Wednesday, March 02, 2011

Pay Down Debt or Build Up Savings?

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.

Month number 1  2  3  4  5  6 Total
Number of marbles22222212 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:

Option 1
Month number 1  2  3  4  5  6 Total
Number of “debt” marbles22222212 marbles (2x6)
Number of saved marbles1111116 marbles (1x6)
Total33333318 marbles


Option 2
Month number 1  2  3  4  5  6 Total
Number of “debt” marbles33330012 marbles (3x4)
Number of saved marbles0000336 marbles (3x2)
Total33333318 marbles


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.)

5 comments:

  1. What your "model" omits, is that you are paying interest on the loan. That makes it a bit more beneficial to pay off early.

    With our house mortgage, we did about what you option 2 suggests. That is, we continued to put savings into a retirement account, and into a children's college fund account. And we kept enough in the bank to serve as a cushion in case a problem arose. We paid down the mortgage (i.e. repaid more than required), when there was some more left over. It worked out pretty well.

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  2. Oops, I said that wrongly. Make that "option 1".

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  3. I understand your point, but I have not really omitted the fact of paying interest. I know I pay interest, but my payments never exceed "2 marbles." As long as my payments are always "2 marbles," it doesn't matter whether I'm paying 5% interest, or 2% or 20%. 2 marbles is what I pay each month and it's a payment structure I can handle.

    While it might offend me to have to pay 20% interest, it does me no good to pay down that debt at the cost of my savings--so long as the monthly payments always stay at 2 marbles.

    I am totally not against paying down debt, especially high-interest debt. But I think that having savings is just as important, maybe more important, than eliminating debt.

    It's too easy to have a "cushion" just to see it evaporate in an instant. In my experience, I've suddenly needed a roof re-shingling ($4K), a new boiler and water heater ($8K), a new car ($16K). In all these cases, having a cushion was some help, but my work to pay down debt had very little impact.

    My thinking right now is that cushion needs to be quite huge and it needs to be ever-growing.

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  4. carlsonjok4:52 PM

    Actually, you have ignored interest. Because what you have not included in your analysis is that in Option 1 you will end up paying more marbles (and perhaps significantly more) than option 2. Option 2 may only involve paying 12 marbles, but option 1 means paying 13 or 14 marbles because a) additional interest accumulates in the first four months because you have paid down less principal, and b) you have an additional two months where you are carrying principal that interest is charged against.

    The "pay down debt" guru, Dave Ramsey, advices to only establish minimal savings for emergencies and then put every available dollar towards paying down debt.

    If Ramsey's homespun advice doesn't ring your bell, all you need to do is a discounted cash flow analysis. The faster you pay down debt, the better the Net Present Value

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  5. Carlson,

    My family's done, been doing, the Ramsey thing and I am not impressed with it as a real (as opposed to on-paper) practice. Why? Because new sources of debt continually pop up. For us it was a new boiler/heater, a new lawnmower, a medical/dental bill.

    That "minimal" emergency fund really ought to be in the $10K-$15K range, not the $1K-$2K Ramsey recommends.

    I understand all too well that my two-marble payment may be extended over more time with Option 1 than with Option 2, but that doesn't really matter. What matters is the monthly payment. As long as I can make that monthly payment (and as I build savings I get to use the option to pay down debt, too) and build savings, I am in a better position to allocate funds toward investments, retirement, debt reduction, and emergencies.

    In fact, the better my savings the better my ability to avoid what I think is the central problem: new debt. I want to be in a position next year to buy my new car outright. I want to have the funds on-hand to absorb a sudden expense.

    I also want to tackle debt aggressively. Don't think I don want to. But I am convinced that without a sensible and sizable reserve of on-hand savings, we end up being serfs to banks and to circumstance.

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Feel free to comment if you have something substantial and substantiated to say.