Deciding Whether To Save Or Pay Down Debt Isn’t Just About Math

June 29, 2017

I recently saw this article titled, “A financial expert says deciding whether to save or pay off debt comes down to a basic math question” that quotes financial writer Jean Chatzky asking, “What am I getting on that money?” For example, if you can save in your 401(k) and get a 100% or 50% match from your employer, that’s probably the highest return you can get. That would be followed by paying off high-interest debt like credit cards that often have double-digit interest rates.

However, you may be better off investing extra money rather than paying off low interest rate debts like many student loans, car loans, and mortgages if you can expect to earn more on your investments than the debts are costing you. In other words, earning a 6% average annualized return on your investments is better than paying down a 4% mortgage (especially if the 6% return is in a tax-sheltered account and the mortgage interest is tax-deductible).

More than basic math

This is generally good advice. There are a couple of problems though. First, it doesn’t take into account emergency savings, which should be kept in a low-risk, low-return account like a bank account or money market fund. With bank interest rates typically below 1%, you would NEVER save for emergencies using that logic because you could always find someplace else to put your money with a higher expected return.

You know how there’s generally an inverse relationship between risk and return? Well, emergency savings and insurance policies have low or negative expected returns. (If returns on insurance policies were expected to be positive, insurance companies would go bankrupt). That’s because they provide the value of reduced or negative risk.

Where does the emergency fund fit in?

So how should you prioritize emergency savings? Like having adequate insurance, I would actually put them first. Yes, your expected return is low but the goal here is to reduce the risk of losing your home and/or car if you lose your job and can’t make the payments.

However, because the return is so low, you don’t want to have TOO much in savings. A good rule of thumb is to have enough to cover at least 3-6 months of necessary expenses and perhaps even 8-12 months, depending on how risky your income is, what other resources you have available, and who else you’re providing for. A tenured teacher with a retirement plan they can borrow against and no dependents needs a lot less than an entrepreneur with little retirement savings and a family to take care of.

Figuring in your personal feelings about debt

Second, don’t forget the emotional component. Some people are more bothered by debt than others. Even if they know they can earn more by investing extra savings, they would derive more happiness (or at least stress relief) from being debt-free than from having those extra investment earnings.

In the end, isn’t happiness the goal? (This isn’t to be confused with making emotional decisions that we’ll later regret. The key is to make decisions that will maximize our long term happiness.)

So remember, when you’re deciding whether to save or pay off debt, it’s not just a basic math question. It’s a personal question too. That’s why we call it “personal” finance.