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Finances: Don’t Take them So Personally

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I've got some personal finance blasphemy to get off my chest. It will probably even ruffle the feathers of more than a few personal finance writers. I'll take that risk, because I hate to see money wasted. People are wasting money every day and not realizing it. They aren't even spending it, but these people are just giving it away for nothing in return.

How are people giving away this money? They ignore math to feel good about what they are doing. That doesn't make a lot of sense now, but after a couple of examples, my point will become more clear.

Paying back debt - Let's say you have 3 debts... a student loan for $5,000 at 5%, a car loan for $8,000 at 9% , and a credit card for $15,000 at 18%. Many people, notably personal finance "guru" Dave Ramsey, would say that you should pay off the student loan first as it's the lowest amount. The theory is that paying off that first loan will give you the psychology boost to stick with the program. Some basic math that I don't have the space to go into here shows that you will save more money by paying off the high interest credit card first.
Here's the fix: Don't consider each debt separately. Put them all in a spreadsheet (Excel, OpenOffice Calc, Google Spreadsheets), so that you can view how much you are paying off each month. I suggest you keep one side of the spreadsheet for how you are progressing by paying the highest interest and the other side for how you would be progressing if you went with the smallest debt first strategy. You'll be able to see savings you are making by being smart, which should give you psychological boost each month - not just when you pay off on of the debt.

Not convinced? Here's another example:

Paying off your mortgage early - Many people decide to make an extra payment or two a year to pay off their mortgage early. Some are crazy enough to pay a fee to set up bimonthly payments (most banks allow you set automated payments for free) to pay it off early. I don't want to say that paying off your mortgage is universally a bad idea, but depending on your mortgage rate it might not be the best plan. Many people think they are doing themselves a favor by paying off their 6% mortgage - which may act like 5% if the taxes are deductible. That's fine, but many of these other people will tell you that by investing in the stock market they would make 8-10%. If you are one of these people, you probably fall into the majority of Americans - and you are losing 3-5% of a very significant amount of money compounding over a lot of time (typically 30 years). This math mistake can cost you hundreds of thousands of dollars.

There are usually two arguments for paying off the mortgage early even when the math doesn't seem be on your side.

  1. The first is that paying off your mortgage is a guaranteed savings of 6% (or whatever your mortgage is). My answer to that is over any 30 year timespan that you choose, equity markets (if properly diversified) have always done better. If you don't believe in the equity markets span over a long time, perhaps your retirement plan should be based in real estate instead of 401K and Roth IRAs.
  2. The second argument is that having a mortgage forces you to save money. I can't argue this point, but it's hardly the only way to save money. I have my bank send a check to my mortgage company every month. It's just as easy for me to have my bank send a check to a mutual fund company. It only amounts to typing a different address in my online banking software. Like the mortgage, I only have to do this once and I'm set for 30 years. Google says I'm the 4th laziest man on the Internet and if I can do it, what's your excuse?

We all have psychological beliefs when it comes to money. Some might be addicted to their daily latte. Personal finance writers rail against it showing the savings one can have from eliminating this one cost. I suggest that convenient psychology excuses are many, many people's daily lattes. People, these are things that can and should be changed.

I know that other bloggers will say that personal finances are just that, personal. All that means is that they applies to you. It shouldn't give you a license to ignore math and take the easy way out. If you are on reading this site, or any personal finance site, I imagine that you are looking to change, learn, and grow. This is another way to do that.  Why not step up the challenge?

Last updated on December 13, 2010.

This post deals with: ... and focuses on:

Psychology

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30 Responses to “Finances: Don’t Take them So Personally”

  1. The Div Guy says:

    LM,

    I see your point on making the best posible use of your money to make the best return and agree with it for the most part. I also think there are some personal issues that don’t fit into a neat equation all the time.

    We paid cash for our house so my wife could stay home with the kids and I could work for a non-profit organization.

  2. anonymous says:

    As an engineer, I agree with your argument. However, I think you downplay the psychological effect too much.

    Psychology is not an excuse, it’s a fact. You and I succumb to our weaknesses and so does everyone else. If paying off debts in a slightly sub-optimal way encourages one to pay them off more quickly, that person will come out ahead.

    Your example, of course, is perhaps somewhat extreme, but let’s look at an extreme case on the other side. Let’s say you have a $15K credit card debt at 18% and a $500 credit card debt at 17.5%. Your argument would have the debtor pay off the $15K credit card while making only the minimum payment on the $500 card. I believe that’s foolish.

    Regarding paying off one’s house, personally I believe there is a lot to be said for owning the roof over your head. To me, that’s worth more than a couple extra points of return. Another blogger made a good point recently; if it really doesn’t make sense to pre-pay your mortgage, you are implicitly saying that it *does* make sense to maximize the size of your mortgage, and invest the extra in the stock market.

  3. Amber Yount says:

    Math doesn’t always matter. If it was all math, then NONE of us would be in debt don’t you think? Also with the housing thing I really disagree. I would rather pay off my mortgage and not have to worry about any payments and THEN invest, then the other way around. Think about this. If you lost your job today, wouldn’t you rather have no housing payments and be able to stop investing at any time, or stop investing and you still HAVE to pay your mortgage and face foreclosure? hmmm.

  4. Emma says:

    You know, the funny thing most of these mathematical equations miss that is key to ‘personal’ finance is risk. Risk occurs when life happens. I’d say that’s personal, no? I’ve also never met someone who regretted being out of debt and having no mortgage payment. Must be nice to have cash to save and invest. :)

  5. Lazy Man says:

    @Amber’s point about having no mortgage payments… I didn’t say that the investments couldn’t be used to pay off your home and have no mortgage payments. In fact, if you believe the market will return a greater percentage than your mortgage, this is the fastest route to being mortgage-free. I play to go into this in greater detail in another post using… math.

    @Anonymous: “To me, that’s worth more than a couple extra points of return.” So many believe that based on the fact that a couple of extra points of return seems so small – insignificant. Yet it can make a difference of hundreds of thousands of dollars. I’ll save the math for a follow-up post, but many have seen the difference mutual funds fees make – and that’s usually just a 1% difference. We could be talking a 3-4% difference here.

  6. With the mortgage vs. investing argument, it really depends on the person. The person who fears debt will pay off the mortgage first. The person who looks for riches will invest the extra money in the market. Personally, I think it should be a balance of both.

    FT

  7. Mike says:

    I think that asking people to ignore their feelings assumes that they want to do things in the most efficient way possible. I’m not sure that is a valid assumption. At the end of our lives, does it really matter what kind of number that we put up on the net worth scoreboard over how we felt in getting there?

    Sure, I can pay off 5 loans interest-order-first aggregately in less time and save more money than if I did it in balance order… but suppose the difference in time & money isn’t worth it to me over the feeling that I don’t owe money to 5 different people but just 4, then 3, then 2, then 1.

    Likewise with the mortgage, I might be making more by removing the debt from the list of “gotta get out of this” loans, but suppose I’d rather live in a home I owned than a home somebody else owns. My goal here wouldn’t be to use money most efficiently, it would be to acquire the asset I desire.

    You mention in a comment above in response to Amber that one can still invest the excess and use those profits to get out of the mortgage faster.. but I think that is really just a more risk-tolerant version of the same philosophy that you’d like to own your home over merely accumulating wealth expressed above. At that point, finance is once again personal because it is up to the person as to:
    (A) Whether they are risk-tolerant enough to use investing to pay it off vs using the investment money to pay off the loan straight off
    (B) Just how risk-tolerant are they with that investment money, because they have to decide how they want to invest with the intention of paying off the mortgate soon
    (C) What timespan they are looking at. Just because the market will outperform their 30-year mortgage, it might not necessarily outperform their 15 year mortgage that they are already 6 or 7 years into

    Personally, I’m all for hitting the loans in interest-first order, because I’m not bothered by the the number of debts outstanding (Currently 3) but the prospect of owing anything to anybody at all. But while I know that I am guaranteed to end up with more money by investing (or even putting cash into a savings account @ 5.05%) – once I have the higher interest debts out of the way, I’m still going to pay off my 4.5% car loan before investing the money. The marginal profit I might make just isn’t worth it to me, I don’t mind missing out on a bit of opportunity cost to say that the car is mine.

    Look at it as a parallel of the cheap vs frugal mindset: If you buy the cheapest thing on the rack then you are just being cheap. If you buy the item that brings the most value to you – after evaluating quality, benefit, and cost then you are being frugal. You may wind up with more money by being cheap, but you’ll probably feel better about your life by being frugal. Likewise, you may wind up with more money by going strictly by the numbers, but unless those numbers line up with your goals it won’t necessarily make you any happier.

  8. dong says:

    While I agree with the points, and most assuredely when it comes to ranking debt, I do think a logical argument can be made towards paying off the mortgage earlier. We don’t measure return purely by absolute returns but risk adjusted returns. Otherwise, we wouldn’t diversify at all. We would all be investing in the riskiest stocks possible given that over the long run small cap stocks have the best returns, etc, etc. I think given that prepaying the mortgage is guaranteed return, it might make sense to prepay the mortgage especially if as investor your risk tolerance was leaning towards some portion of bond investments.

  9. Lazy Man says:

    Dong, I made sure that I ONLY addressed the people that believe the market would earn 8-10% over the long term. If you don’t believe in that, then this advice wouldn’t apply to you. I’m really making the point that if you believe (as many people do) that you have a 99% chance of make 8-10% over the length of your time, you might want to rethink the hundreds of thousands of dollars you are likely giving up for that extra 1% of guarantee.

  10. Anne says:

    Lazy Man, I totally, completely agree with your points. I strive to keep my emotions out of my financial decisions, so I can make as much money as possible. The numbers tend to be more reliable than my emotional state.

  11. Brip Blap says:

    I hear LM’s point about only addressing people who believe the market returns 10%, and that’s a good point – a lot of this is based on your beliefs about the future. I brought it up on my blog, but I believe there’s little chance of getting a NET 8-10% return in the market over the long term. That’s a number that’s often kicked around, but after inflation and taxes your market investment will return less. Chances are that paying off a 6% mortgage would give you more or less the same return.

    Paying off a mortgage has a guaranteed 6% (in this example) rate of return. The market could be more, and could be less. However, if you already have 401ks and 529s and IRAs heavily in the market, paying off your mortgage early (to me) is primarily a way of diversifying into real estate without becoming a landlord – so it makes sense from that point of view, too. I think a strong argument to be made against paying off the mortgage early is the premature loss of the tax benefit, but then again tax laws change and nothing is for sure in that regard.

    As far as paying off debt goes, I’m a little bit perturbed that the advice is not always always always pay off the highest interest rate first. I mean, it just doesn’t make sense to me otherwise. But then again, I have only one debt (mortgage) so I have a different mindset altogether, since from my earliest days debt avoidance has been the primary goal of my financial life.

  12. I’m on the fence about prepaying a mortgage vs. investing the difference. I think it can come down largely to personal preferences regarding debt and investing.

    However, I will add to what Brip Blap says regarding the difference between market returns of 8-10% and what you actually net. He mentioned inflation and taxes as reasons for getting less. I think even bigger drains are expenses and the inability of most individual investors to match (much less beat) market returns. I’ve written that Morningstar now publishes Investor Returns which in many cases badly trail traditional time-weighted returns. It turns out that individual investors often buy a hot stock fund, just before it cools off and sell funds that haven’t performed well, just before their area of focus comes back into vogue.

    The bottom line: it can be misleading to cite the 8-10% figure, without realizing that most individuals probably don’t achieve that over the long run, net of expenses.

  13. Matt says:

    I can see the benefits of paying off the smallest amount first but realistically doing that will cost you more money in the long term, especially since in your example the smallest amount also had the lowest interest. I’d go through and figure out what is financially the best combination (which would probably be to start with the 18% card) and maximize your repayment.

  14. mb says:

    I’m sure the math still works out that not pre-paying a mortgage is better, BUT if you do pre-pay a mortgage, you most likely need a lot less of an emergency fund (thus you can invest that extra instead of having it sit around in a money market or savings) and most likely, less life insurance. (I know term doesn’t cost too much but still.). If your house is paid off, you may also be more likely to try opening your own business, or take a more agressive investment philosophy, or not have to contribute to 529s because you know without a big mortgage payment, you’ll easily be able fund kids’ college as you go along. Maybe with mortgage paid off on primary home, you’re then able to buy rental properties or your eventual retirement home. Point is …. paying off mortgage might give you some options for generating even greater wealth than investing extra payments would.

  15. Richard says:

    I agree with your arguments for “Paying Back Debt”. If people really want a psycological boost, they should dedicate the time to figuring out how much money they will save by paying the ‘highest interest first’ rather than ‘lowest balance first’. Its the difference between doing whats ‘easy ‘and whats ‘smart’.

    I agree with you on the mortgage argument as well, and think it is again an example of doing what is ‘easy’ versus ‘smart’. Its easy to just write another check to the bank to pay off debt because its a no brainer (everyone agrees that its good to pay off your debts & to pay off earlier is even better). Deciding where/how to invest that money takes work.

  16. laura k says:

    Those who promote paying off your mortgage early use the “what if you lost your job tomorrow?” argument an awful lot. Say I pre-pay my mortgage so that I can pay it off in 20 years instead of 30 (that’s the best I could do). If I lose my job tomorrow, and “tomorrow” is less than 20 years from now, I still owe the bank a minimum mortgage payment each month. However, if I invest that extra money instead and for some reason haven’t found a new job by the time I’ve burned through my emergency fund, I have an additional cushion (assuming the market hasn’t tanked; there _is_ this additional risk). For me, liquidity is key.

    The stress of worrying for the next 20 years about whether or not I’ll lose my job while I work to pay off my mortgage early isn’t worth it to me. I may well die before the 20 years is up from some stress-related illness! :)

  17. plonkee says:

    I think that its about getting the psychology to work in the same direction as the maths. Like adding up the total debt balance. In an ideal world, the personal would be in tandem with the finance.

  18. beeRad says:

    Philosophically, I agree with LM on all counts. However, I’m still learning some things and I have a couple points or questions, depending on the accuracy of my thoughts.

    I think having more of your mortgage paid off can be an advantage in a couple other ways. You have the ability to get HELOC’s easier. Also, I think you have some timeline and money flexibility with selling your current house and buying a new house if you have more money into the current house.

    Of course, the point remains, if you made more money through the 8-10%, nothing stops you from dumping it into the mortgage at any time, and theoretically, you’d be ahead of where you’d be had you put the money into the house over time.

  19. Kenny says:

    This morning you’re the THIRD laziest man on the Internet.

    Keep up the good work!

  20. Lazy, this is a good post but I agree with Brip and Dong that the mortgage example is not the same as the credit-card example because the former is essentially the same “what is the lowest cost?” puzzler but has a mathematical dispute about the real numbers and only time will tell if the people who “believe” in future 10% stocks are as emotionally misguided as the Ramsey people paying the smallest debts first.

  21. Lazy Man says:

    @Brip: You are right that after inflation it’s hard to NET 8-10%, but in this scenario, you don’t need it to. Your mortgage doesn’t rise every year with inflation, it stays constant. Looking at this way, the money you pay in year 30 of your mortgage should be a very small amount in comparison to today’s prices. By prepaying your mortage, you may be cutting those years off, but that $1500/mo. mortage would really be like $618 in today’s dollars (assuming 3% inflation).

    Taxes are an issue, but when most people prepaying a mortgage lose the tax deduction, so I think that balances it out.

    @J: Thanks, I tried to stress the point that mortgage example only applied to those who believe the market will grow 8-10%. If you don’t believe that and think it will be less than your mortgage, then it’s a smart move to pay off the mortgage.

    I’d say that 90% of people (for better or worse) subscribe to the 8-10% market return notion. And probably about 70% of that 90% think they are better off taking paying off their mortgage even if it’s at a significantly lower rate. This tells me they really don’t hold their belief of the market returning 8-10%, they are bad at math, or they are investing with psychology instead of math. Something has to give.

  22. Lazy, you did a good job of trying to cover the bases, although my earlier comment applies to #1 too because there is a mathematical (not emotional) debate on the numbers/probabilities (and #1 confuses mortgages with real estate).

    I agree with your basic point that people ignore “inconvenient” math when they dislike the results.

    I know the topic is not easy because I am trying to tackle it bit by bit in a series of articles–and I see 3 more articles for me on this page with comments, so thank you for the inspiration.

  23. I think your fix for the credit-card example is a good one and better than Ramsey’s advice.

  24. mbhunter says:

    With debt reduction, you’re correct about which debts to pay off first in order to do it the fastest. And there are other great reasons why you should hold onto a fixed-rate mortgage, like inflation.

    People have different backgrounds and different attitudes about money, and different things motivate different people. Some people can reap the benefits of the faster debt repayment even though it takes longer before they pay off their first card. But others need the extra motivation, and want to see that first card gone. This isn’t the fastest way to do it, but if you get frustrated by having to send out the same number of bills month after month, then it makes a lot of sense to get rid of one of them! To stick with the most logical course in this case would be counterproductive.

  25. Kim says:

    I make my husband nuts. We have a few crdit cards that we are paying off plus a small hospital debt that we are paying $10 per month with no interest. Since we have less that $200 in the hospital debt, he wants to through the extra funds at that and pay it off – for the psychological effect. I say no way! Every penny spent paying that off needlessly takes money out of my pocket in he form of interest.

  26. Susanna says:

    Thank you. I never understood how paying off a smaller, low-interest debt was supposed to help me feel better about my finances when I still had a large, high-interest debt looming over me.

    Personally, watching that “minimum monthly payment” number go down each month is all the psychological boost I need. (And yes, I know to pay more than that amount.)

  27. […] Finances: Don’t Take Them So Personally A big piece of success with personal finance is to extract your own foibles from it. That’s a difficult thing to do, but for most people, when they master that relationship between emotions and wallet, they’ll succeed greatly. (@ lazy man and money) […]

  28. Edward says:

    Now I know I am a little late getting to this post
    but looking at what has happened to the housing market do you still subscribe to the thought that paying off your mortgage first is the best idea. What is the math saying now. just wondering

    Thanks

  29. […] Man looks at personal finance and wants to get rid of the personal. Yikes… Interesting, thought-provoking […]

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