Lasting Situations of Wealth

With the turbulence in the economy over the past several years, many Americans were compelled to reevaluate their financial positions. Instead of maximizing retirement account contributions, pursuing high-flying investment returns, and leveraging equity to “trade up,” there is now a greater emphasis on the preservation of wealth. For a lot of people, their new financial priorities have become defensive: to keep their job, their home, and their retirement.

Preservation of wealth has always been an integral part of sound financial thinking. In this issue, several “defensive” strategies are discussed. While these items may not specifically address some of your wealth preservation issues, the underlying concepts should provide insight and perhaps prompt you to reevaluate your wealth preservation activities.

ACCELERATED DEBT PAYOFF
From 15 years to 18 months (but maybe 20 months is better)

A year-end report from The Federal Reserve found that credit card debt had been declining for 14 consecutive months. Revolving credit, the majority of which is credit card debt, decreased at an annual rate of 18.5% in November, 2009, the largest percentage drop ever recorded. After years of amassing higher levels
of unsecured debt, many Americans have decided it’s time to stop paying high interest rates and get their financial houses in order.

  One option recommended frequently in the financial press is to divert some or all of the dollars previously earmarked for saving and investing to now pay down debt. For these “experts,” paying off debt is equivalent to earning the interest rate charged – “when you pay off a credit card that charges 16% interest it’s like earning 16% guaranteed.” Is this true? Are accelerated debt payments really the equivalent to high rates of return?

To begin this assessment of accelerated debt payments, let’s look at the minimum-payment terms offered by a typical credit-card provider. Assume the following scenario:

• An $8,000 credit card balance.
• An annual interest rate of 16%, compounded monthly.
• A minimum monthly payment equal to 3% of the outstanding balance, with a minimum payment of $25.

Note: These payment terms are typical (although many credit card companies compound interest daily instead of monthly), and according to the April 30, 2010 report from Credit Card Monitor, the national average credit card interest rate was 16.74%.

In a minimum-payment program, here are the first 5 months of a schedule of payments, assuming no new purchases are made:

Since the minimum payment decreases as the balance diminishes, the time it takes to fully repay the debt will be lengthy. How long? The final payment is made in the 175^th month, which is slightly more than 14½ years!

Even though the monthly payment goes down each month, paying the minimum payment for almost 15 years hardly qualifies as “speedy” debt reduction. Suppose you take the first month’s minimum payment of $240 and keep paying it every month (see Plan B). This reduces the payoff period to 44 months. Here are the last five months of this amortization schedule:

 Paying off the credit card balance in 44 months is better than 175, but continuing to make today’s minimum payment (while not adding additional debt to the account) isn’t really accelerated debt reduction. Suppose you decide to pay extra dollars, perhaps a portion of what had been previously allocated for saving or investment. For simple calculation, let’s add another $260 each month to equal a $500/mo. payment.  Here’s the math for Plan C:

The numbers tell a simple story: Extra payments dramatically reduce the time to fully repay the credit card obligation. In the example, making extra payments changed the payoff period to 18 months from 175. This plan also significantly reduces the overall interest cost of the debt. In the minimum-payment scenario, the total payments are $13,687.29 ($5,687.29 is interest). In contrast, the total payments for the $500/mo. plan are just $8,923.97, an interest savings of $4,763.32.

Mathematically, an accelerated paydown – assuming you have the resources to implement it – seems like a no-brainer. But wait, there’s more…

PLAN D:  There’s not much difference between 1% and 16 % (really)

Debt is really about control. When you owe a creditor, the creditor exercises a measure of financial control over you until the loan is satisfied. As long as there is a lien, they can lean on you. Paying the debt faster (making extra principal payments) without paying the balance in full does not decrease the creditor's immediate control over a portion of your finances. Even with extra principal paid, you still have an obligation to make next month's payment. The lender’s control is not removed until the loan is completely repaid.
In fact, you could argue that making additional
periodic payments on debt obligations actually gives greater immediate control to the lender. Not only do you still have another monthly payment coming, but the additional debt repayment means more of your “discretionary” dollars are also in the lender’s hands.

Considering the financial control issues, an alternative debt-reduction strategy might be to systematically fund an account for the purpose of accumulating enough to make a single balance-clearing payment. Rather than sending an extra $260 to the credit-card company, a “control” strategy could be to deposit that same amount into a savings account, while continuing to make a $240/mo. “minimum” monthly payment. When the savings account equals the remaining balance, you pay the loan balance off. In the interim, you maintain control over the “extra” money.

Yeah, but…

Some may point out that the interest earned in the savings account will not equal the rate of interest charged by the lender, thus you will “lose money” by not paying the additional savings directly against the credit-card balance. This is true. Saving in an outside account will take longer to fully pay off the obligation. But if the key financial issue here is control -- not rate of return – then keeping the money under your control gives you greater current financial security and opportunity than if you send those dollars to a creditor. And guess what? The difference isn’t that great. Read on:

Here’s Plan D. $260 each month is deposited in a savings account earning 1% annual interest. The balance accumulates until there’s enough to pay the credit card balance in full. See “Plan D” below, including the “Remaining Net Balance” showing the credit-card payoff:

At the end of 19 months, the savings account has $4,981.37. If you take this balance and add a payment of $88.37 at the start of the 20^th month, the credit card is paid off.

How is it that there’s only one month’s difference between 16% interest charged and 1% interest earned?

Math doesn’t lie; there is a significant difference between 16% charged and 1% credited. But other variables in this illustration make the interest rate numbers relatively irrelevant. The Plan B decision to make $260 monthly payments means the debt already has a short amortization schedule – less than four years. Since interest expenses increase geometrically over time, the shorter payback period negates a large portion of the interest expense. The additional $260, whether added to the credit card balance in Plan C or saved in Plan D, is more than double the scheduled payment and primarily becomes additional principal payments, with very little interest involved. Over 18 months, the interest difference between extra payments (Plan C) and saving at 1% (Plan D) is around $300.

However, if the regular minimum payments were smaller, or the amortization period was longer, or the additional principal payments were proportionately lower in comparison to the minimum credit card payment, the spread between the time it takes to achieve full pay off could be much longer. The bottom line: Every debt-reduction scenario is unique and deserves to be evaluated individually.

But this financial exercise highlights an over-arching financial concept worth consideration, regardless what individual circumstances might show.

Paying down debt is not the same as saving. Sometimes financial commentators confuse the two ideas, or view them as interchangeable. They are not. When you save, you accumulate money under your control. You can decide where to put it, when to take it, what to use it for. As you repay debt, you reduce the amount of control the creditors have over you. But just because the creditors control you less, doesn't mean you have more financial control.

If all your “extra” funds are put toward debt reduction, and you have no savings or no capital reserves, how can you take advantage of financial opportunities, or meet unexpected financial challenges? Either you won't, or you will go back to your creditors — you'll run up the credit card to its limit, or visit the bank for another loan. When you must rely on borrowing to participate in financial opportunities or fight off financial challenges, the ultimate decision-making power (control) lies with the lender, not you. No matter what the interest rates are, paying off debt is not saving.

IF YOU WANT TO IMPLEMENT A DEBT-REDUCTION PROGRAM, BE SURE TO COORDINATE IT WITH YOUR SAVINGS PLANS.

RUN THE NUMBERS. AND GET INPUT FROM YOUR FINANCIAL PROFESSIONALS AND ADVISORS!