When it come to financial decisions, you can learn a lot from both Captain Kirk and Mr. Spock. What they teach us – together – is that when it comes to financial decisions, you need to go beyond the math.
So much of finance involves math, and we certainly don’t shy away from that here. I talk often about Excel formulas and calculations because the numbers do matter. But they’re not the only thing that matters.
If you’re a fan of Star Trek, you know that Mr. Spock is logical. He reasons through everything, and his every decision is based on numbers and probability. Captain Kirk, on the other hand, is full of emotion and gut instinct. He listens to Mr. Spock, of course, but sometimes he makes decisions that Mr. Spock just can’t understand – decisions that simply don’t compute.
In finance – beyond personal investing – that’s true as well. Here are four examples of how and why you should go beyond the math in making financial decisions:
The Debt Snowball
If you’re only considering the numbers, the answer’s easy. You should make extra payments on the debt with the highest interest rate. It’s as simple as that. It’ll get you out of debt faster and you’ll pay less interest.
The problem is that paying off debt isn’t all about the math. It’s as much about psychology and motivation and behavior as it is about the numbers. Studies have shown that for some folks, paying off the smallest balance first – even if it has a lower rate – can be very motivating. You get that first debt paid, and it motivates you to keep going.
There’s a psychological benefit in doing it that way. If that helps you get motivated to get out of debt, then you may want to start with the smallest balance first, even if it doesn’t have the highest interest rate.
I received an email from a reader recently that talked about just this. His family started with the smallest balance debt first because they thought they needed that boost – that psychological kick-in-the-butt, so to speak. And it worked for them. They got the first debt paid off, and they felt great.
By the time they did that, they decided that they were motivated enough to start paying extra money towards the highest-interest debt next. So they followed a hybrid approache, and it worked for them. A little bit of math plus gut instinct helps get the job done.
Zero-Percent Balance Transfer Cards
My wife and I used zero-percent balance transfer cards to help climb out of debt. With these cards you pay no interest on whatever debt you transfer, as long as the offer is at 0%. Eventually, these offers expire and the rate returns to regular APR for the card. (Check out this podcast for more information on 0% balance transfer cards.)
Mathematically, these 0% offers are a great deal. Considering just the numbers, zero-percent balance transfer cards make all the sense in the world. Sure, there’s a transfer fee, which is typically 3%. But if you’ve got a credit card at 15% interest, it’s a no-brainer, right? But here’s where you need to go beyond the math.
It’s not uncommon for some to transfer their 15% interest debt over to a 0% balance transfer card. Then they continue using the old credit card. They run that debt right back up. So what made all the sense in the world from a math perspective results in some doubling their credit card debt.
There are ways to avoid this outcome. You could cancel your old card. You’ll take a credit score hit, but it would keep you from using the card. Alternatively, you could cut up the card so you can’t use it anymore.
But if you know you’re going to charge up the old credit card, don’t bother with a 0% balance transfer card. Just grin and bear the 15% interest rate, and get the thing paid off as fast as possible. The last thing you want to do is transfer that debt for what is a good deal, mathematically, but end up doubling your existing debt.
There’s a lot of literature out there about whether you should invest in a Roth or deductible IRA. This is a perfect finance question for the math geeks among us.
The basic rule is this: if the amount of taxes you pay when you make your contributions is the same as you’ll pay in retirement, it’s a wash. It doesn’t matter if you go with a deductible IRA or a Roth IRA – the result will be the same.
Mathematically, this is correct. Now let’s go beyond the math. Imagine that you can max out your IRA regardless of which type you choose. If you go with a deductible IRA, what will you do with the tax savings?
In order for the math to work, you’ve got to take the tax savings and invest them. But a lot of people don’t do that. So if you’re going to spend your savings instead of investing them, you’re probably better off with a Roth IRA, even if the math and taxes would suggest either that a traditional IRA would be better, or that it doesn’t matter.
Paying Debt vs. Saving Money
This is always a big topic. Do you pay off all your non-mortgage debt before saving for emergencies and retirement? When you get out the calculator, many tend to compare the interest rate on their debt with the average returns of the stock market. For the number crunchers they tend to favor saving over paying off debt, particularly if their debt is at relatively low interest rates.
That’s the math. But when you go beyond the math and get into everyday reality, you bring up a whole bunch of other issues and questions.
Yes, it may be true for some that they’ll earn more in the stock market than they will pay in interest. But what happens when the market goes down by 30% or 40%? Unfortunately, many folks get nervous and make big mistakes when the market is in a decline.
We can look back at history and see that the average market returned 10%, but the reality is that most investors never saw anything close to that. The point isn’t that you should always pay off debt before investing. In fact, I generally think that, in many cases, that could be a mistake.
The point is that You need to look beyond the math. Consider issues of motivation and behavior.
It really comes down to knowing yourself, knowing your family, and knowing how you interact with money. Whether it’s a debt snowball, credit card transfer, retirement investing, or paying down debt, all of these questions have a math component. That’s important, but you have to look at behavior, as well. Look at what motivates you, and what you will or might do in certain circumstances. By combining these two approaches, you’ll make better financial decisions for your situation.