Financial Planning Money Management

Bird In the Hand

“A bird in the hand is better than two in the bush” is a proverbial saying used to declare the belief that it is better to hold onto something one has that is certain than to risk losing it by trying to get something better that is not certain. Often folks will use such a phrase when justifying a decision to forgo a chance at something better by playing it safe and holding onto what they have already.

However, what if what one is holding onto is actually causing the person to lose the very thing they think that is certain in a slow and insidious way because of the refusal to try an alternative strategy?

Cash In the Bank

Let’s talk about cash positions earning little to no interest, for example a savings account at the bank. Now contrast that with a credit card debt balance equal in size, but charging an interest rate much higher than your cash in the bank is earning. One is positive albeit making little progress for the owner. The other is backsliding further and further as the interest charges mount and debt grows.

This is something that we seem to be running into frequently when meeting new folks. Therefore, I thought it is time we address the issue head on, and then you can make the judgment for yourself. Is the cash in the bank (the bird in the hand) better than paying off the immediate debt (two in the bush)?

Suppose someone is sitting on $50,000 of cash in their emergency fund. It’s currently in a bank savings account earning 0.10% annual percentage yield. In a year’s time the account will produce $50 of taxable interest. I suppose it’s better than a stick in the eye, but not by much.

Suppose that same person has $6,000 worth of credit card debt at an average annual interest rate of 15%. The annual interest charge would be roughly $900 to service the debt. The same person has an outstanding automobile loan balance of $5,500 at 5% interest resulting in an annual interest debt service of approx. $275, and a HELOC balance of 10,000 at 4.5% interest racking up an annual interest charge of $450. The total outstanding debt is $21,500, and the total interest paid in one year is about $1,625.

Is it better to hold onto the cash? After all a bird in the hand is better than two in the bush, or so the saying goes. Or is it better to pay off the debt?

It’s a Simple Math Problem, Right?

It seems like we run into some resistance frequently when we suggest that folks to pay off their high interest consumer debt with their low interest earning cash. What seems quite logical to us is often met with an emotion of fear of loss. We may hear things like, “I don’t want to drain my savings account,” or “I’d rather have access to the cash in the bank in case I need it.” These answers seem justifiable to the folks who utter the words. It is their “truth” and it feels right to them.

From my observation it appears like they are worried about giving up access to the cash, but ignoring the fact that they’ve already spent it. The money is already gone. That is why they have the debt. However, now they are choosing to service the debt at often very high interest rates while at the same time their cash in the bank is actually going backwards. How is it going backward?

First of all, it is earning less than the rate of inflation. Therefore, their purchasing power is eroding. On top of that, the interest on the debt is often magnitudes great as in the previous hypothetical example.

So how much would that person be spending in interest payments in one year’s time versus the interest rate that they’re earning from the cash held at the bank? That’s relatively simple. We just have to add up all the interest charges for that year, subtract the interest payments on the cash, and the result is the cost of holding onto the cash in the bank.

On $21,500 worth of debt interest charges of $1,625 mount up. Meanwhile, $50,000 of cash is sitting in the bank isn’t even making enough interest offset 3% of the interest charges on the debt. $50 worth of interest is generated in our example, but it’s taxable. Assuming 5% state and 15% federal, the net result is only $40 on $50,000. $40 – $1,625 = a net loss of $1,585.

In reality we only need $21,500 of the $50,000 in cash to eliminate the debt. Once the debt is eliminated, there’s still $28,500 in the emergency account earning 0.10%. The net after-tax interest is just shy of $23. By paying off the debt, our hypothetical saver is now better off financial by $1,608 annually ($1,585 of net interest charges no longer owed + $23 of net after tax interest earned).

It just doesn’t make financial sense to hold onto the cash, yet folks do this routinely.

When Does Carrying the Debt Makes Sense?

Can you earn a rate of return without taking risk that is greater than the interest charged against your outstanding debt? If the answer is yes, then perhaps it makes sense to carry the debt and service it as opposed to paying it off. However, the interest rate on your debt would have to be relatively low given the interest-rate environment today in order to justify carrying the debt.

For example, let’s assume someone has a 15-year mortgage with a $50,000 balance at 2% interest rate. They also have $50,000 sitting in the bank earning nothing. If a relatively low-risk opportunity to earn an interest rate greater than 2%, say 3% for example, is available it may make sense to carry the debt and position the cash in a place to capitalize on the 3% return. In this example a positive arbitrage has presented itself, and it may make sense to act on it with your free cash while you can. In this example paying off your mortgage sooner than later might be a mistake.

However, it is rare in today’s interest rate environment where the 10-year treasury is below 1.50% to find such opportunities without taking on some form of risk (be it market risk, interest rate risk, credit risk), or without giving up access or control of your money for a period of time.

If you’re debt is costing you more interest on an annual basis than what you could earn on that same dollar positioned in a relatively risk-free investment, then you may want to think twice about carry the debt into the future when you have the resources to eliminate it today.

Freed Cash Flow

When you eliminate debt balances two things happen.

  1. You eliminate the interest charges on the debt, which we’ve already pointed out.
  2. You also eliminate the payments you would’ve made (say on a monthly basis) from your spending plan.

Eliminating payments frees up cashflow to be directed towards something more productive. For example, you could begin to build up your savings again. If you already have an adequate emergency fund you could consider contributing to a retirement account like a Roth IRA.  Perhaps you may choose to invest the cashflow for long-term growth in a well-diversified portfolio with a reasonable opportunity to outpace inflation.

Whatever you choose to do, you have choices now! You are no longer a slave to your debt! You hold the cards.

In effect, you’ve killed the debt and the interest charges, and now you’ve turned the tables on the creditors. You now become the one with the upper hand. You have the chance to become the lender. You have the chance to make money with your money, and perhaps let other folks pay you interest for the use of your savings.

When you kill the debt you’ve just caged the two birds in the bush, by letting go of the one in your hand.

To quote one of my favorite movies, “How about that, It’s a two-on-one switcheroo. Now the Joe’s have the upper hand!”