Which would you prefer: to have $20,000 in the bank while owing $20,000 on credit cards, or to have $0 in the bank while owing nothing on credit cards?
Thinking about it rationally (and given only those two choices) it makes more sense to have $0 in the bank and owe nothing. The interest you’ll pay on $20,000 in credit card debt far outweighs any interest you might earn on $20,000 in the bank.
I suspect most people would give the rational answer, but when you look at what people really do, the results are often different.
People keep money in the bank instead of using it to pay off debt. That’s because our actions are not so rational. How we feel about money guides our choices more often than not. We feel safer with money in the bank. This is the case even though it costs us to carry debt, and even though the safety is really just an illusion. We don’t seem to get the disconnect.
Getting into debt in the first place isn’t all that rational either, especially credit card debt. Sure, sometimes there are exceptions. If one of my loved ones needed life-saving treatment and the only way I had to pay for it was with a credit card, you can bet I’d be slapping down the plastic.
But many people start their debt story by getting a credit card “just for emergencies”. Before they know it, there’s an emergency every month. Unless it causes you to be stranded without water on a summer day in Death Valley, your car breaking down is not an emergency. It’s an inconvenience.
It’s not logical to depend on potential debt for emergencies instead of saving up money or planning ahead for those (not so) unusual months. If you can’t seem to get ahead, it’s because you’re either spending more money than you can afford to spend, you don’t have enough income, or both.
Maybe it’s time to give our irrational money minds a talking to, so we can start aligning our behavior with what we know is best for us.
Posted in Debt, Emotions & money on 02.26.10 with 12 comments.
I would agree that credit card debt should be avoided to start with, but if I had any, I wouldn’t use my whole emergency fund to pay it off. I’d leave at least $3000 in the bank and work off the debt difference. You always need a little cushion so minor emergencies don’t push you backwards, right?
I completely agree – I was going to post a comment to this effect, but you beat me to it!
I’d agree with a little cushion, but how much a “little” is would depend on a lot of different things…
I agree with having the cushion. If it wasn’t for the cushion that I had built up before I was laid off last year, my debt would have sky rocketed.
I do agree that paying off debt should be on the top of the priority list. You can not be truly comfortable when you are paying so much in interest. I would say have a 3 to 6 month cushion built up for emergencies and then completely focus on the debt in your life.
If we are talking about having a cushion, yes, I do think people should have at least a small emergency fund while they are getting out of debt. (And then I think they should build up a large one afterward.)
But the point was that many people are reluctant to pay off debt even if they have plenty of money sitting in the bank because that money makes them feel safe.
I didn’t know anybody would do that – have more than enough laying around but choose to keep interest building debt…well, unless they weren’t ever planning to pay it off (which is weird to me as well).
My irrational mind explains that chocolate is good for me, but it does not (thankfully) talk me into holding onto debt for no reason…yay.
Do you know anybody who does this? Do they really have extra cash or do they have the money in retirement accounts?
I wouldn’t cash in my 401k to pay off my car loan, but I’d totally pay it off if I had the extra cash after building up one year of expenses in an emergency fund…we’ll be in this boat next year.
Oh, and I would only need 3 months of expenses built up to be comfortable with putting the rest towards high interest debt. If I had debt higher than 8% (our car is at 4.1% and our home is at 5.375%), I’d lower my cushion standards.
Well, I sat there with $4000 extra in my bank account instead of paying off my student loan. (And that wasn’t my emergency fund.) So I know me…
I’ve heard other people say that they’ve done similar things as well.
That will teach me to make assumptions…open mouth, insert foot. Thanks for the post!
Budgeting – Oh, don’t worry about it! But you can pretty much bet that if there’s a mistake out there to be made, I’ve made it…
This is a great post. We often make irrational decisions when it comes to money, and even if we know we’re doing it we can’t stop. That’s just how our brain works, although reading more articles about this would naturally help you to rethink your financial situations and make more sound decisions.
I had to trained myself for a long time in order to switch the mindset from having $20,000 in the bank and debt to having $0 in both. Right now I’m only holding interest free debt and putting the rest of the money into investing and self improvement.
There’s a great book that talks about this too, “Why Smart People Make Big Money Mistakes”. I highly recommend it if you’re interested in learning how to stop making totally irrational financial decisions! It’s a fun read too.
Thanks.
Ken, I think sometimes we don’t realize that we’re making the irrational decisions, although there sure are times when we do and just don’t stop. I do think it’s important to set aside some money as an emergency fund — if all money is tied up in investments it can mean that you have to cash them out at inopportune times.