Tuesday, May 17, 2011

Paying Down v. Holding Onto

This is such an awesome (and not at all ignorant) question!! From the post yesterday, Elizabeth asks:

OK, but I have an ignorant budget question. Sticking with your scenario of spending only $200 of the $650 grocery budget example...

Why, instead of holding the unspent grocery for later - even though we know there will be a later - do you not dump that onto debt? Is it because when that killer month comes you don't have to add back to the debt? But, even if that's the case, doesn't it save you some interest? Is it just too complicated this way?

It’s a perfectly logical thing to do, putting any ‘extra’ cash from the household budget into debt reduction. You do usually save at least some interest, although the actual savings can be less than you’d think – especially if you’re going to turn right around and charge things back on, and your issuer is using the ‘average daily balance’ method to compute your interest charges. The longer you go between ‘extra payment’ and ‘extra charges,’ the better off you are…but, well.

Let’s say you’ve got $5,000 sitting at 15.99% on a card with average daily balance interest calculation (which is the majority of credit cards – check your statement or {gulp!} disclosure agreement if you’re not sure if that’s how your card rolls), and your normal payment is $250. This month, you add that extra $450 from the grocery budget to your payment.

Normally, your average daily balance after the $250 payment was applied on day 3 of the 30-day cycle would lead to a monthly finance charge of (roughly) $63.52. If you make that extra $450 payment and charge nothing new, you end up with about $57.92 – saving yourself $5.60 in interest.

But, if on Day 17 of the cycle you put that $450 back on the card to buy something you now can’t afford because you made that extra payment instead, your average balance at the end of the full thirty days earns you a $61.32 interest charge – you’re down to only $2.20 saved in interest.

And if it happens earlier in the month, even just a week earlier, say on day 10, your interest savings drops to only $0.80.

On the one hand, it’s still a savings…on the other, it would be (for me, anyway) a bit of an emotional rollercoaster. Day 3 when I make the payment I’m all, “Yay me! I rock! I’m paying an extra $450 to this, yippeeeeee!”…and then, a week or two later, I’m pulling that card out of my wallet and thinking, “…dammit, I suck…I shoulda known this was gonna happen…meh…” {begin downward spiral of self-loathing, buy a few extra things since a) I’m a lost cause anyway and furthermore b) a little pick-me-up is probably needed around now and plus c) not like it matters since we’re all doomed anyway, etc. etc. etc.}

But even if I wanted to do that anyway…I personally can’t. The accounts I’m paying down at this point aren’t available to me in that way, so if I send them money I can’t turn around later and say, “Wait, actually, I need that back!” and charge something new to them.

Meanwhile in other news, I’ve sharply limited my ready access to new debt. I can’t just run out and charge up things if I find myself short – I’ll just have to let whatever it is go if the money isn’t there for it. Which I find to be less awful than ending up with a whack of new debt I didn’t want, but which is still darned annoying when I had known this day was coming, but instead of being smart and keeping the money I knew I needed, I’d gone ahead and blown it all on Something Else – because it was there, and the Something Else was there, and oh…what the heck!

That’s why this has suddenly become a more difficult challenge for me than it used to be; back in the day, I could smooth out those hills and valleys quite a bit by using the grace period on Old Reliable. Now that I’ve switched over to a card with a lesser limit and gotten rid of all the “extra” cards I wasn’t using, I’ve been discovering just how hard I used to lean on that available credit.

Which of course was what got us into the first round of trouble, you know? I could float things, so I did; then I could finance things, so I did; then I could make the payments work…on increasingly tight margins…so I did. Because whatever-all I was buying seemed so necessary, so important, so not-optional.

Hindsight is so much clearer than day to day vision. When I look back, what we got in exchange for all those new debts was so not worth the price we ended up paying, especially when I throw in the stress of watching the security we fought so hard to get crumble like a dried-out sandcastle around me.

I remind myself of that whenever I get frustrated with my new limits, when I have to let something I want pass me by because I wasn’t able to get the cash together for it, when some stupendously awesome deal pops up on my radar and ooooooooh, gawd, I want to grab this, the price per unit is just crazy good…but…it’s a $150 minimum purchase, and I only have $100…it frustrates me no end. It makes me feel poor. It makes me feel like I’m not doing it right, somehow.

But at the same time, I know I am doing it right. I’m not going to let us go there again, not without having to work at it a little harder.

So, for me…I need to hold onto money I know I’m going to need, and keep it available to me when the time finally comes to part with it.

Even if there's a really good sale, or I find myself tempted to add just that little bit more to the debt repayment.

It just won't be worth it, in the end.


eclair said...

I find having that bit of 'spare' cash (garnered from saving my budgeted money) stashed away helps me to sleep at night. I have an emergency fund for repairs and unexpected purchases (like the old dishwasher just blowing up and a flat tyre all in one month!) means that I don't have to turn to the credit cards or undo all the paying-off-the-loans hard work. I could, of course, delay buying a new dishwasher until I've saved up for it - from the budgeted housekeeping money - but by tucking the 'spare' money aside for a while I have it ready when I need it. The peace of mind has its own payoff which is equal to the interest on the loan!

Colleen Mole said...

Thanks for the insight! (I'm still highly frustrated with myself as I sit here eating my drive-thru lunch, but meh, there is always tomorrow!)

Rena said...

really helpful. Thank you for breaking this down. I had no idea how little I was actually saving attacking the debt with "extra" money. I think I'd rather sock that money away in savings so I don't need to use a card if the car breaks down.

Kaviare said...

I got rid of all my credit cards when I bought my house, about a year ago. I can redraw my mortgage myself, at any time, and that's my emergency fund. BUT. I have to have strict rules about what an emergency is, and how much I can get out at a time. Last christmas I dipped in once, and then there was an emergency vet visit. While I never took out more than the extra I'd been putting in for that purpose, it came close. I started to think of my mortgage as something I could dip into.

It's still my emergency fund, but I'm also slowly building up a savings/bills account. I'm aiming to have $500-1k in there. It'll be earning about half as much interest as it would be saving on my mortgage. But it's not as risky, for me, personally. I have to know my own spending/saving style and sometimes that means not being able to save that bit extra in interest. That loss means a safety gained, makes it less likely I'll slip, and incentivises me, personally, in useful ways.