Invest? Borrow? Why Not Both?

Free Money Finance had a "Help A Reader" post the other day with an email from a woman asking if folks thought it was a good idea to take money out of her mutual funds to  pay off $24K in credit card debt.

The broad consensus from commenters on the post was yes, cash out the mutual funds and pay off the cards, C Cards 2 (Andres Rueda)provided those funds are not inside an IRA or something similar. Okay, fine.

A few commenters obliquely approached the core craziness here by asking if the reader would have borrowed money on her credit cards to invest in the mutual funds. Of course that sounds like a really loopy idea, and of course that is what she (effectively) did.

Not paying off a credit card or other high-interest consumer debt so you can save or invest is, or at least should be, an intuitively bad move. The returns on the investments are unlikely even to approach the cost of borrowing the money.

Nevertheless, I am quite certain that this situation that ought never to happen, substantial investments offset by substantial credit card debt, is fairly common. About half of American households own stocks directly or through mutual funds. And a little less than half of households carry balances on credit cards. In theory, there could be no overlap between those groups, but we all know better than that, don’t we?

And then there is my nomination for most disturbing statistic about American consumers: 80% of car purchases are financed.

There is some powerful psychology at work here. Nobody makes long-term plans to go into credit card debt. You charge a little more than budgeted one month, and then add to it the next, and before you know it you’ve got a high interest loan to pay off. Or not.

For many people, it is more upsetting to tap savings to pay off consumer debt than to carry consumer debt. Especially for something as amorphous and fluid as a credit card balance, it is almost as if until you write a big check to pay it off it does not fully exist. It is like how losses on stocks that are down are "only paper losses" until you actually sell them. (Which is equally as illogical, BTW.)

Drawing from savings can seem like an act of surrender, a collapse in the willpower that got that money saved to begin with. And moving money from the long-term savings bucket to the short-term credit card bucket violates the mental accounting rules we all use to deal with money. It is similar to the problems we have with cell phone contracts.

But if the savings was accumulated while the credit card balance was run up, then the feeling of willpower was a false one. A person would have been better off not saving and not borrowing as much.

I do not know of any givers of personal finance advice who tell people to save and at the same time incur debt, or even fail to pay off existing debt. Dave Ramsey, for example, is rigid in his insistence that a person should eliminate all non-mortgage debt before investing in the stock market. Suze Orman is a little fuzzy on the edges, advising against borrowing from a 401k to pay off credit cards, for example, but as far as I know she has never gone so far as to tell people to start investing while they still owe.

Yet in a larger sense, I still blame the gurus and others in the personal finance establishment. The oft-repeated mantra is "save more" not "increase your net worth." Saving is, generally, a good thing, but it is increasing net worth that is the point of the exercise. If that big picture perspective is not carefully explained first, what is meant by "save more" can easily be lost. And in their haste to simplify the complex into the easily digestible and palatable, the gurus tend to skip the big-picture part.

[Photo: Andres Rueda]

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  • By Rob Bennett, January 13, 2010 @ 1:47 pm

    The returns on the investments are unlikely even to approach the cost of borrowing the money.

    I think it’s great that you are pointing out the contradiction, Frank. I also think that the issue is much, much bigger than you today appreciate.

    When I first began investigating the realities of stock investing, I had a mortgage. As I began saving large amounts of money, I faced a choice — I could pay off the mortgage or I could buy stocks. The conventional wisdom was that I could earn 6.5 percent real (roughly 10 percent after counting for inflation) from stocks. If this were so, I was better off letting the mortgage remain and buying stocks. But I wondered –

    Why was the bank willing to lend me money knowing that the interest rate I was paying was far less than what they could have obtained for the money by investing it in stocks? Were all these smart people really all that concerned about my personal welfare that they would take a huge loss just to help me afford a home? Something about that story didn’t sound quite right to me.

    So I checked what the likely return on stocks would be if I took the price at which stocks were selling into account when forming expectations of the long-term return I would obtain. That analysis presented a very, very, very different story.

    Money questions are not primarily numbers questions. They are primarily emotion questions. When large numbers of us decide that we would like to be told fairy tales about stock investing, it is fairy tales that we will be told. They will be fairy tales with numbers in them because money is viewed as a serious subject for which lots of numbers and graphs and charts and “experts” are required. It’s pretty much all a game. The idea is not to reveal the realities but to help us hide from ourselves the realities that we would prefer not to face.

    It’s good to point out these contradictions. They are everywhere. However, at some point I think we need to get about the business of doing something about the problem. I believe that the thing we need to do is to acknowledge openly that we are not nearly as smart about money matters as we think we are, go into humility mode, and begin Learning Together.

    Emotion trumps Logic. So long as we are as intensely emotional about these matters as we are today, logic really never stands a chance. I don’t think it is reasonable to expect logic in money discussions until we open ourselves up to more discussion of the emotional drivers.

    Rob

  • By Jim, January 13, 2010 @ 2:37 pm

    “I do not know of any givers of personal finance advice who tell people to save and at the same time incur debt, or even fail to pay off existing debt.”

    Suze Orman was recommending people build up an 8 month emergency fund before paying down existing credit card debt. She wasn’t recommending investing in mutual funds so its not exactly the same but pretty close.

  • By Jim, January 13, 2010 @ 2:46 pm

    BTW, I’ve known a couple people who’ve had large savings balances and large credit card debts at the same time. In both cases I think the savings account gave them a sense of financial security. So there was an emotional attachment or need to have that pile of cash. But I also think they considered it a short term situation when their income wasn’t great due to unemployment/underemployment. If I’m unemployed I’d rather have $50k in the bank and $40k of debt than $5k in the bank. Worse comes to worse I can default on the credit cards and live off the $50k. Of course paying 15-30% interest on that $40k isn’t worth doing in most situations for the potential security of cash in the bank.

    But this is more exception to the rule situation. And now I’m rambling.

  • By Holly, January 13, 2010 @ 2:53 pm

    Frank-
    As you mentioned, until a big, fat check writes off the c.c. balance, people feel that they can ignore their balances and go on with “business as usual”.

    I think there are many messages out there telling us that we need to get in the game early to save for retirement, esp. when stocks/funds are on an uptick. There’s a sense of security in having those stocks and mutual funds. You know that you can cash them out if the other shoe drops and a financial emergency ensues.

    Also, we keep hearing success stories of people finally paying off that c.c. You know… the woman who paid off her $150,000 of debt in under 6 years’ time. Makes it all seem within reason.

  • By Trent McBride, January 13, 2010 @ 3:02 pm

    I violate the rules about adding to savings instead of paying off debt, but I think both are justified. First, I max out my (Roth) IRA contributions before paying off mortgage, car, or student loan debt. Those loans are less than 7% and of course the IRA is tax deferred. I feel at worse, I break even there.

    Second, my big student loans are consolidated at a rididulous 2.875%. It’s a lot of debt, but I am confortable letting the interest rollover (while I am currently in a forebarence period) while I buy stocks with my savings.

    Of course, I wouldn’t dream of doing either with credit card debt.

    Any objections?

  • By Mike Piper, January 13, 2010 @ 5:12 pm

    “I do not know of any givers of personal finance advice who tell people to save and at the same time incur debt, or even fail to pay off existing debt.”

    From David Bach’s Automatic Millionaire:

    “Here’s what I suggest for people with credit card debt. Whatever amount you decide to Pay Yourself First, split it in half, with 50 percent going to you, and 50 percent going to pay off your debt.”

    (When he says “Pay Yourself First” he’s talking about retirement savings.)

  • By Heather B, January 13, 2010 @ 5:25 pm

    Back when I had debt and was aggressively paying it down, I contributed enough to my 401(k) to get the full match, and maxed out a Roth IRA. This made sense to me because in each case I can only do the beneficial thing for a limited time.

    In the 401(k), the 100% and 50% matches are clearly better returns than the debt payoffs, and can only be obtained by continuing to contribute. In the Roth, I will not be able to contribute for much longer (due to income increasing faster than the limits), and I would like to have an account with those tax rules and inheritance benefits (even if made less cool later) available in 40 years.

  • By Dasha, January 13, 2010 @ 5:30 pm

    If a family has a few thousand dollars of credit card debt and a steady income, how much do you think they should they maintain in a savings account (not investments) while they pay down the debt?

    On the one hand, if you have $24k lying around, you should probably pay off the debt entirely. On the other hand, you should probably not send in your last $100. Where is the line?

    Personally, I think at least one month’s of expenses (plus any expenses you can foresee, like taxes) should stay in the bank. I’d rather have $2k in the bank and $5k in credit card debt than $0 in the bank and $3k in credit card debt.

  • By mwarden, January 13, 2010 @ 6:53 pm

    @Trent:

    Roth earnings are not tax deferred, they are tax free. But so are your gains from paying down your interest-bearing debt. I would re-consider your logic with this in mind.

  • By mwarden, January 13, 2010 @ 6:57 pm

    @Dasha:

    “Personally, I think at least one month’s of expenses (plus any expenses you can foresee, like taxes) should stay in the bank. I’d rather have $2k in the bank and $5k in credit card debt than $0 in the bank and $3k in credit card debt.”

    The only additional safety a cash cushion gives you over a credit cushion is that theoretically the credit card provider could cut off or reduce your credit limit. Aside from that, your position is one that provides emotional comfort rather than logical gain.

  • By Dasha, January 13, 2010 @ 7:02 pm

    @mwarden, I agree that it is almost entirely emotional. There is a small convenience factor too, as you can’t use a credit card for everything.

  • By Lorax, January 14, 2010 @ 1:02 am

    You might have missed something more, em, business-sharp. Bankruptcy. Retirement plans are generally protected. But unsecured debt like credit card debt can be discharged.

  • By Monevator, January 15, 2010 @ 1:07 pm

    Mortgages are the classic example of where it can be best for long-term net wealth to run debt at the same time as investing for the future.

    If you can maintain a large mortgage and a large portfolio, you’re effectively running a leverage fund that isn’t marked to market with pretty cheap debt – great!

    Add in potential house price appreciation (I know, but we’ll see it again one day) and it’s a double whammy.

    Sadly I still don’t own though, due to personal idiocy related reasons.

  • By Investor Junkie, January 15, 2010 @ 2:34 pm

    Hmm What you describe can be form of arbitrage.

    Let’s use my personal example. If I have a mortgage that’s 4.875% (real rate is 3.25% after tax deductions) and inflation on average is 3.0% (we just found out last year it was 2.7%) It is almost an interest fee investment. In addition, I should be able to beat 3.25% with other investments. Obviously with high rate consumer/credit debt you are silly NOT to pay of that debt before investing.

  • By Dave, January 15, 2010 @ 5:24 pm

    Bear in mind some of that 50% who own mutual funds do so in a retirement account, so the dollars are not purely fungible to allow a penalty free payoff of the CC’s.

    In my case, I have retirement accounts that are just about equal to my mortgage ($250K each). So in effect, I am financing my retirement investments with a 4.875% mortgage. I sometimes think I’d rather be debt free. But since you can only add 16.5K + 5K to 401(k) and IRA’s (unless self employed w/ a solo defined benefit plan), building the $250K balance (50/50 Roth/deferred) would take a number of years.

    I don’t like the mortgage so I want to kill that sooner. Of course I say that, but actions speak louder, I just cut my mortgage prepayments to finance a Roth conversion. In my model I am earmarking the vesting of future stock grants to debt retirement.

  • By R Shumway, January 18, 2010 @ 7:57 pm

    In general, it makes sense to pay off your non-mortgage debt before investing in riskier vehicles, but there are always exceptions to the rule, especially when you need to factor in flexibility and budgeting for uncertainties.

    Suppose you have some unsecured debt such as student loans at a low interest rate. Even if you had the cash on hand in a savings account earning a rate lower than those student loans, a good argument could be made for not paying off your debt, since that cash can act as your emergency fund. Your overall utility is not always maximized by putting your money to work at the highest expected ROR.

  • By L @ SMG, May 10, 2012 @ 12:59 am

    Psychology is a powerful determinant of human behaviour. The aggregate of millions of peoples behaviour drives the financial and real estate markets. On the subject of building up excessive savings at the expense of lingering credit card debts- there are several US blogs that extol the virtues of dumping spare cash into IRA/Roth/401k (whatever it is you guys have got there) at the expense of paying off the credit card debt. I don’t really know how your retirement vehicles work over there but unless the tax advantages are huge, I fail to see how that can be a good strategy?

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