Thanks for stopping by Apathy Ends! Today I want to talk about how financial decisions are made, the factors that go into them and share our personal strategy.
Two main factors that weigh heavily in personal finance decisions, Math, and Emotion. They can manifest themselves in different ways, and often have competing priorities or goals.
Mrs. Math: “This is a math problem, bust out your calculator and pick whichever option yields the best return or reduces interest costs”
Mr. Emotion: “How does this situation make you feel? What will make you feel more secure or motivated?”
Math Vs Emotion: Real World Example
The logical side of me turns everything into a math problem. How much will I save in interest vs what would this money generate in returns every X number of years if invested.
While I trust math and think it should weigh heavily in financial decision-making, your emotions or emotional relationship with money is a huge factor in the decision-making process.
A Recent example from one of my close friends that doesn’t know I run this site:
“We are thinking about buying a new house next year, but need to get rid of some of our other debt first. We still owe about $55,000 on our student loans and about $10,000 on the car. “
My first reaction was, this is a math problem. Take the interest rates and start plugging them into a loan calculator and figure out which one will save you the most in the long run. Then he said…..
“Our car loan is only 1.29% and our student loans are at 6.2%, but I feel like paying off $55,000 is an unattainable goal”
Personally, I think there is a pretty clear answer on where my friend should put any extra cash, I don’t even need a calculator to say he would save thousands paying down the Student Loans faster. At the same time, you can’t discount the emotional side of this argument. If the quick win gives him the confidence to tackle student loan debt ferociously, maybe the short-term negative swing is worth it.
6.2% Student Loan Interest Rate…..I was in the same boat before refinancing with SoFi
Financial Decision Making – Math vs Emotions
What factors should we consider when making financial decisions?
The below list of factors are what we use to make financial decisions, they can overlap and intertwine depending on the situation.
Interest Rate
Very straight forward for debt repayment, the higher the interest the higher the cost. Purely used on the math side of financial decision making.
Cash Flow Needs
Cash flow needs are a factor when deciding to pay off debt over investing, or what debts should be paid off first. Most of the time I recommend rolling positive cash flow from debt payoff into an investment account. If you are used to living without that money already, you might as well put it to work for you.
If you have a life changing event (Baby anyone?) that will increase your expenses, or you are already saving adequately for retirement you may want/need to spend the extra cash every month.
Time until retirement
Time is a major financial decision-making factor. Compound interest can work wonders with enough time (see my Would you be a millionaire if you stopped investing today post for some proof).
Another way time factors in is reducing costs as you approach retirement. If you have built a substantial nest egg, it might be wise to start paying down your mortgage. Lower expenses equals a greater chance of retirement success.
Expected Returns
What can you realistically expect to earn on an investment and what is your timeline for keeping the money. I use a compound interest calculator to compare the expected long-term return vs the money saved from increased debt payment.
Generally the less risk, the less return, and the longer it takes your money to double. The flip side – if your expected return is too high it might incorrectly sway your decision towards a risky investment.
Motivation
Progress, quick wins, security, or seeing growth in investment portfolios can all be motivating factors and weigh into your Financial Decisions. When we started our journey, I didn’t give motivation the value it deserved. Seeing our progress and reading other people’s success stories pushed us to do more.
Motivation ties directly into the common debt pay-off strategies: Debt Snowball or Debt Avalanche
Debt Snowball – Pay off the smallest balances first, then roll that payment into the next smallest balance. If you are motivated by quick wins, you would naturally go toward the Snowball method
Debt Avalanche – Attack the accounts with the highest interest rates first and work top down. If you liked seeing the actual dollar savings the Avalanche method would motivate.
Risk
What is your emotional response to the thought of losing money? Can you stand the thought of seeing a losing quarter when you open your 401K statement?
Investment risk can elicit powerful emotional responses that affect your financial decisions. Some people are willing to take excessive risk (to a fault). Some need to toughen up and accept that Investment Risk is More Than Losing Money and they can’t afford to skip investing.
What if I lean heavily one way or another?
It’s perfectly normal to lean heavily one way or another, I definitely lean towards the math side of the scale right now. It’s why we have a 10-1 investing vs extra debt payoff ratio. As time goes on and we build a substantial nest egg, my tune might change to reducing our expenses by paying off our mortgage.
There are a lot of personal finance bloggers that lean towards 100% debt payoff vs investing (including primary residence). There are bloggers that keep a substantial amount of money in cash for security and capital protection. None of these are wrong, but I think you should at least make informed decisions using all the tools and criteria available to you.
Take Aways
When making a financial decision take all factors into account, I have listed out the comparisons we go through before making financial decisions below:
Factors and Comparisons:
- Know the opportunity cost of debt payoff vs realistic investing returns.
- Know the opportunity cost of investing in a CD vs Bonds vs Stocks
- Understand investment risk (especially short-term investing) and how that risk level affects your decision
- Understand how time impacts your expected investment returns
- Look at your past decisions and figure out what motivates you
- Are you expecting major changes in your expenses
For people that are married or make their financial decisions with a partner, remember that they might be motivated or inclined to use different factors. Mrs. AE leans towards the emotional side, especially when it comes to debt payoff. It took awhile to compromise on where we switch from investing to debt repayment. We default to investing at a higher rate but put financial windfalls towards our debt. Use Math and Emotions to make your Financial Decisions together!
Do you lean towards using Math or Emotions when making Financial Decisions?
I definitely fall on the emotional side when it comes to debt payoff-I want this mortgage gone even though I know likely I would do better in the long-run investing. However, the way that I look at it is that I can be more aggressive with my overall investment strategy having it paid off. I don’t have to worry about covering a mortgage anymore and can afford to take more risk. My investments are in a solid 80/20 portfolio across the board, and investing-including huge market downturns-doesn’t scare me. I’ve invested through the tech bubble burst and the Great Recession, when many others sold out, and I know from experience that a dip doesn’t scare me. So emotions are driving my debt-payoff strategy, but math drives my investments.
Thanks for the comment Liz, not having to coverage a mortgage is a huge plus! We will go that direction eventually but need to keep building our investment portfolio for the time being.
I fall to the math side of the equation as well. My wife is definitely more on the emotion side. She would pay off 0% financing early if I let her.
I’m glad you pointed out cash flow as I don’t normally see this taken into consideration when deciding to invest or pay down debt. Paying down debt locks in a safe return for you at whatever the interest rate is on your debt, but that money is also gone. With investing, you might have the opportunity for higher returns depending on the interest rate of your debt, and that money is available to you in case of emergency.
Very good post here. Lots of good points to consider.
Thanks GFY, I draw the line at our .9% car loan on extra debt payoff – we will wait that one out an invest the excess.
The cash flow point is one I used to overlook, if you do it right a lot of flexibility follows
Aghhh this is a tough one. At the end of the day I lean towards the Emotion end of the spectrum. Money is a tool to achieve the things you want–it’s not the be-all-end-all. But it’s crucial to take money into consideration when you make big moves. Even though Mr. Picky Pincher and I wanted a house for a while, we waited until we paid off our credit card debt and had a big chunk of cash for a down payment. We still got the thing our emotions pined for, but not after letting math rule the “when” of everything.
Math can stomp down the emotional side pretty quick if there is not enough $ to go around!
Appreciate the comment Mrs PP
There no one size fits all answer, all situations are going to be different. When we were face with $109K worth of debt and a long period of time to pay if off, we wanted the small wins, momentum to help carry us. So we went with the emotion side of the debt snowball, regardless of interest rate. We wanted to achieve the end goal of being debt free. It did help that on the math side our interest rates were similar and not a big factor too. Given a different situation we might go a different route.
Thanks Brian,
Agreed, there is not a “right” answer for everyone, just want to make sure people look at the decision from both sides and know what they are giving up.
I’m usually pretty logical with my approach, but I also think many people are too quick to discount the emotional side. I recently has a post where I advocated for attacking the debt you hate most. Every case is different, and simply paying off Loan A because it has the smallest balance or the highest interest rate won’t be terribly motivating for everyone. But if you have a debt that you despise – why not throw that loan a blanket party?!
Good stuff, as usual. Getting down to crunch time. Hope all is will with Mrs. AE and the baby!
I hate my student loan debt with a blazing passion, its the biggest financial mistake I have made (and better be forever) – a blanket party might come next year!
Thanks Ty – she is doing well but getting ready for the baby to be out
We lie somewhere in the middle. After we fill up tax exempt accounts I tend to dump extra money onto the mortgage to pay down debt. I treat it as the equivellent to my Bond allocations for my investment allocation for the year. Investing it in bonds has roughly the same yield as my debts so it’s largely a wash. My bond allocation is about risk tolerance not liquidity. Also I’m trying to avoid income, so investing in a taxable account is something I’m not exactly targeting.
Makes sense FTF, that is a good way to look at paying down the mortgage. Having a free(ish) place to live one day sounds pretty good in my book.
Right now, I’m going with the math. We do have the mortgage, but are banking extra cash to buy rental property, plus we’re investing in our tax advantaged accounts. I do stay on top of it to make sure we are actually saving/investing the extra and it’s not just disappearing. That said, I despise the mortgage, so the plan is to have enough extra saved up to pay it off if we want to, but let it grow in the meantime.
Thanks for the comment Amanda, I can understand the mortgage hate – it takes up a ton of cash flow every month. I would hate ours a lot more if the interest rate wasn’t so low. When I look at historical rates over 6% (and even in the double digits!) my attitude would change pretty quickly.
Sometimes I let math rule, other times emotions win, it really just depends. I try to take all the factors into consideration, and having a partner to make decisions with helps to do that.
having a partner to balance out helps a ton!
Great topic. I would take a more dynamic approach to the student loans. First, I would ask him if there are other options available to reduce the interest rate, such as a one time refinance. If that is the case, I would then ask him to switch to a much longer repayment time frame. A low enough interest rate, that is tax deductible up to $2500 per year and reduces your adjusted gross income (AGI) for tax purposes is even better than the home mortgage interest deduction.
Instead of paying off our mortgage, I have kept a “mortage payoff ratio” calculation as motivation to continue to motivate us to invest (instead of payoff our 2.89% mortgage early– cray cray). The simple math is, taxable investments + cash in savings account/mortgage principle. I am proud to say that as of this week, this ratio has gone over 100%, for the first time ever. With such large gains in stock indices over time, I think this is a much faster path to build wealth. As you state, the math just works. From my experience, the math is working.
We were on the math side when choosing the highest interest debt to pay down first, but we’re on the emotion side when it comes to debt payoff vs investing. One of the most important emotions is uncertainty or fear, and while the market might usually pay more than the interest on debt, we’ve lived through several years when it hasn’t. Getting the guaranteed return of paying no interest is pretty appealing.
You have to know the numbers but I think there are times when some emotion can play a role. Especially when paying off debt. Even if the rate is low I love having a lot of cash flow and control of where my money is going every month. So I’m ok paying off low interest debt. Good article!!
“Cash Flow Needs”
I look at this one a little more than I really should. I’m always thinking something bad will happen and I will need a lot of cash immediately. But that is never the case (knock on wood). Therefore, I need to release the urge of maybe hoarding and deploy. Plus at the moment, I feel like prices of investment are a bit inflated so I suppose I can also say Iām being opportunistic š
Well Jared is definitely emotional and so am I. We’re completely emotional so I’m trying to be more pragmatic to balance out our girlish screams. I want to hold on to our rental long term which is another liability but time is powerful with real estate so…yeah still debating. The money makes sense but so does the stress!