Tuesday, December 06, 2005

Start saving before paying off debt

Ready for more contrarian debt advice? The first thing you should do when you are trying to get debt free is save money in a retirement account. I know this is antithetical to common advice in this area, but hear me out.
  1. As soon as you pay off $1,000 on your high rate credit card, you can re-charge that $1,000 fairly easily. But if on the other hand you had put that $1,000 in an IRA your credit card would still be maxed, but you would have a stable increase in your net worth that you couldn't blow at the mall (at least until you are 59 1/2). The good thing about being maxed on your credit cards is you can't spend any more money with them.
  2. If you end up declaring bankruptcy in a few years, assets in 401(k) and IRA plans are generally protected from your creditors. (source)
  3. Growing your assets becomes addictive. As soon as you have some assets growing, making them grow more is a very addictive hobby. I have $4k in my Roth IRA right now which I contributed in the past few months. Over that period of time I have been carrying a $5K credit card debt. Personally speaking, having $4k in my retirement account motivates me to be frugal more than only having $1k in credit card debt would. If I only had $1k on my cc I'd likely go out and "reward" myself for doing such a good job paying it down.
  4. The most important step in growing your net worth to $1,000,000 is to start investing now. Read Eight Steps to Seven Figures: The Investment Strategies of Everyday Millionaires and How You Can Become Wealthy Too (audio) if you don't believe me.
I think it is a fairly safe bet that most people whose stated goal is "get out of debt" aren't stating their full goal. "Get out of debt" is just one step in what I imagine is the real goal - financial independence. Get out of debt pretty generally means 1) Get out of Debt 2) Stay out of debt and 3) be financially well off. So, if there is a three part goal, why only focus on one part? Especially if focusing on other parts of the goal will likely help you reach your end goal faster (if increase your rate of achieving your proximate goal of being debt free).

The best analogy I can give for this is weight loss. If you start a weight loss plan by cutting calories your chances for success are low. But, if you start trying to get into shape by learning a new and fun sport - for me it is skiing - then your chances of then eating right and ending up both fitter and skinnier is much greater. The same with debt reduction. If you only go about the boring, long, monotonous part of financial independence the temptation to splurge to reward yourself for your good behavior and ruin the whole plan is quite high. But if you find something rewarding which also helps you to repay your debt, then I know I at least would have a higher probability of success.

If you were the kind of person who could myopically attack debt day in and day out without a shred of additional motivation, then I think it is highly unlikely that you would have much debt to get out of in the first place.

The first step in winning the battle with debt is understanding yourself. If you know there is a likelihood you will run up the credit card again in a few months, then your first step to financial independence should be to save, not to repay.

UPDATE: After reading Richest Man in Babylon (audio download, auido cd) I wrote this post, and the plan I'm setting forth here is very similar to the get out of debt proposed in the book: Save 1/10 of all you earn, then use 2/10 of all you earn to repay your debts. Live off the rest.

3 comments:

Loi Tran said...

It's always better to pay off higher interest rate credit cards instead of putting it in your retirement. You'd be paying 10-20%+ on credit card and only earning 6-10% on your retirement savings. If you do the math and use common sense, it's easy to see why paying off credit card first is the best thing to do.

I understand you argument about people wanting too see some tangible result to motivate themselves to get out of debt.

A good solution would be to transfer your balance on your credit card to a 0% APR card and then using your money that you used to pay on interest to pay off the credit card slowly until the debt is gone. Just make sure that you keep your spending under control.

tt said...

loi,

I couldn't agree more that if you were able to keep your spending under controll and maintain motivation then the numbers work out better to repay your credit cards first. But, just looking at the lottery can show you that people often don't behave rationally when it comes to money - emotions get involved.

I like your 0% APR card solution, but I still stand by my statement that starting saving and repaying debt should happen at the very least at the same time (if not saving before repaying).

And, in terms of keeping your spending under control - having money in an IRA with withdrawal penalties as well as a maxed out credit ensures all but the most self destructive people won't return to overspending because they can't. Repaying your credit cards creates the ability to charge yourself back to 0, while I think the net worth gains in an IRA are would be more stable.

Thanks for sharing the great points. And thanks for the insightful comments elsewhere as well.

Half Sigma said...

NOT paying off my student loans and instead investing in the stock market was the best financial decision I ever made.

Getting the education in the first place was the worst financial decision.