Think like Mr. Spock but act like Captain Kirk

Search Smart Spending:

In today's world of rising costs and shrinking paychecks, consumers need all the help they can get. Smart Spending combines the best money-saving tips from around the MSN Money site and the rest of the Web.

Donna Freedman is a student, freelance writer, baby sitter and handywoman in Washington state. Learn more about her in this video. She also moderates a forum for savings tips on the MSN Money Smart Spending message board.

Posted Jan 09 2008, 09:00 AM by Karen Datko

Filed under: Investing, Debt, Saving, The Dough Roller

Rating:

This post comes from partner blog The Dough Roller.

Sound personal-finance and investing decisions flow from two things -- knowing the numbers and knowing ourselves.

If we know the numbers but not ourselves, our decisions will look good on a spreadsheet, until our real-world decisions deviate from the plan. If we know ourselves but not the numbers, our decisions may feel right, but will lead us down the wrong path.

What's the answer? We need to think like Mr. Spock, but act like Captain Kirk. Allow me to explain.

Mr. Spock was a human computer (at least when he wasn't mating). He took in data, processed it and spat out an answer. He could calculate the odds of the outcome of an action to multiple decimal places. Any decision that deviated from his statistical analysis was, in a word, illogical.

And that brings us to Captain Kirk. Kirk was one big ball of energy, emotion and passion. He made decisions based on instinct and gut feeling. He listened to Mr. Spock, but he didn't always follow his advice. He was the yang; Mr. Spock was the yin.

That brings us back to personal finance and investing. To make sound money decisions, we need to know the hard, cold numbers like Mr. Spock, and we need to know our own emotions and human nature like Captain Kirk. To show you what I mean, let's apply this way of thinking to some real-life money decisions many of us have faced or will face.

Buying vs. renting a home

There's been a lot of discussion lately about whether it is best to buy or rent. A few years ago, homebuyers were king of the hill. Today, as the market declines, renters are grinning like Cheshire cats. When the market eventually improves, homeowners will be back on top, and the cycle will repeat itself. So how should the decision to rent or buy be made?

The numbers: Crunching the numbers on renting vs. buying is not an exact science. In addition to considering the interest rate, maintenance costs, insurance and tax consequences, you have to make a best guess at future rent increases and home prices. Fortunately, online calculators make this analysis easier. Here is one of my favorite rent vs. buy calculators. Once you've figured out the numbers, there's still more to consider.

The decision: One significant benefit that renting sometimes offers comes from investing the money you save by avoiding a higher mortgage. If you lack the discipline to invest the difference, however, buying may be the better choice even if the numbers say otherwise. Buying can "force" you to save each month as you pay down the loan and as the value of your home goes up. If the numbers support buying a home, renting could still be the best choice if you would be tempted to use your home equity like an ATM machine. Constantly refinancing and taking money out of the home to finance vacations, cars and other purchases can quickly erode the benefit of buying. This is a perfect example of the importance of knowing ourselves, not just the numbers.

Paying down debt or investing

A reader recently asked me this question: Should he borrow from his home-equity line of credit to invest in the stock market? While you may never choose to borrow money to invest in the market, you may confront a similar question: whether to pay off credit cards and other debts before investing for retirement.

The numbers: Here we need to determine whether we can make more in the stock market than we will pay in interest on the debt. To answer that question, we'll need to make some assumptions about future stock market returns, which is always a dangerous business. We'll also need to consider whether any of the interest on our debt is tax deductible. If it is, we'll need to reduce the interest we'll pay by the tax savings. Once we have made these calculations, we simply compare how much we expected to make on our investments (after tax) with how much interest we'll pay on the debt. If we believe our after-tax investment returns will be higher than the cost of the debt, the numbers tell us to invest the money. If the cost of the debt will be higher than our expected investment returns, the numbers tell us to pay down our debt first (or not borrow to invest in the market in the first place).

The decision: There are many factors beyond just the numbers to consider here. For example, consider whether you are disciplined enough to pay down your debt without borrowing more money. I know some who decided to pay down their debt before investing, but then got caught in the cycle of paying down debt -- borrowing -- paying down debt -- borrowing -- repeat until broke. The result is that they never invest. For some (like our government), the best cure for deficit spending is not to have any available credit. I'm not suggesting, of course, that we max out our credit cards. But for somebody who has trouble controlling spending, waiting until debt is paid off to begin saving may mean that person never saves.

A second important factor to consider is risk. While over the long run stock investments may beat the 4.9% effective rate on a line of credit, the investment comes with more risk. The 4.9% return from paying down your debt is guaranteed. The stock market guarantees nothing. And over the short term, the risks in the stock market are even greater. It's because of this factor that I never borrow to invest in the stock market.

Which debt to pay off first

The numbers: This one seems easy -- pay off the debt with the highest interest rate first. Of course, as with the example above, we'll need to consider taxes if any of our interest is tax deductible. After considering the tax, paying off the debt with the highest interest rate first will retire our debt in the shortest time for the least amount of money. Spock would be proud.

The decision: There are at least two other factors to consider. First, many (like Dave Ramsey) suggest paying off the debt with the lowest balance first, regardless of the interest rate. Why? It will motivate many people because it will allow them to achieve some successes early on in the process of debt reduction. If you pay the highest-interest debt first and it happens to be a large balance, it could take years before your first debt is paid off. Also, paying off a loan frees up additional cash flow, although if it's all going to debt reduction anyway, this factor seems less important.

Second, it's important to consider whether the loan is revolving credit (e.g., credit cards and home-equity lines) or an installment loan (e.g., car or school loans). Why is this important? Two reasons: First, if you are concerned that you'll be tempted to charge more as the balance goes down, it may make sense to focus on installment loans first. You can't run up your car loan after you've paid it down. Second, if you're concerned about having available credit during an emergency, paying off revolving debt may be the best place to start. That's what I do. My main debt is on a home-equity line of credit, and I pay it off rather than my school loan so that I have available credit if I need it. Yes, a cash emergency fund is best. But reality doesn't always cooperate with what's best.

Invest in a traditional or Roth 401(k) or IRA

The numbers: I recently wrote "The ultimate guide to traditional and Roth 401(k) and IRA retirement accounts." A section of the article describes whether it's best to invest in traditional or Roth retirement accounts, and for the numbers, you can check out this traditional vs. Roth 401(k) calculator. The calculation requires an assumption about your tax rates in retirement, although most assumptions favor the Roth over a traditional account. Why? Let's go to the decision.

The decision: Let's assume you max out your 401(k) contribution at $15,500 ($20,500 for those 50 or better). With a traditional 401(k) you'll save the income tax on this contribution up front. Assuming a 30% tax rate, you'll pocket $4,650. With a Roth, you'll pay that tax now, but won't pay tax when you withdraw the funds during retirement. Here's the question: What will you do with the $4,650 you save in taxes if you invest in a traditional 401(k)? If you don't invest it, the Roth is the best choice because it in effect forces you to "invest" it. This is where being honest with ourselves before we make a financial decision can make all the difference.

Personal-finance and investing decisions are not one-size-fits-all. While it is critical to know the numbers before making a decision, we can't live life in a spreadsheet. Understanding our own strengths and weaknesses when it comes to money, and making decisions in light of them, will help us make the right financial decisions for ourselves.

And as a parting note, click here to see a great montage of Mr. Spock and Captain James T. Kirk (video credit: Mortmere).

May you live long and prosper.

Other articles of interest at The Dough Roller:

"TwoWiseAcres.com: Check out my real estate investing blog"

"My annual investment portfolio tune-up: Did I beat the S&P 500 in 2007?"

"Frontier markets: To boldly go where few investors have gone before"

Back to Smart Spending