# Saving vs paying down debt



## dilbert789 (Apr 20, 2010)

I was taking a look yesterday at a budget worksheet yesterday on the Gail Vazoxlade site and it got me thinking. If you have debt (other than mortgage) why would you be putting money into savings? I'm thinking debt like LOC or CC's where you have a higher interest rate. My wife used to do this constantly when we first met, "I have $400 in my savings account!" but had $1000 on a Line of Credit. 

link:
http://www.gailvazoxlade.com/resources/interactive_budget_worksheet.html

I'm trying to understand some reasoning behind it.


----------



## Taxsaver (Jun 7, 2009)

Making a budget in an Excel file is the FIRST step to get out of debt and live a healthy financial life.


----------



## MoneyGal (Apr 24, 2009)

The puzzling phenomenon of "debt diversification" is an area of interest for behavioural economists, too: I have a bunch of academic papers on this topic and last year I crunched a lot of data from the most recent U.S. Survey of Consumer Finances to look at interest rates and debt diversification for U.S. households. 

The typical explanation I've seen for this is Kahneman and Thaler's notions of "mental accounts" - that is, that investors mentally separate their accounts into different "lock boxes" for different purposes. 

So, for example, people set a financial goal to pay off their mortgage within 10 or 15 years, even if it means incurring other debts at higher interest rates along the way (or, conversely, people build up "emergency savings" which pay less in after-tax, after-inflation returns than simply paying off their mortgage would).


----------



## dilbert789 (Apr 20, 2010)

I can see the emergency savings account being a good idea if you do not have access to a LOC at a low rate. Reason being if something did come up where you did need access to money quickly, you would have it. There are other items to consider here too, how good is your credit, and how likely would it be that a bank could just say that your LOC that you have been relying on is now closed.


----------



## dilbert789 (Apr 20, 2010)

Taxsaver said:


> Making a budget in an Excel file is the FIRST step to get out of debt and live a healthy financial life.


The question isn't so much in regards to making a budget, it is in divvying up the funds that are left at the end of the budget.


----------



## crazyjackcsa (Aug 8, 2010)

I think the idea is to build up savings to avoid repeating the cycle. When you're dealing with people trying to get out of debt it's important to not go back into it.

As an example, there is very little advantage to aggressively pay off a credit card just to have to put a car repair on the card again because you didn't build savings. (Granted there would be some gain in the form of intrest savings)

Furthermore, It's a psychological boost seeing savings grow, and when an unexpected bill does come in, it's a good feeling knowing you don't have to turn to the credit card.


----------



## GeniusBoy27 (Jun 11, 2010)

It depends if you're a person who's sway by the psychology of money or not. I'm not. I'm grounded by the realities of where money is best used, and keeping things in order is the key to not getting swayed by the psychology of money. For example, keeping buckets of money targeted toward specific activities.


----------



## DavidJD (Sep 27, 2009)

A business prof once told me to be wary of businesses/companies with too little debt.

For the same reason I did not wait until I could pay cash to buy a home. Also unlike a company I am a mere mortal and want to enjoy some things sooner and with some health and time left. 

I like borrowing to make money. I purchased $17K in stock on my HELOC and the yield (Please don't comment on which yield calc was just over 14% and the book value has increased by 33%. I saw an opportunity, had the credit and acted on it. However I am 'hit' with a borrowing cost of 3.75% (increased recently from 3.25%). I can enjoy this spread and am paying down the HELOC at my leisure. I am comfortable with the risk and, if for some reason could not carry the small debt, I would liquidate the investment (or an amount to cover the borrowed sum) and have a capital gain taxed. The dividend is from a Canadian company so taxed better than some.

Should everyone do this? Nope. I am I glad I did. Yup. Would i do it again? I intend to. Borrowing to save can be a very useful tool.

I own no GICs or Bonds.


----------



## brad (May 22, 2009)

MoneyGal said:


> So, for example, people set a financial goal to pay off their mortgage within 10 or 15 years, even if it means incurring other debts at higher interest rates along the way (or, conversely, people build up "emergency savings" which pay less in after-tax, after-inflation returns than simply paying off their mortgage would).


That rings true to me. Very few people I know have a "total bottom line" mentality, and are perfectly comfortable with the idea that they might be losing opportunities to make more (or pay less in interest) as long as they're on their way toward meeting their various financial goals.

I do this to an extent myself: I use a TFSA for my emergency fund and I contributed the max to it last year and this year (and intend to continue doing so) even though my TFSA pays a considerably lower interest rate than I'm paying on my mortgage (which is my only debt). If I had a "total bottom line" mentality I would have applied that money toward paying down my mortgage, but it's important to me psychologically to have an emergency fund, and the TFSA is a good way for me to do it.

Another thing to consider is that (hopefully) debt will be paid off quickly whereas your savings could have decades to grow.


----------



## ShowMeTheMoney (Apr 12, 2009)

I agree with Brad. An emergency fund is just that, an emergency fund, the money is there and safe, and if lose my job and my LOCs are cancelled, I can still live and keep paying my expenses and debts, at least for some time to find a new job. 

With that funded, then the options for leverage investing and taking advantage of riskier investing options are open. It is psychological, I realize, but I feel risk taking is something I have to earn, otherwise I feel it's gambling, I'm not confident that my investment decisions will always pay off as even the best professionals in the industry don't always make money. Obviously, I'm not a gambler, but do I like to invest in things I believe will pay off. Pay off the mortgage, have an emergency fund, then you can play (even better if you have a pension plan!). 

It's important to think of the additional risk taken to your life and whole portfolio for the after-tax spread between building an emergency fund, paying off the mortgage sooner, or investing the money somewhere else (with a best estimate of the risks/payoff profile in those investments). It's important to do the math, then you can have a clearer view of the risks you are psychologically willing to take or not.


----------



## Square Root (Jan 30, 2010)

What is "the psychology of money"?


----------



## brad (May 22, 2009)

Square Root said:


> What is "the psychology of money"?


I think the psychology of money can be illustrated this way:

Start with the assumption that there is already a considerable gap between economic theory and observed economic behaviour in the real world. Then multiply that gap by 10 and you have the gap between economic theory and the behaviour of most individuals when making personal financial decisions.

It boils down to the fact that economic rationality plays a fairly small role in many personal finance decisions. There are many factors at play, both economic and non-economic, ranging from one's cash flow situation, one's education, one's risk tolerance, personal likes and dislikes, the need to please one's partner or at least maintain a state of domestic tranquility, one's degree of acquisitiveness or frugality, etc.

I'd go so far as to say that most personal finance decisions are ruled by psychology rather than any economic or financial principles. In business there's a somewhat stronger tendency toward rationality but psychology plays a role there too. And it plays a huge role in markets.


----------



## andrewf (Mar 1, 2010)

My perspective is that emergency savings are all about liquidity. LOCs are quite liquid, so if you have plenty of assets that are less liquid (stocks, bonds, etc.), it is probably fine to have a small emergency account. I'd count this as the spare few grand in my chequing account. In the event of an emergency, you can draw on this fund/LOC in the short term while you raise cash from your less liquid assets. This is also my perspective on self-insuring against potential job loss. Six months income is an awful lot to have sitting in a savings account, quite unproductively, in the event that you might lose your job. 

That said, since LOCs are callable, there is no guarantee you will always be able to draw on one. For this reason it makes sense to have some assets rather than dedicating all savings toward debt repayment. But for god's sake, don't keep $60k+ in a savings account wasting away.


----------



## brad (May 22, 2009)

andrewf said:


> LOCs are quite liquid


I think it's important to draw a distinction between HELOC and other types of LOCs. The interest rate on a HELOC can be low, wheras the interest rate charged on a personal line of credit may not be much less than you'd pay on a credit card. I have a personal LOC with my bank that I had to set up temporarily to provide some extra cash when we bought our house, and I think the interest rate is something like 19%. I only used it once and paid it off in a couple of weeks; I certainly wouldn't want to rely on it as my emergency fund unless I were sure I could pay it off very quickly from other sources.


----------



## dilbert789 (Apr 20, 2010)

brad said:


> I think it's important to draw a distinction between HELOC and other types of LOCs. The interest rate on a HELOC can be low, wheras the interest rate charged on a personal line of credit may not be much less than you'd pay on a credit card. I have a personal LOC with my bank that I had to set up temporarily to provide some extra cash when we bought our house, and I think the interest rate is something like 19%. I only used it once and paid it off in a couple of weeks; I certainly wouldn't want to rely on it as my emergency fund unless I were sure I could pay it off very quickly from other sources.


Our LOC is actually lower right now than our house!
LOC - 4.75(prime + 2) 
mortgage - 5.4 fixed, 2 years left till it's done. oh how I wish I knew then what I know now...


----------



## kcowan (Jul 1, 2010)

dilbert789 said:


> ... oh how I wish I knew then what I know now...


It's never too late. Many people in their 60s still have not learned about finance.


----------



## Underworld (Aug 26, 2009)

Im of the train of thought that I want to build up a decent sized savings buffer rather than pay off debt. But i only think this is because I am constantly toying with the idea of quitting my job and becoming a contractor.

Otherwise id ignore the buffer and pay down my debts.


----------



## dilbert789 (Apr 20, 2010)

Underworld said:


> Im of the train of thought that I want to build up a decent sized savings buffer rather than pay off debt. But i only think this is because I am constantly toying with the idea of quitting my job and becoming a contractor.
> 
> Otherwise id ignore the buffer and pay down my debts.


Are your savings just in a high interest account? or is it invested in something gaining a bit more? What are your debts? Is it just a mortgage? or is it really low interest like some car financing?

To me this just sounds like you are paying money for money. Pay 5%, make 2% in interest, pay 40% of that 2% to tax... to make your actual interest income 1%... Now you are costing yourself 4% a year to have money in that account.


----------



## Spidey (May 11, 2009)

The first poll response does not leave much leeway, as you almost always need at least a few thousand to cover expenses.

That being said, I've always viewed consumer debt and to a lesser extent mortgage debt as an emergency. What's the worst that can happen by throwing available money towards debt (which probably has an effective return of 7-30%) rather than an emergency fund (which will probably return about 2%)? If you keep your credit cards current, you can always use them for a small emergency, and then pay them off asap. What would constitute a bigger emergency? -- one spouse loosing their job? I contend that you will be better able to face that emergency with less debt, even if you have less of an emergency account.


----------



## andrewf (Mar 1, 2010)

brad said:


> I think it's important to draw a distinction between HELOC and other types of LOCs. The interest rate on a HELOC can be low, wheras the interest rate charged on a personal line of credit may not be much less than you'd pay on a credit card. I have a personal LOC with my bank that I had to set up temporarily to provide some extra cash when we bought our house, and I think the interest rate is something like 19%. I only used it once and paid it off in a couple of weeks; I certainly wouldn't want to rely on it as my emergency fund unless I were sure I could pay it off very quickly from other sources.


PC Financial offers an unsecured LOC for Prime+3. Not cheap, compared to a HELOC, but not excessive. You probably need good credit to qualify.


----------



## Elbyron (Apr 3, 2009)

I am a strong proponent for paying off debt before accumulating savings. I like to look at the bottom line, and do what it takes to come out as far ahead as possible in the end (retirement). However, it is still important that you have access to some liquid funds in case a large sum is needed in a very short timeframe. I'm not talking about losing your job; that can be handled by reducing mortgage payments (if you had previously increased them), getting a temporary crappy job somewhere, or taking out a loan to get through the rough times. I mean like a big medical emergency or severe damage to your home that for some reason wasn't covered by insurance. My safety net is my HELOC, which the banks would have no reason to call since it's secured against my house which has plenty of available equity. And if I were to need to borrow from it, I would quickly pay it back by redirecting the "savings" that I currently apply to the mortgage.

Spidey says you need at least a few thousand to cover expenses (I assume that's referring to various bills and such). While I currently keep around that much in my chequing account, if I had debt on my HELOC I would probably transfer all funds to it and keep the chequing account empty. Bills and other expenses could then be paid directly from the HELOC since it acts just like a chequing account with huge overdraft.


----------



## dogcom (May 23, 2009)

Reading the wording of the poll I would say it would be dumb to put all your money to debt, with no saving or emergency fund in a safe account like a savings account. If you like the risks like putting all your money into gold as an example knowing you could get destroyed, then that is fine. 

Otherwise you are potentially walking a tightrope with no safety net.


----------



## ShowMeTheMoney (Apr 12, 2009)

I think the discussion is coming down to the size of the emergency fund. 6 months of expenses, not gross salary, is what I'm comfortable with. That'll cover most anything for me. If you have a spouse in a different field that can cover the bills, then I can see not needing an emergency fund at all. I don't have a spouse, but I do have a secured lined of credit on the house at prime that'll keep me going longer should my savings run out. 

On the psychological angle, personally I would hate going into debt (even at prime) at a time where I'm dealing with some sort of emergency. Knowing I'm ready for one ahead of time, is worth a few or less percentage points difference between the mortgage and savings account.


----------



## Ben (Apr 3, 2009)

I keep very nearly a year's worth of expenses in savings. A used minivan will be in order in 3 years which will deplete it somewhat. Kids are landing in the recent past and near future, and with mat leaves and wanting to keep some options open should momma want to reduce hours etc. Much easier to have built a cash cushion in the DINK years. Guess I'm a conservative sort. Seems to be working so far though.


----------



## Shayne (Apr 3, 2009)

These polls are always interesting but the problem with them is we are not getting an accurate response due to the "demographics" of the users.

Generally everyone who posts here and keeps up with the financial blogs cares about their financing and handles them well.

I am a big fan of paying down debt before saving, but everyone has their own unique situation. 

If you have $15K in an emergency and are carrying a $15K balance on your credit cards my thoughts are to totally deplete the emergency fund and pay off the credit cards. What if you have an emergency? Use the credit cards. You are no further behind. If you don't suffer an emergency you have saved tons of interest.

Just my two cents.


----------



## ShowMeTheMoney (Apr 12, 2009)

Totally agree with that! But I doubt there are many people out there, even not on these forums, having credit card debt that still manage to have savings and that option to pay off the CC, unfortunately.


----------



## crazyjackcsa (Aug 8, 2010)

Every situtation is different, with varying levels of risk tolerance. One thing that has only been touched on is the financial knowledge.

I took the OP question from the angle of somebody with very little knowledge, trying to work thier way out of a bad situation. In that case, it's hard to recommend using a HELOC or credit card as an emergency fund, as that's what likely got themselves into trouble.

Also income and family life play quite a role. If I was a DINK family with high wages, I'd be more likely to borrow to invest, or use a credit card for emergencies. As I'm actually in a family with a gross income under 60k with zero job security and two small kids, conservative is the name of the game.

We have a full year's expenses sitting in cash in the bank just in case we both lose our jobs at the same time. 

We only have the mortgage, and we already have a 9 year plan to pay that off, so I'm happy to let it sit making no intrest, "just in case"


----------



## hystat (Jun 18, 2010)

I put every nickle towards debt. I keep $1K in my chequing account so I don't get hit with account fees. 
My HELOC is my emergency fund.


----------



## dogcom (May 23, 2009)

I would think that hystat will do well paying down debt , but if the money stops and the bank pulls the HELOC for some reason then your done. Having savings for emergency gives you that last source of secure money to keep you going when all else fails.

Think how much of a shame it would be to lose a great asset like your house after you have paid a lot of it off because you had run into short term money problems.


----------



## hystat (Jun 18, 2010)

dogcom said:


> if the money stops and the bank pulls the HELOC for some reason then your done.


that's not a situation I could ever be in, but I guess that's what another poster meant about these polls being too general.


----------



## dogcom (May 23, 2009)

Hystat your situation could be different, but in general never put yourself in a corner, lose control or put yourself in a desperate situation that causes you to dump your assets at any price.


----------



## hystat (Jun 18, 2010)

maybe there's a scenario I haven't thought of, but I seem to be getting a lot of solicitation through the media, online and mail from institutions wanting to lend me money.
Isn't that how they make money in part?
Are the banks getting out of that business?

I can't follow the logic. In fact, CIBC just paid for a home appraisal in the spring so they could UP the HELOC limit (their idea- not mine).... why would they now want to lower it to zero?


----------



## mrbizi (Dec 19, 2009)

not to hijack the thread, but has anyone here or know of someone who actually had their HELOC cancelled/called in or reduced by their lending institution at the most inopportune time e.g. period of unemployment?

I have 6 months worth of living expenses stashed away in a money market fund in TFSA accounts, but sometimes feel tempted to use it to pay down my HELOC (aside from my mortgage and HELOC I have no other debt).


----------



## dogcom (May 23, 2009)

I think it is important to check the possibility of these things happening when talking about no safety net of an emergency fund. Here is one example I found http://www.mortgageloan.com/heloc-cancellation-are-you-at-risk-2439 I would think that stuff like a HELOC cancellation would probably occur at the worst possible time because that is also when people will be at the most risk to the lender.

So yes lenders are in it to make money but at the same time they must protect their money like you would if you buy bonds or whatever.


----------



## hystat (Jun 18, 2010)

If they cancel a HELOC, why wouldn't I just go get a conventional mortgage? Or an unsecured line.

I just can't understand why I would want to pay interest on money so it can sit in my chequing account. 

I also can't fathom an emergency for which I would need money.

Illness? I have disability ins., and live in a country with health care.

Maybe if someone lives "on the edge" and figures they might need bail or legal counsel in a serious way someday soon... not my M.O.


----------



## dilbert789 (Apr 20, 2010)

hystat said:


> If they cancel a HELOC, why wouldn't I just go get a conventional mortgage? Or an unsecured line.
> 
> I just can't understand why I would want to pay interest on money so it can sit in my chequing account.
> 
> ...


I think the idea is that if times are bad enough that they call your mortgage or LOC that you were planning on using to cover you through the rough times, your probably not going to be able to get another loan or LOC easily. That's where the risk of the 'no savings' comes into play. 

When I made the poll I should have been more specific in exactly what I had meant. I lean towards the no savings method as we have debt other than our mortgage currently. This doesn't mean that my checking account has $0 in it though. I keep probably around $1k in the checking account to cover day to day expenses and to cover any normal for-seen bills(heat, hydro, insurance...). But other than that, every savings account has $0 in it. We currently have about 20k of room on LOC's and another 20k on CC's if it ever came to that. Also family as a last resort.


----------



## the-royal-mail (Dec 11, 2009)

dilbert makes a valuable point about LOC recalls. A friend of mine lost his LOC the moment the bank found out he was going through a divorce. This is why people need to have their own cash savings in case of adversity. Don't rely on credit to save you.


----------

