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The Best Decision vs. The Financially Smart One

Ramit Sethi

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. avatar

    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. avatar

    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. avatar
    Jim Kane

    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. avatar
    Debt Hater

    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. avatar
    J.D. @ Get Rich Slowly

    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. avatar
    Dan Esparza

    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. avatar

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

  8. avatar

    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. avatar

    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. avatar

    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.

  11. avatar

    I think the point here is to make a good financial decision and a good personal decision, not the best financial decision that leaves you with night terrors and nail biting.

    No one’s mentioned doing something STUPID. No one should do stupid things. 🙂

  12. avatar

    Putting money into the stock market for less than five years rather than paying off debt is actually not the “best” financial decision. You would be taking on significnat market risk in doing so. Hindsight tells us that the market would have retuned 10% for your friend, but at the time, for all you knew, it could have returned -20%.

  13. avatar

    I think your friend was right. One money advisor I always listen to is Suze Orman. She always says, “people first, money second”. By paying off that debt your friend was removing a dark cloud from his life. That’s one less worry he has now.

  14. avatar

    Your friend’s decision is right. I myself would have paid the minimum and invested the rest but it really depends on the person. It’s one thing he doesn’t have to think about too and concentrate more on something else that might be his liking. I myself pay a good amount for workers to take care of my backyard because I don’t want my weekends eaten up by that kind of work, I already work more than 10 hrs a day and educating myself career/future wise, which I believe is more important than saving a few hundred dollars a month and eat up hours of my rest period(weekends). In retrospect a cousin of mine fixes up his backyard personally because it’s relaxing and fun for him.

  15. avatar

    As others have already said your friend is being economically rational if paying off the debt first maximizes their utility. Most people don’t seem to be happy with leveraged risky investments (not me though)… the interest on the debt is certain the return on investment is risky. So someone who is risk-averse will pay down the debt first.

  16. avatar

    Great post. I actually picked up a similar tidbit from Suze Orman a couple years ago: it’s important that you feel good about your finances. Sometimes the “smartest” financial decision doesn’t feel right. You’ll be happier in the long run if you feel more comfortable with what you’re doing, even if it might be a little “wrong” from a purely economic POV.

    In the last year, I paid off my HELOC and my car payment, because I wanted to be debt-free. The conventional wisdom said that I should have established an emergency fund instead, but the HELOC is virtually as liquid as a cash savings account would be, and I feel a lot more secure with two less bills every month.

  17. avatar
    Hermann Klinke

    Hi Ramit, I am with your friend here. There are only 2 things that can fuck up your life and take your freedom away: Debt and being criminal. Having debt is an intoleratable risk for me. I would just hate to have any.

  18. avatar

    This is a great post. I understood exactly what was meant by the best decision vs. textbook decision. Sometimes, if we are properly self-aware, it is best that we do something contrary to the textbook’s advice if only because we know that, in the long run, it will actually get us to our goal more directly. Had it been me, for example, the money I would have “made” off the difference I probably would have gone off and spent many times over… So I would have been best off paying off that debt as well. For shame, I know. Ah well. Thanks.

  19. avatar
    Ross Hill

    Your right there, you’ve gotta be able to sleep at night with what you are doing.

  20. avatar

    I also am paying off $13000 in student loans instead of investing. Much to my financial advisor’s chagrin, I feel that debtlessness will be a wonderful state to return to. One interesting way to think about it is this. If I choose to quit my day job and do a startup, my monthly expenses dropped by $150 a month since I don’t have payments to make. Having an easily sustainable minimum monthly expense has some monetary value, especially if I do something profitable with the time that I can free up. 😀

  21. avatar

    (I discovered your site today, very interesting!)

    In general paying off the 4% loan doesn’t result in loss. so, it’s not the worst decission.

    Anyway, TypeKey says:
    “The site you’re trying to comment on has not signed up for this feature. Please inform the site owner.”

  22. avatar

    Dude, there is a difference between good debt and bad debt. Any debt that a person takes to make financially sound decisions which would increase his net worth is good debt. The opposite is true for bad debt.
    Well, in the end it is a personal choice and i agree with you about doing things you are personal with.

  23. avatar

    I have a really specific question for you —

    I currently have $4500 in outstanding debt on a credit card. The card is only at an 8.9% APR, so I’m lucky that the rate is significantly lower than most college students. I try to pay a over the minimum every month (the min is currently at about $150 — and I’m paying about $200). As I’m going back into classes for the fall I don’t have a steady stream of income. I have enough money in my bank account to continue making payments, however, so I’m not worried about that.

    What I am curious about your opinion on is this: I’m applying for another loan for school this year should I calculate in the extra $4500, pay off the credit card, and then deal with that balance along with the (significant) loans I will be paying off after I graduate when I will have a steady stream of income?

    Thanks! & Great blog

  24. avatar

    why was that a bad financial decision? he paid the debt entirely, without have interest rate for a year or whatsoever. now, he works and uses a part of his monthly income to invest. good move.

  25. avatar

    I would say invest the money in make more money and pay off low interest loans later, but make sure you pay of the minimum amount right on time.
    Few loans like education loans and home mortgage loans should never be closed very quickly, since we might never get credit at such low interest.
    Its a bit of risk, but it suits me.

  26. avatar
    Patrick Bateman

    I agree – ultimately if you are not comfortable holding debt then pay it off! Investment decisions are sometimes made to feel good that your future is on the right track.

    See my article on “The Investment Waterfall” for more info. My website is Thanks!

  27. avatar

    Actually, that was not the wrong financial decision. The wrong financial decision is to invest that money and project a 10% return on investment in the future. Unless you have a crystal ball, there is no way of knowing whether that’s realistic or not. What has been the return of the stock market for the past 10 years? About 4%.

    Most likely, your friend would have failed to achieve that lofty objective because he would have needed the money and had to liquidate his “long-term” investments at a loss.

    A bird in the hand is worth two in the bush. 4% after taxes is a sure thing and hard to beat.

  28. avatar

    I thought like Ramit did and didn’t pay off my debt when I had some cash, and invested in the stock market and made some money. Now, I am not student loan-free or crazy rich because I invested. I am never gonna be comfortably rich, as an individual investor, by investing in stock market with $15k unless I am an investment genius.

    It was a choice – I wanted to see if I could make money investing – and now I have a better idea of how I invest. I know which sector/stock I like, I know what types of stocks / investments to avoid, I know when not to invest (which is equally important), I know when to cash out and realize return.

    I know that I get large sums of money only so many times out of one year (usually once).
    If I am saving every month to build up that $15k, that’s $1,250/month, and I know that I can’t set aside that kind of money every month for 12 months at my salary/spending. I’d rather use that $15k to invest now, than to wait for 1 year for $15k to build up, because investing $15k and $1000 is a totally different story.

    I was thinking in terms of opportunity cost and time value of money.

    I also knew that student loan rate was cheaper than what I could take out from bank as a regular loan, where interest rate is significantly higher than the student loan rate.

    I knew that I had only one student loan debt interest rate, so took the bonus cash amount to my advantage.