6 ms·

From an economics point of view, it's basically another way of saying that wealth maximization is different from utility maximization. While the two are frequen

by sdz 16y ago

From an economics point of view, it's basically another way of saying that wealth maximization is different from utility maximization. While the two are frequently correlated, it's not necessarily so. The snowball strategy could be perfectly rational for people who gain more utility from the small but frequent accomplishments of paying off debt earlier than they do from maximizing their overall lifetime wealth. It's not what I would do, but as they say, there's no accounting for taste.

sudont 16y ago
I've had this argument with my parents on saving for retirement vs paying off loans. It would seem like one would prioritize savings, but due to the variance in interest, the net gain is in favor of paying off high interest loans vs building low interest savings.
- dkokelley 16y ago
  It is better mathematically to pay off debt than to save (since debt is usually costing you more than the opportunity cost of not saving). Still, from a practical standpoint, you shouldn't put ALL of your disposable income towards debt, as you will want some sort of emergency fund to keep you afloat when your car breaks down. Otherwise, you go rely on more debt. Spending saved money is cheaper than spending borrowed money.
  - sudont 16y ago
    Absolutely, I try and keep about a 2k float, but aim on building that higher. And my car did just break down hard enough for it to be junked.
  - xenophanes 16y ago
    Assuming you have a credit card, you should pay off all debts worse than credit card debt, and all credit card debt, saving no money. If your car breaks down, charge it. It's only if you have a source of debt that's more pleasant than credit card debt, and which you can't easily get back in case of a car-breakdown-forcing-credit-card-use that you'd want to save some debt to keep cash around for emergencies. And even then you'd want to look at the extra interest you're paying compared with the risk of emergency and the difference between the interest rates of that debt and your credit card, and a lot of the time it'll be like (IF i have a car breakdown, which is 5% likely, then I'll end up paying 5% higher interest on the repair money for a few months ... this is NOT worth failing to repay some debt immediately which will cost in interest a lot more than the expected loss of that incident)
- btilly 16y ago
  It would seem like one would prioritize savings, but due to the variance in interest, the net gain is in favor of paying off high interest loans vs building low interest savings. Sorry, but you're wrong. Your retirement savings should go into relatively high risk investments with good long term average returns, such as the stock market. At this point the average return on investment for retirement savings exceeds the interest rates on your loans, and therefore the net gain is for preparing for retirement. (Unless, of course, you're facing a short term cash crunch where long term returns become irrelevant to your utility.)
- sdz 16y ago
  At a very general level, accumulating savings while carrying debt only makes sense if you can get a greater (risk-adjusted) return on your savings than the interest rate you need to pay on your debt. So if your return on your savings is lower than the interest on the debt, paying off your loan with your savings is like getting the difference between the return and the interest rate for free -- i.e. you should definitely pay off your debt. Of course, there are lots of complications to this general rule in the real world. The US, at least, taxes the returns on your savings (capital gains and dividends) and gives you tax benefits for your debt. When saving in a 401k, employers often match your contribution, which amounts to a guaranteed 100% return on your investment for the portion that's matched. Liquidity is also a concern. For example, if you have a 30-year mortgage on your house at 5%, you probably wouldn't want to put all of your savings into paying down that mortgage since you can't get it out again until you sell your house. If you have a sudden need to raise cash, you'd need to get a home equity loan, which can be tricky if your house value has plummeted or if interest rates are high. Thus the full answer is that, well, it depends on a lot of life factors, and although paying off your debts is generally good advice, especially for very high interest loans like credit cards, there are many factors to consider other than the spread between the return on your savings and the interest rate on your debt.

by sdz 16y ago

sudont 16y ago

I've had this argument with my parents on saving for retirement vs paying off loans. It would seem like one would prioritize savings, but due to the variance in interest, the net gain is in favor of paying off high interest loans vs building low interest savings.

dkokelley 16y ago
It is better mathematically to pay off debt than to save (since debt is usually costing you more than the opportunity cost of not saving). Still, from a practical standpoint, you shouldn't put ALL of your disposable income towards debt, as you will want some sort of emergency fund to keep you afloat when your car breaks down. Otherwise, you go rely on more debt. Spending saved money is cheaper than spending borrowed money.
- sudont 16y ago
  Absolutely, I try and keep about a 2k float, but aim on building that higher. And my car did just break down hard enough for it to be junked.
- xenophanes 16y ago
  Assuming you have a credit card, you should pay off all debts worse than credit card debt, and all credit card debt, saving no money. If your car breaks down, charge it. It's only if you have a source of debt that's more pleasant than credit card debt, and which you can't easily get back in case of a car-breakdown-forcing-credit-card-use that you'd want to save some debt to keep cash around for emergencies. And even then you'd want to look at the extra interest you're paying compared with the risk of emergency and the difference between the interest rates of that debt and your credit card, and a lot of the time it'll be like (IF i have a car breakdown, which is 5% likely, then I'll end up paying 5% higher interest on the repair money for a few months ... this is NOT worth failing to repay some debt immediately which will cost in interest a lot more than the expected loss of that incident)
btilly 16y ago
It would seem like one would prioritize savings, but due to the variance in interest, the net gain is in favor of paying off high interest loans vs building low interest savings. Sorry, but you're wrong. Your retirement savings should go into relatively high risk investments with good long term average returns, such as the stock market. At this point the average return on investment for retirement savings exceeds the interest rates on your loans, and therefore the net gain is for preparing for retirement. (Unless, of course, you're facing a short term cash crunch where long term returns become irrelevant to your utility.)
sdz 16y ago
At a very general level, accumulating savings while carrying debt only makes sense if you can get a greater (risk-adjusted) return on your savings than the interest rate you need to pay on your debt. So if your return on your savings is lower than the interest on the debt, paying off your loan with your savings is like getting the difference between the return and the interest rate for free -- i.e. you should definitely pay off your debt. Of course, there are lots of complications to this general rule in the real world. The US, at least, taxes the returns on your savings (capital gains and dividends) and gives you tax benefits for your debt. When saving in a 401k, employers often match your contribution, which amounts to a guaranteed 100% return on your investment for the portion that's matched. Liquidity is also a concern. For example, if you have a 30-year mortgage on your house at 5%, you probably wouldn't want to put all of your savings into paying down that mortgage since you can't get it out again until you sell your house. If you have a sudden need to raise cash, you'd need to get a home equity loan, which can be tricky if your house value has plummeted or if interest rates are high. Thus the full answer is that, well, it depends on a lot of life factors, and although paying off your debts is generally good advice, especially for very high interest loans like credit cards, there are many factors to consider other than the spread between the return on your savings and the interest rate on your debt.