bonds and money-market accounts for your portfolio. Paying down the debt diversifies your risk, and makes your net worth less dependent on Wall Street.
– How liquid are your assets? While paying down debts provides a risk-free return, it’s unlike a true investment in which you have access to the money.
If you tie up all of your spare cash in paying down the mortgage, for instance, and need to take a home-equity loan to pay for emergencies or tuition or any long-term goal, you actually are paying fees to get your own money out.
That’s why you want to make sure that debt reduction won’t put you in a position to borrow again, a situation in which the fees and costs of new debt eat up some of your savings.
Conversely, if paying down the debts frees up cash flow that is needed for you to meet obligations, say when tuition bills come due. you could be better off by zeroing the debt and making payments out of cash flow, rather than investing the money and paying taxes on your gains when you need the cash.
– What is the opportunity cost on the money? This is where the numbers come into play. The higher the rate of interest, the more likely you will want to pay it off.
But if you have a low-rate credit card, for example, you may feel confident that you can come out ahead by servicing the debt but throwing the bulk of your resources into investments.
“It depends on what you want the money to do,” says Bill Newell of Atlantic Capital Management in Sherborn, Mass. “You have a riskless investment if you pay off the debt, so you must decide if you want to assume the risk to get a return that is higher in the stock market, or if you want to settle for the sure thing.”
– What is your tolerance for debt? Most people focus on risk tolerance, but their stomach for debt is equally important. If you are among the many people who can’t rest comfortably so long as you have a debt, the decision should be clear.
Says Gerri Detweiler, author of The Ultimate Credit Handbook: “If it bugs you a lot to have this debt, then you get some added peace of mind by paying it off. That’s worth something, even if you could get a better return on the money elsewhere.”
– Once the debt is gone, what’s next? Some people eliminate their debts only to start spending again. Rather than investing the amount of extra capital that went to reducing the debt, they see smaller monthly bills as proof that they have more money available.
If they wind up back in the debt hole again, they have double trouble: the new debts plus the money they didn’t save while paying things off in the first place.
As odd as it sounds to even imply that some people are better off carrying the debt than paying it off, it’s true in some cases. Before you commit to trimming investments and paying off your obligations, make sure you have the discipline to free up the cash flow and use it the right way once you are debt-free.
If you have cleared your debts a few times in the past but now face the problem again, you may be better off paying things down gradually and socking money away this time.
Says Keating: “The important thing is that you take advantage of an opportunity to start a disciplined investment program, where you can eventually see yourself reaching your goals and paying down your debts. So don’t just look at this as a financial problem, but look at it as something you have the discipline to do.”
