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The Best Decision vs. The Financially Smart One

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The financially smart decision isn’t always the right one. When I say this, it usually irritates engineers and economists, who love to believe that we all behave rationally. This just makes me even more gleeful, resulting in an upward spiral of doom. Seriously, I love messing with them.

Anyway, my friend told me an interesting story the other day: After graduating, he had about $12,000 of debt from college loans at a ~4% interest rate. He also had a good job and about $15,000 lying around in a money-market account. Now, because his interest rate was so low, technically the financially smart decision would be to invest that $15k and pay the minimum monthly payments on his loan, profiting off of the difference. In other words, assuming he could get a 10% return on his investment, he would make approximately 6% (i.e., 10%-6%) because his loan’s interest rate is lower than the returns he could theoretically get. Yes, I’m leaving out trading fees/taxes/risk/etc, but you get the point. If he went by the book, he should have invested the money and paid off his debt slowly.

But he didn’t do that. He paid the loan off entirely, all at once, despite my loud protests. Why? Because he hates debt. Like really, really hates it.

When I first heard this, I wanted to hit him with a bat, attach him to a long string, push him out of a plane, and then instruct the pilot do to 25 or 50 lazy loops in the sky. I would also make him wear one of those striped propeller hats, just for fun.

But I realized that he made the best decision for himself, even though it wasn’t necessarily the financially smart decision. Even though he technically should have made monthly payments, he hates having any debt and it would have been intolerable for him. (You know how certain people act badly with debt? They forget to pay it off, it makes them really uncomfortable, etc? That’s him.) His move isn’t the right move for most people, but there’s a larger point behind it: There are some things with money–e.g., having debt, lending to friends, having money sitting in our checking account–that drive us so crazy that we start doing weird things. The question is, can we recognize it? And then what do we do? My friend was smart to recognize that having debt drove him crazy, and he did something about it. It wasn’t the textbook move, but it was probably the right one.

Another friend of mine has had to borrow small amounts of money from her family a couple times in the last few years. Technically, when she paid it back, she should have calculated the time/interest rate and paid back the precise amount. Instead, she just paid back the amount plus $100. There’s more to life than interest rates.

“But Ramit,” anal calculation-loving dorks might point out, “you always talk about budgeting and making smart financial decisions. If she only owed $15 interest and she paid $100, she made a mistake. And now you’re writing an article to try to justify what she did!”

printf(“get a life dude”);

The truth is that your money decisions should (1) get you closer to being Rich and (2) make you feel increasingly confident and comfortable about what you’re doing. The minute your financial infrastructure starts making you feel oppressed is the minute you start ignoring it. No, don’t be stupid and use this as an excuse to do dumb things (“It makes me comfortable to buy this new $2000 flatscreen TV, so I’ll do it! Thanks Ramit!!!”). But if it makes you feel really happy, go ahead and hide $20 in your coat pocket for next season. If having debt absolutely, truly makes you go crazy and do stupid things, you don’t always have to go by the book.

Think big picture. What could you do today to make you less hesitant about managing your money for the long term?

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  1. A well known example of the best financial decision not being the best decision necessarily–The decision of former USC and now Arizona Cardinals quarterback Matt Leinart staying an extra year in school. In short he passed up being a top 5 pick last year to go back to school and this year his draft status sunk as he he was chosen 10th. This amounted to a loss of millions in contract money as well as the millions he could have made over the last year by skipping his senior year. Hell, he could have even gotten injured this year and had no NFL career. Some people thought he was an idiot. But consider that he probably lived like a king at USC. He was loving it there and wanted to hold on to that for as long as he could. Besides, most people’s lives don’t get any better than when they are in college. So yeah I’d say his decision to stay, enjoy being a king and get a degree was the right one even though it wasn’t according to “the numbers”. Besides, his family wasn’t starving in the projects by any means.

  2. Great article, finally someone to back up the way I do things! I’ve got cousins who also graduated recently with me they are all about spending the next 3 years paying off debts. They get pretty confused when I tell them I still pay minimum on my loans. I invest the rest and get a lot more than the interest rate in returns.

  3. I think the term you’re looking for is “financially peaceful.” Your friend paid off his debt because he knew that the peace of mind he’d gain was worth the (small) amount money he would make off the spread.

  4. Great post! I’ve been looking at my financial picture and wondering if I’m wasting time by not getting into investing now and just focusing on debt. Then I think about every little money decision I could make to save or make money and it overwhelms me and makes we want to go shopping! Obviously, that wouldn’t be the smart financial move. So, for right now, I just want to get rid of the credit card debt. I’ll go from there.

  5. This is the same thinking behind the Debt Snowball method of debt reduction (as popularized by Dave Ramsey). It doesn’t make the most financial sense to pay off your lowest-balance debts first instead of your highest-interest rate debts, but sometimes that is the Best Decision. I have friends who just don’t understand. “But you’re wasting money,” they tell me. “You pay much more in interest this way.”

    I understand that I’m paying more in interest using this approach. What they don’t understand is that using the high-interest rate first method, I was never getting my debts paid off at all. There were psychological issues. For me, and for many others, the Debt Snowball method is a perfect example of making the Best Decision…

  6. Ramit, I hate debt that much, too.

    I like your advice — but be careful — I’m pretty sure I could take you. You might be the one in the propeller hat when I get finished. 🙂

  7. Ramit,
    I believe what you are talking about can be classified as bounded rationality.

  8. I know where your friend is coming from.

    It took me about a decade of constant returns to build enough confidence for investment borrowing.

    And even now debt backed investments account for only about 5% of my portfolio.

    Financially foolish.
    But it lets me sleep at night.

  9. Frank is right regarding bounded rationality. There is no conflict between the best decision and the financially smart decision. What you are ignoring is the utility curve.

    As long as you are aware of what you are giving up, then making a decision to spend now, rather than save later, will make good financial sense.

    Your friend who decided to pay off the debt instead of investing with leverage was merely more risk averse than you. He made the proper financial decision.

  10. Not to be nitpicky, but economists usually use utility rather than dollars when modeling individual behavior. If a person is highly averse to debt then it would still be considered economically rational.