Thanks for stopping by Apathy Ends! Today I want to talk about how financial decisions are made, the factors that go into them and share our personal strategy.
Two main factors that weigh heavily in personal finance decisions, Math, and Emotion. They can manifest themselves in different ways, and often have competing priorities or goals.
Mrs. Math: “This is a math problem, bust out your calculator and pick whichever option yields the best return or reduces interest costs”
Mr. Emotion: “How does this situation make you feel? What will make you feel more secure or motivated?”
Math Vs Emotion: Real World Example
The logical side of me turns everything into a math problem. How much will I save in interest vs what would this money generate in returns every X number of years if invested.
While I trust math and think it should weigh heavily in financial decision-making, your emotions or emotional relationship with money is a huge factor in the decision-making process.
A Recent example from one of my close friends that doesn’t know I run this site:
“We are thinking about buying a new house next year, but need to get rid of some of our other debt first. We still owe about $55,000 on our student loans and about $10,000 on the car. “
My first reaction was, this is a math problem. Take the interest rates and start plugging them into a loan calculator and figure out which one will save you the most in the long run. Then he said…..
“Our car loan is only 1.29% and our student loans are at 6.2%, but I feel like paying off $55,000 is an unattainable goal”
Personally, I think there is a pretty clear answer on where my friend should put any extra cash, I don’t even need a calculator to say he would save thousands paying down the Student Loans faster. At the same time, you can’t discount the emotional side of this argument. If the quick win gives him the confidence to tackle student loan debt ferociously, maybe the short-term negative swing is worth it.
6.2% Student Loan Interest Rate…..I was in the same boat before refinancing with SoFi
Financial Decision Making – Math vs Emotions
What factors should we consider when making financial decisions?
The below list of factors are what we use to make financial decisions, they can overlap and intertwine depending on the situation.
Very straight forward for debt repayment, the higher the interest the higher the cost. Purely used on the math side of financial decision making.
Cash Flow Needs
Cash flow needs are a factor when deciding to pay off debt over investing, or what debts should be paid off first. Most of the time I recommend rolling positive cash flow from debt payoff into an investment account. If you are used to living without that money already, you might as well put it to work for you.
If you have a life changing event (Baby anyone?) that will increase your expenses, or you are already saving adequately for retirement you may want/need to spend the extra cash every month.
Time until retirement
Time is a major financial decision-making factor. Compound interest can work wonders with enough time (see my Would you be a millionaire if you stopped investing today post for some proof).
Another way time factors in is reducing costs as you approach retirement. If you have built a substantial nest egg, it might be wise to start paying down your mortgage. Lower expenses equals a greater chance of retirement success.
What can you realistically expect to earn on an investment and what is your timeline for keeping the money. I use a compound interest calculator to compare the expected long-term return vs the money saved from increased debt payment.
Generally the less risk, the less return, and the longer it takes your money to double. The flip side – if your expected return is too high it might incorrectly sway your decision towards a risky investment.
Progress, quick wins, security, or seeing growth in investment portfolios can all be motivating factors and weigh into your Financial Decisions. When we started our journey, I didn’t give motivation the value it deserved. Seeing our progress and reading other people’s success stories pushed us to do more.
Motivation ties directly into the common debt pay-off strategies: Debt Snowball or Debt Avalanche
Debt Snowball – Pay off the smallest balances first, then roll that payment into the next smallest balance. If you are motivated by quick wins, you would naturally go toward the Snowball method
Debt Avalanche – Attack the accounts with the highest interest rates first and work top down. If you liked seeing the actual dollar savings the Avalanche method would motivate.
What is your emotional response to the thought of losing money? Can you stand the thought of seeing a losing quarter when you open your 401K statement?
Investment risk can elicit powerful emotional responses that affect your financial decisions. Some people are willing to take excessive risk (to a fault). Some need to toughen up and accept that Investment Risk is More Than Losing Money and they can’t afford to skip investing.
What if I lean heavily one way or another?
It’s perfectly normal to lean heavily one way or another, I definitely lean towards the math side of the scale right now. It’s why we have a 10-1 investing vs extra debt payoff ratio. As time goes on and we build a substantial nest egg, my tune might change to reducing our expenses by paying off our mortgage.
There are a lot of personal finance bloggers that lean towards 100% debt payoff vs investing (including primary residence). There are bloggers that keep a substantial amount of money in cash for security and capital protection. None of these are wrong, but I think you should at least make informed decisions using all the tools and criteria available to you.
When making a financial decision take all factors into account, I have listed out the comparisons we go through before making financial decisions below:
Factors and Comparisons:
- Know the opportunity cost of debt payoff vs realistic investing returns.
- Know the opportunity cost of investing in a CD vs Bonds vs Stocks
- Understand investment risk (especially short-term investing) and how that risk level affects your decision
- Understand how time impacts your expected investment returns
- Look at your past decisions and figure out what motivates you
- Are you expecting major changes in your expenses
For people that are married or make their financial decisions with a partner, remember that they might be motivated or inclined to use different factors. Mrs. AE leans towards the emotional side, especially when it comes to debt payoff. It took awhile to compromise on where we switch from investing to debt repayment. We default to investing at a higher rate but put financial windfalls towards our debt. Use Math and Emotions to make your Financial Decisions together!
Do you lean towards using Math or Emotions when making Financial Decisions?