An Against the Grain Approach to Prioritizing Your Savings

Frequent readers of personal finance blogs are familiar with the importance of getting out of debt and staying out of debt. The reasons for avoiding debt are both economic and emotional, and they are so well known that we can call “staying out of debt” Personal Finance Truism #1.  Let’s briefly review the reasons behind Personal Finance Truism #1:

• First, the economic: The interest rate on debt is crushing.  If you pay only the minimum on your credit cards, the interest rate continually compounds.  Buy an item for $100 and you ultimately pay two or three times that amount including the interest cost.

• Second, the emotional: Scientific studies have documented the strain that being in debt puts a strain on people’s lives.  For example, a paper in the American Journal of Health Promotion in 2008 showed that college students with credit card debt were more likely than their peers to be overweight or obese, watch too much television, eat too much fast food, feel dissatisfied with their bodies, and engage in binge drinking, substance abuse, and violence.

Despite these evils, debt pervades American society.  In 2007, immediately before the onset of the financial crisis that still plagues us, 46% of American families carried a credit card balance.  Interestingly, middle and upper middle class families had an even higher ratio: of families between the 40^th and 80^th income percentiles, 56% carried a credit card balance.

If debt is so destructive, both economically and emotionally, why do people go into debt? There are many possible answers, but they all boil down to this: people feel the need to purchase something that they cannot pay for with available cash.

To avoid this condition, people need to think about their savings goals in a manner that may seem counter-intuitive, and which certainly runs against the grain of much of the advice given by personal finance experts.  That is, they must prioritize saving for their short-term needs over saving for their long-term needs.

This may seem sacrilegious.  Just like we have been repeatedly told of the evils of debt, we have been told repeatedly about the virtues of saving for long term goals like retirement.  In fact, we can call “Saving for Retirement” Personal Finance Truism #2.  After all, we are familiar with the reasons that substantial retirement saving will be necessary for most of us:

• We are all living longer and will thus have a longer retirement to support.
• Social Security faces severe funding deficits and will almost certainly need to reduce the amount of benefits each person receives.

Here is the problem: for many people, Personal Finance Truism #1: Stay Out of Debt, conflicts with Personal Finance Truism #2: Save for Retirement. If someone can manage his budget effectively enough to do both, fantastic.  But many people cannot: they cannot reduce their spending enough to do both, so they must choose between staying out of debt or saving for retirement.

In reality, people don’t often make a conscious choice to choose retirement saving over being debt-free.  They may think, or hope, they can do both, but at some point the available cash just isn’t there.  Unexpected or infrequent large expenditures wipe out bank accounts, forcing people to use their credit cards.

This dynamic explains why there are so many people who are in debt even though they have substantial assets in savings or retirement accounts.  Remember the statistic that 56% of middle and upper middle income American families have credit card debt?  Well, nearly 70% of those families also have stock holdings.  Putting money in retirement accounts at the same time you have outstanding credit card or consumer debt is a bad idea.  The money in those accounts would create more wealth paying off the credit cards.

To avoid this error, people need to rethink their savings priorities, accumulating capital for short-term spending needs before saving for expenditures in the distant future.

Of course, that does not mean people can permanently avoid saving for long term goals.  The point is that they absolutely need to avoid the dynamic of going into debt, digging themselves out of debt, then falling back into debt and digging themselves out again, all while they continue to add to their retirement savings accounts.  The interest they pay during the periods of indebtedness accumulates faster than the retirement savings accounts grow.

Following the pattern of moving in and out of debt not only subjects people to all the emotional stresses of debt discussed above, it will leave them less wealthy in the end, with less money to support their retirement than had they stayed out of debt and been able to later devote the money otherwise spent paying interest to contributing toward their retirement fund.

Do you recognize this pattern in your own life? Have their been times that you have ignored saving for short-term needs for too long, forcing you to take on debt you might have otherwise avoided?

Doug Warshauer is the author of the book If I’m So Smart…Where Did All My Money Go? He blogs in personal finance issues at www.dougwarshauer.com.