Sound personal finance and investing decisions flow from two things: (1) knowing the numbers and knowing ourselves. If we know the numbers but not ourselves, our decisions will look good on a spreadsheet, until our real world decisions deviate from the plan. If we know ourselves but not the numbers, our decisions may feel right, but lead us down the wrong path. So what’s the answer? We need to think like Mr. Spock, but act like Captain Kirk. Allow me to explain.
Mr. Spock was a human computer (at least when he wasn’t mating). He took in data, processed it and spat out an answer. He could calculate the odds of the outcome of an action to multiple decimal places. Any decision that deviated from his statistical analysis was, in a word, illogical.
And that brings us to Captain Kirk. Kirk was one big ball of energy, emotion and passion. He made decisions based on instinct and gut feeling. He listened to Mr. Spock, but he didn’t always follow his advice. He was the yang, Mr. Spock was the yin.
And that brings us back to personal finance and investing. To make sound money decisions, we need to know the hard, cold numbers like Mr. Spock, and we need to know our own emotions and human nature like Captain Kirk. To show you what I mean, let’s apply this way of thinking to some real life money decisions many of us have or will face:
Buying versus renting a home
There’s been a lot of discussion lately about whether it is best to buy or rent. A few years ago, home buyers were king of the hill. Today, as the market declines, renters are grinning like a Cheshire Cat. When the market eventually improves, home owners will be back on top, and the cycle will repeat itself. So how should this decision be made?
The Numbers: Crunching the numbers on renting versus buying is not an exact science. In addition to considering the interest rate, maintenance costs, insurance, and taxes consequences, you have to make a best guess at future rent increases and home prices. Fortunately, online calculators make this analysis easier. Here is one of my favorite rent versus buy calculators. Once you’ve figured out the numbers, there’s still more to consider before making a decision.
The Decision: One significant benefit that renting sometimes offers comes from investing the money you save from avoiding a higher mortgage. If you lack the discipline to invest the difference, however, buying may be the better choice even if the numbers say otherwise. Buying can “force” you to save each month as you pay down the loan and as the value of your home goes up. If the numbers support buying a home, renting could still be the best choice if you will be tempted to use your home equity like an ATM machine. Constantly refinancing and taking money out of the home to finance vacations, cars and other purchases can quickly erode the benefit of buying. This is a perfect example of the importance of knowing ourselves, not just the numbers.
Paying down debt or investing
I reader recently asked me this question: Should he borrow from his home equity line of credit to invest in the stock market. A related question we often face is whether to use extra cash to pay off debt or to invest.
The Numbers: The question here is whether the returns from the investment will exceed the cost of the debt. To answer that question, we’ll need to make some assumptions about future returns, which is always a dangerous business. We”ll also need to consider whether any of the interest we pay is tax deductible. If it is, we’ll need to reduce the interest rate by the tax benefit before making the comparison. For example, a 7% home equity line of credit that’s tax deductible becomes 4.9% assuming a 30% tax rate at the margin (interest rate * (1 – tax rate) or 7% * 70%). So if we also assume an 8% return on our investment in a Roth IRA, the numbers tell us to invest the excess cash rather than pay down the debt. Note that if the investment were in a taxable account, we also would need to reduce the investment returns by our expected tax bill. If we assume 15% long-term capital gains, the 8% before tax return still beats the 4.9% effective rate on the line of credit (8% * 85% or 6.8%).
The Decision: There are many factors beyond just the numbers to consider here. For example, consider whether you are disciplined enough to pay down your debt without borrowing more money. I know some who have decided to pay down their debt before investing, but then get caught in the cycle of paying down debt–borrowing–paying down debt–borrowing–repeat until broke. The result is that they never invest. For some (like our government), the best cure for deficit spending is not to have any available credit. I’m not suggesting, of course, that we run out and max out our credit cards. But for somebody who has trouble controlling their spending, waiting until their debt is paid off to begin saving may mean they never save.
A second important factor to consider is risk. While over the long run stock investments may beat the 4.9% effective rate on a line of credit, the investment comes with more risk. The 4.9% return from paying down your debt is guaranteed. The stock market guarantees nothing. And over the short term, the risks in the stock market are even greater. It’s because of this factor that I never borrow to invest in the stock market.
Which debt to pay off first
The Numbers: This one seems easy–pay off the debt with the highest interest rate first. Of course, as with the example above, we’ll need to consider taxes if any of our interest is tax deductible. After considering the tax, paying off the debt with the highest interest rate first will retire our debt in the shortest time for the least amount of money. Spock would be proud.
The Decision: There are at least two other factors to consider. First, many (like Dave Ramsey) suggest paying off the debt with the lowest balance first, regardless of the interest rate. Why? It will motivate many people because it will allow them to achieve some successes early on in the process of debt reduction. If you pay the highest interest debt first and it happens to be a large balance, it could take years before your first debt is paid off. Also, paying off a loan frees up additional cash flow, although if it’s all going to debt reduction anyway, this factor seems less important.
Second, it’s important to consider whether the loan is revolving credit (e.g., credit cards and home equity lines) or an installment loan (e.g., car or school loans). Why is this important? Two reasons. First, if you are concerned that you’ll be tempted to charge more as the balance goes down, it may make sense to focus on installment loans first. You can’t run up your car loan after you’ve paid it down. Second, if you’re concerned about having available credit during an emergency, paying off revolving debt may be the best place to start. That’s what I do. My main debt is on a home equity line of credit, and I pay it off rather than my school loan so that I have available credit if I need it. Yes, a cash emergency fund is best. But reality doesn’t always cooperate with what’s best.
Invest in a traditional or Roth 401(k) or IRA
The Numbers: I recently wrote a lengthy article called The Ultimate Guide to Traditional and Roth 401(k) and IRA Retirement Accounts. A section of the article describes whether it’s best to invest in traditional or Roth retirement accounts, and for the numbers, you can check out this Traditional versus Roth 401(k) calculator. The calculation requires an assumption about your tax rates in retirement, although most assumptions favor the Roth over a traditional account. Why? Let’s go to the decision.
The Decision: Let’s assume you max out your 401(k) contribution at $15,500 ($20,500 for those 50 or better). With a traditional 401(k) you’ll save the income tax on this contribution up front. Assuming 30% tax rate, you’ll pocket $4,650. With a Roth, you’ll pay that tax now, but won’t pay tax when you withdrawal the funds during retirement. Here’s the question: what will you do with the $4,650 you save in taxes if you invest in a traditional 401(k)? If you don’t invest it, the Roth is the best choice because it in effect forces you to “invest” it. This is where being honest with ourselves before we make a financial decision can make all the difference.
Personal finance and investing decisions are not one-size-fits-all. While it is critical to know the numbers before making a decision, we can’t live life in a spreadsheet. Understanding our own strengths and weaknesses when it comes to money, and making decisions in light of them, will help us make the right financial decisions for ourselves.
May you live long and prosper.