With the economic turmoil of the past few years still roiling their personal finances, many American households have made a focused effort to “deleverage,” that is, to pay down their debt balances. Financial planning to pay off debt can be valuable. And while the average American consumer may have given lip service to reducing their indebtedness in the past, this time it appears they are serious about it. The Federal Reserve reported that revolving credit debt for Americans (mostly in the form of unpaid credit card balances) was at its lowest level since 2004. The Fed also determined that total household debt dropped 8.6% since 2008. (Read our Ultimate Guide to Financial Planning Myths for more thoughts on debt.)
Because consumer spending is also down, it seems that most of the accelerated debt payments are primarily because people are reducing or eliminating purchases, and instead applying those unspent dollars as additional payments on their credit cards, loans and mortgages. But some financial commentators are also touting the idea of redirecting funds previously allocated to long-term savings toward paying off debt. Their logic is as follows:
With the volatility of the stock market and diminished real estate values, paying off debt is a good “investment,” with a rate of return equivalent to earning the interest rate charged. In other words, paying off a credit card balance which charges 12% interest is akin to earning 12% – guaranteed.
Mathematically, this is an enticing perspective. It’s simple to picture, simple to calculate. But a closer look at some of the other issues involved (instead of just the simple parts) should prompt most people to think twice before they divert too much of their savings to increased debt reduction.
Paying down debt is not the same as saving.
Sometimes financial commentators confuse the two ideas, or view them as interchangeable. They are not. When you save, you accumulate money under your control. You can decide where to put it, when to take it, what to use it for. When you repay debt, you reduce the control the creditors have over you. But just because the creditors control you less, doesn’t mean you have more financial control.
If all your earnings were put toward debt reduction, and you had no savings and no capital, how would you be able to take advantage of a financial opportunity? Either you couldn’t, or you would go back to your creditors — you’d run up the credit card to its limit, or see the bank for another loan. When you must rely on borrowing to participate in a financial opportunity, the ultimate decision-making power (control) lies with the lender, not you. Paying off debt is not saving.
Debt is really about control.
When you owe a creditor, the creditor exercises a measure of financial control over you until the loan is satisfied. As long as there is a lien, they can lean on you. Paying the debt faster (such as making extra principal payments) without paying the balance in full, does not decrease the creditor’s immediate control over a portion of your finances. Even with extra principal paid, you still have an obligation to make next month’s payment. The lender’s control is not removed until the loan is completely repaid.
In fact, you could argue that making additional periodic payments on debt obligations actually gives greater immediate control to the lender. Not only do you still have another monthly payment coming, but the additional debt repayment means more of your “discretionary” dollars are also in the lender’s hands.
From a control perspective, a better approach to reducing debt could be to systematically fund an account for the purpose of accumulating enough to make a single balance-clearing payment. Rather than sending an extra $500 on the credit card balance, the “controlled alternative” is to deposit that same amount into another savings vehicle, while continuing to make the regular minimum monthly payment. When the savings account equals the remaining balance, you would pay the balance off.
Some may be quick to point out that the interest earned in the savings account will most likely not be equal to the rate of interest charged by the lender, thus arguing that you “lose money” by not paying the additional amount to the credit card account. That’s probably true, and saving in an outside account might take a few months longer to fully pay off the obligation. But the key financial issue here is control, not rate of return. Keeping the money under your control gives you greater current financial security and opportunity than if you send those dollars to a creditor.
Integrating Deleveraging and Saving
Under almost all circumstances, paying off debt is a good thing, and so is saving. Being debt-free gives you financial freedom, savings allows for financial opportunity. And the two actions are not mutually exclusive – you can pay off debt and save at the same time. Furthermore, you may find a financial advantage in integrating the two activities by saving in a format that can eventually reduce or eliminate debt.
IF YOU ARE INTERESTED IN WAYS TO COMBINE SAVING AND DELEVERAGING IN YOUR FINANCIAL PROGRAMS, NOW MIGHT THIS BE THE BEST TIME TO EXPLORE NEW IDEAS OR ADJUST YOUR CURRENT PLANS.
By some measures, the past four years have been the worst economically since the Great Depression of the 1930s. But while today’s financial difficulties are real, there are some positives. For example…
According to statistics from Freddie Mac, the average interest rate on a 30-year fixed rate mortgage was 18.45% in October 1981 (i.e., 30 years ago). The average interest rate on a 30-year fixed rate mortgage last week on Thursday, 10/13/11, was 4.12%. The former mortgage rate would produce a $1,544 monthly “principal and interest” payment on a 30-year fixed rate mortgage for $100,000 while the latter would cost just $484 per month.