How would you like to earn a guaranteed return of 17.03%?
Of course you would. With long-term expected returns for both bonds and equities only barely or modestly positive, who wouldn’t jump at the prospect of such a high return—especially when it’s guaranteed?
Even more incredibly, you already are aware of how to earn this return. It’s simple, straightforward and right under our noses—and yet way too often overlooked or ignored.
I am referring to the simple step of paying down your credit card debt. According to the latest estimates from website MagnifyMoney.com, the total amount of such debt that is not paid off each month—known as revolving credit—currently amounts to nearly $700 billion. The 17.03% rate referenced at the beginning of this column is the average credit card interest rate according to the latest survey.
Though the data don’t show how much credit card debt retirees and soon-to-be-retirees carry from month to month, we know that 38% of all households have revolving credit card debt. Furthermore, we do know that total debt among retirees and soon-to-be-retirees has been growing. As I detailed in a Retirement Weekly column last December, the median debt-to-income ratio for those in their final years before retirement (aged 62 to 66) has grown from 0.01 in 1968 to 0.26 today.
So chances are that you carry credit card debt from month to month. If you instead paid off your balance each month, your interest costs would be reduced by whatever is the annual percentage rate on the card; that rate is what currently is north of 17%.
The catch, if there is one, is that you are limited in this investment by the amount of your credit card debt. By why would you not take advantage of the opportunity, however limited? It’s as though you saw a $100 bill on the sidewalk and chose to ignore it and walk on by.
A similar cost-benefit analysis applies to other forms of debt, even though in such cases the interest cost is often far less than on credit cards. The average mortgage rate currently on a 30-year fixed mortgage, for example, is around 4.3% which, on an after tax basis and depending on your tax bracket, works out to about 3.4%. Though many of you no doubt believe that you can do better than 3.4% annualized in your investments, how confident are you?
Consider, for example, the seven-year forecasts from GMO, the Boston-based money management firm co-founded by Jeremy Grantham. Though their forecasts are not infallible, the firm strikes me as one of the more serious and thoughtful on Wall Street. It should at least give you pause that the firm is projecting than the S&P 500 SPX, +0.03% over the next seven years will lag inflation by 4.9% annualized. U.S. bonds aren’t projected to do much better with an inflation-adjusted total return of minus 0.2%. If the firm’s projections are even moderately close to being accurate, paying off a mortgage begins to look increasingly attractive.
Many retirees recognize the virtue of debt reduction, of course, so this column may come across as preaching to the converted. Where they come up short is in failing to live up to what they already know to be good financial management.
Consider an academic study that recently began being circulated by the National Bureau of Economic Research: “Sticking to your Plan: The Role of Present Bias for Credit Card Paydown,” by finance professors Theresa Kuchler of New York University and Michaela Pagel of Columbia Business School. They found that even among individuals who signed up with a financial management service to work out a debt reduction plan, actual debt repayment typically falls far short of what is planned.
As you can see from the accompanying chart, in fact, the typical individual doesn’t even come close. On average over the subsequent three months following the initiation of a debt reduction plan, the average individual reduces his credit card debt by just 16 cents for every dollar that he had committed himself to. Over a six-month horizon the actual debt reduction is just 12 cents out of every dollar that was committed.
And this is just the average. The professors founds that, in more than 25% of the cases, individuals actually had more debt at the end of six months than at the beginning, notwithstanding ambitious commitments to reduce their debt.
One of the major factors in why individuals so often came up short, according to the professors, is a behavioral tendency known as “present bias”—which means individuals are “overly impatient in the short run relative to their long-run preferences.” To put that another way, they will choose immediate gratification (going out to eat at an expensive restaurant, for example) over the longer-run benefit of having a smaller debt load.
There is hope, however. The professors point out that mere awareness of present bias can have a significant positive impact in coaxing investors to live up to their debt-reduction commitments.
There’s no “one size fits all” solution, of course. The key thing for each of us individually is to engage in honest self-reflection about (a) how far short we have fallen in living up to the commitments we previously have made about funding our retirements, and (b) what behavior modifications would help us do better.
One possibility that the professors suggest would help us overcome present bias “would be to allow consumers to select a certain amount to be deducted from their regular paycheck to be put towards debt repayment, and to make it costly or complicated to change this selection.”
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email email@example.com.