In personal finance, the numbers almost always suggest a single correct answer. Economics used to focus on “Economic Person,” a hypothetical being who would make the best financial choice based on numbers only. The field of behavioral economics has risen to prominence because we’ve learned we’re mostly nothing like an Economic Person, and regular people frequently make choices that are far from financially optimal.
Imagine you receive a windfall, which isn’t allocated to your financial life in any way. Then imagine you have one loan outstanding, with a payoff amount equal to the windfall. We’ll say for simplicity that it was a $6,000 check and your loan is at 5 percent interest with $500 payments and a year remaining on the loan, but feel free to scale these numbers up or down to a value meaningful for you. The question is, should you pay off that loan or not?
One school of thought would suggest immediately paying it off. The money is unexpected, and you could reduce your monthly outlays by $500 instantly. This would create more monthly net cash flow and reduce risk in case of a job loss or other unexpected event. And you would avoid the interest for the remaining life of the loan. Paying off debt is probably never incorrect, if for no other reason than peace of mind. There’s an old saying that it’s impossible to be bankrupt without debt, and there is a huge emotional dividend from being debt-free that can be a goal in itself. For example, we can show in our modeling that it almost never is likely to make long-term sense financially to pay off a mortgage early, but we will encourage you to do so if the peace of mind you experience exceeds the slight financial benefit of making the absolute optimal choice.
Economic Person might look at the long-term performance of investment portfolios and the expected returns based on current circumstances and say it is foolish to pay off the loan today. They would invest the windfall in their financial portfolio, pay the loan off on schedule as planned, and expect to be financially better off. Economic Person would even understand that the market might be flat or fall over the next year, yet be confident they made the best choice given the information and never have a second thought if they did not quite achieve the 5 percent break-even return. That is what I would do, but only because I have been hardened from years of watching the markets and truly believe in time in the market vs. timing the market in the long run.
We’ve talked about Economic Person, but what would happen to a typical “Regular Person” in this scenario? If Regular Person did not pay off the loan immediately, they would probably put the funds aside. They may splurge on something with some of the “found money.” They would think about investing the windfall, but probably decide it’s not the best time to put money in the market and that they should wait for ever-elusive certainty to get invested. Without realizing, they’ll probably spend the money with not much to show for it. Maybe it’s okay to splurge with it, but we believe it is far better to make financial decisions intentionally.
It would be great if you like the Economic Person approach to the windfall, but if you are likely to behave like Regular Person, perhaps you should pay off your debt immediately instead.
If you identify too closely with Regular Person, you might go full circle and be better off not paying down your debt at all! For example, if you have a credit card nearly maxed out that you will likely max out again, you perhaps should leave it maxed out and consider the interest a tax on your mindset until you can truly shift your perspective. If you would see the extra monthly cash flow from paying off your car and get the itch to buy a brand-new car, then maybe keep the payment and focus on investing in your managed portfolio (and leaving it there!).
In today’s world, we have all the information we could possibly need to make good financial choices, be healthy, and accomplish anything we can imagine, but we have an execution problem. Regular Person is not maxing out their retirement contributions, eating kale, and learning to be a concert pianist on YouTube. Regular person is sitting on the couch, watching Netflix, and probably not making the best financial decisions (or making very many deliberate decisions at all).
It is okay to not be perfect. We all have a little bit of Economic Person and Regular Person within us. What is important when it comes to your financial future is that you understand yourself and where you fall on the spectrum and work to make the best choices — not in an absolute sense, but the best choices for you.
Gene Gard, CFA, CFP, CFT-I, is Chief Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions. Ask him your questions or schedule an objective, no-pressure portfolio review at letstalk@telarrayadvisors.com. Sign up for the next free online seminar on the Events tab at telarrayadvisors.com.