|From Weakonomics: In the household, you want to keep revolving credit at a minimum, and at least not exceed your savings over the long term. In other words, save enough money to cover your revolving debts, if you insist on running up the debts. This has the effect on this chart of keeping the blue line above the red. What’s good for the economy may be a greater use of debt.|
I recently had the fortunate opportunity to consider whether, given a sum of money, it would be better to pay down debt or to build up savings.
Ultimately, I favored a combination approach. But the really valuable knowledge I gained by thinking about the issue was that I needed to pay more attention to my debt-to-savings ratio and to converting debt into savings.
Here’s how I rationalized the problem.
Imagine that you owe a friend 12 marbles. Because you have a limited monthly marble budget, you agree to provide at least two marbles until you have paid the debt in full.
|Number of marbles||2||2||2||2||2||2||12 marbles (2x6)|
Now, imagine that every month your actual marble budget is three marbles. This means that you can either (1) Pay two marbles per month and save the third or (2) Pay three marbles per month until the debt is paid, after which time you begin to save at a rate of three marbles per month.
In the two scenarios, the distributions of marbles are as follows:
|Number of “debt” marbles||2||2||2||2||2||2||12 marbles (2x6)|
|Number of saved marbles||1||1||1||1||1||1||6 marbles (1x6)|
|Number of “debt” marbles||3||3||3||3||0||0||12 marbles (3x4)|
|Number of saved marbles||0||0||0||0||3||3||6 marbles (3x2)|
In Option 1, you manage debt payments and slowly build savings. In Option 2, you pay your debt as quickly as possible and then build savings. In neither case are you really better off at the end of six months.
But the critical difference is this: In Option 2, at the end of Month 4 you have no spare marbles. Were a new debt to arise in Month 5, you would be in trouble. You would have to borrow or dip into credit.
In Option 1, however, at the end of Month 4 you have four marbles available to deal with at least some new debt. Option 1 empowers you in a way that Option 2 doesn’t.
Option 2 depends on a rather Utopian fantasy that no new debt situation will emerge. Option 2 is a fantasy that one day you will be completely debt free.Then—and only then—will you start saving.
I think reality is actually quite different, and so Option 1 makes more practical sense. One way to think about it is that Option 1 adds one new debt to the mix: you.
So, my household plan is to establish regular monthly savings and build out the stored account (cash on hand) while paying and reducing our current debt at the levels we have been already. Instead of using “extra” money only to pay down debt, we’ll use it also to pay up out savings.
Longer term, the plan is to move certain sums into investments such as IRA accounts, mutual funds, and bonds. I’ll have to re-visit this post next year and see if anything’s come of the plan.
Or if I've lost my marbles. (Come on, that's the obligatory marble joke.)