paying off debt – Memphis Flyer

I think we can all agree that large revolving credit card balances are bad, but what about no balance?

The modern, “responsible” credit card approach seems to be a win for all parties. The card issuer gets the swipe fee every time a card is used. The merchant pays the swipe fee, in exchange for convenience, time saving, and access to a broader audience of buyers. The card user wins by paying off the card every month and accruing valuable rewards or cash back while paying no interest. Where is the problem?

There’s not a problem, if you’re completely content with your level of spending over time. However, most people seem to think they spend a little (or a lot) too much, regardless of income or assets. Even those who think their spending is fine often think their spouse or significant other could tighten up their spending a little bit. But how does this relate to “responsible” credit card use?

The bottom line is that countless studies have shown that using a credit card causes you to spend more, period. There is evidence that credit card holders spend more at department stores. Credit card users leave bigger tips. A study showed that those required to return with a credit card were willing to pay more than double for playoff tickets compared to bidders who were told they had to come back and pay cash. Another study showed that cards create identifiable “purchase cravings” on MRI scans that cash does not. One study even showed that simply the presence of credit card paraphernalia on a desk caused subjects to spend more money than the control group.

Why is this? The best way I can explain it is that having a line of credit untethered to nothing but a sky-high irrelevant credit limit means that there’s no natural scarcity reaction when presented with purchases. If you have $100 in your pocket, you better make sure your restaurant tab, tax, and intended tip is less than $100. With a card, it doesn’t really matter if it’s $82 or $120 or $350, especially if you know you’ll be able to pay the bill off in full at the end of the month.

These little differences add up. Over time, even if a credit card causes you to spend a few percent more than you otherwise would, that extra spending will far exceed any benefit from even the best rewards cards.

Moving fully to cash is not practical for many people, and credit card rewards can have tremendous value — if they don’t lead to additional unnecessary spending. Normally an abundance mindset is a good thing, but in the case of credit card spending, a little scarcity could lead to broader abundance in your financial life. Ironically, card users with a balance close to their limit probably have more cash-like buying habits than someone who pays their card off every month.

Try actually using cash only for a month, and you might be surprised to see a stark difference in spending compared to your last card statement. Consider purposefully lowering the limit on your day-to-day card to a level you’ll have to think about before you swipe. Most importantly, remember that while credit card rewards can be meaningful over time, the low single-digit percent reward can’t make up for spending even slightly more than necessary.

Credit cards can have a role in the path to your secure financial future, but keep in mind the obvious risks as well as the subconscious ones!
Gene Gard 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.

Q: I have debt I want to pay off, but I also want to start investing to enjoy the value of compounding. How should I think about household debt?

A: It’s probably never truly wrong to pay it off, but sometimes a little debt might not be a bad idea.

Let’s start with the easy part. Some types of debt should be attacked mercilessly with singular focus and attention until it’s gone. This would include any kind of payday loan, credit card debt, predatory car loans, or anything with a high interest rate. To me, a high interest rate is anything above what a reasonable investment portfolio could hope to produce on average in the future. Over the last 20 years, U.S. stock market returns have annualized about 10 percent a year and are unlikely to exceed that going forward, so any 10%+ interest rate should certainly be considered high these days and attacked with all available resources.

What about loans with lower interest rates? There’s still a good case to be made for paying them off as soon as possible. Even 0 percent interest sounds like a great deal, but it’s still money spent that you didn’t have at the time, and those payments impact your future financial security and flexibility until they’re gone.

There’s a lot of debate about what defines good debt. The most common example is a mortgage, as it represents a hybrid of paying for shelter and investment in the future. Real estate has made many people wealthy over the years, but not without risk. It’s hard to make big returns in real estate without borrowing, which works great most of the time, but can also go wrong, as we saw leading up to 2008. I believe in buying a house because you need a place to live, not as a speculative investment. Enjoy any appreciation, but don’t expect it and certainly don’t rely on it. A mortgage is usually the lowest-priority debt to pay off in a given household.

A case can be made against almost all other kinds of household debt. The problem is that virtually all household borrowing is financing consumption of things that are currently unaffordable. Some things might be necessary, like a reliable car, but a lot of unnecessary money is spent and justified in the name of reliable transportation. Generally, consumer loans like these should be minimized and paid off as soon as possible.

Student loans are a tricky subject, because right now, many people are expecting eventual forgiveness from the government. Forgiveness might come, or might not. Regardless of your expectations, it’s probably wise to avoid taking advantage of any kind of deferment where payments stop but interest continues to accrue.If possible, make payments so that the balance declines each month.

Credit scores are also tricky. On one hand, a decent credit score is necessary for basic tasks like renting apartments or opening bank accounts. On the other, I’ve seen many financially destructive things done in the name of establishing credit or building credit history. In my experience, credit history will naturally build up over time with things like car loans and a credit card with reasonable limits. There’s no reason to focus on gaming your score.

For some debt, it might make sense to keep the low-interest debt and invest any extra money in the markets. Keep in mind that we may not get another 20 years of 10 percent stock market returns, but there’s a good chance the market will outperform a 2.5 percent mortgage in the long term. Investing in things like 401(k) plans with an employer match should probably be prioritized even above paying off non-mortgage, low-interest debt. Ask your financial advisor about both opportunities and risks in your particular situation. It’s important to look at the big picture.

Many lives have been ruined by overwhelming debt, while I’ve never heard anyone complain about being debt-free, even if it’s not optimal. If in doubt, it’s probably never completely wrong to just pay your debts off if you can.

Have a question or topic you’d like to see covered in this column? Contact the author at ggard@telarrayadvisors.com. Gene Gard is Co-Chief-Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions.