Thursday, April 10, 2014

Mythbusting Again

From U.S. News and World Report
Paying off debt before saving for retirement a bad choice
Some popular financial pundits urge people to pay off credit card and other non-mortgage debt before saving for retirement. Such advice is arguably the most costly mistake a future retiree can make. While every situation is unique, such blanket advice misses the mark for two reasons.

First, the vast majority of a retirement nest egg does not come from the money you save. It comes from the compounding returns earned off of the money you save.

Compounding requires time. Delaying retirement savings by even a few years can significantly reduce your savings decades later. Second, with today's interest rate environment, it's easy to lower the rates on most debt. From mortgage refinancing to credit cards with 0 percent introductory rates, the cost of debt can be dramatically reduced while you work to pay it off.

True, the vast majority of a retirement nest egg does not come from the amount saved, but from compounding returns over time. But what about the compounding interest on debt?

If you make the minimum payments on credit card debt at 18% or more, you'll end up paying for a long long time, and the interest will vastly outstrip any returns you're like to get, even in a bullish market. For my own long term calculations, I like to use 8% returns over the long haul, which is far more realistic than the 12% Dave Ramsey likes to use in his seminars. It is very very difficult to find a credit card that doesn't charge at least 12% interest, so even if you get Ramsey-like returns on your investments, you're only breaking even, not to mention what it's doing to your cash flow.

For example, on a credit card balance of $15,252 (the US average), at 18% interest, making a 2% minimum payment - and that's a constant payment of 305.04, not the decreasing approximately 2% minimum payment that appears on your statement- it will take you 94 months to pay it off, for a total expenditure of $28,674, nearly double the original amount. That figure gets worse if your interest rate is higher.

To end up with $28,674 in your retirement account over 94 months, at even the generous 12% returns touted by Dave Ramsey, you would need to contribute $185.22 each month. If you try to subtract that amount from the minimum payment you have to make on the credit card debt, you'll never pay the credit card off. The amount owed will simply grow unbounded, even without the extra charges the bank is going to whack you with for not paying the minimum.

And, I'd think it would be obvious to anyone with even a tiny knowledge of arithmetic that if you are only required to pay a 1% minimum on your credit card at 18% APR, once again you can never pay it off! The monthly interest exceeds the payments - just staying even requires a 1.5% minimum payment! At 12% interest and 12% return, your debt doesn't grow, but you pay on it forever, even if you don't run up more when the kids go off to college. Quite frankly, the numbers are more likely to be 6% to 8% return and 18% to 21% credit card interest, for most people.

In the opening line of their advice, they say "paying off credit card and other non-mortgage debt", then they go on to talk about refinancing your mortgage as a solution. Are they advocating wrapping credit card debt into a new mortgage? I have no objection to refinancing a mortgage to get shorter terms and lower interest rates, when possible, but increasing the balance on what's already probably the biggest debt you owe isn't really such a good idea.

Psychologically, most people who refinance credit card debt, whether it's into a mortgage payment, or through some other debt consolidation tactic, end up running the credit cards right back up again in a very short time. From that standpoint alone, it's a very bad idea.

What about transferring the balance to a 0% introductory rate card? If...and it's a big IF...there are absolutely no fees for balance transfers, and IF the 0% rates last at least a year, and IF you divide the balance by 12 and make every equal payment, so that it's paid off within a year, it can be a great idea. Again, what really happens for most people is that they get the 0% interest for one year, and either make minimum payments and/or run the balance up higher with new purchases, and when the rate reverts to its default rate, they're worse off than they were before.

The best idea might be a "balanced" approach, where you contribute at least enough to your 401K plan to get the employer match - it's the risk-free yield you'll ever get, and then pay down your debt as aggressively as you can with what's left over. Note: people generally spend everything they have in the checking account if they don't have a spending plan (budget) in place, so I recommend getting a plan and working it asap.

Ok, rant complete. Have a nice day.

1 comment:

ProudHillbilly said...

"compounding interest on debt"

I think a lot of people don't look at that and just look at what they are paying at the moment. So they send the minimum or a small payment each month. And probably add to the debt each month, too.