Don’t Feed the Alligators

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Partially inspired by Five Cent Nickel’s article on Reconsidering Our Asset Allocation, partly by my recent read of Burton G. Malkiel’s A Random Walk Down Wall Street, and partly by an urge to simplify, I have recently been consolidating a number of retirement accounts from a number of brokerages to one. I have chosen Vanguard as the host for the bulk of our assets, primarily because it offers the index fund options that I want with very low fees.

The process for consolidating is pretty easy. I logged into our existing Vanguard accounts and filled out 5 questionnaire pages that detailed what I wanted to move, from where, and into what fund(s). At the end of the process, I was prompted to download and print out a PDF to sign and return to Vanguard. This process had to be completed for each brokerage account not yet at Vanguard.

I called Fidelity to make sure that there would be no problem with Vanguard getting the money for the transfer. I was informed that in order for this to go smoothly, I would have to move all of our assets into cash positions. And by the way, I was told, I should do this today since the market is up… advice that smelled of market timing to me and was promptly ignored… Instead, I opted to wait until I knew Vanguard would have received our paperwork and started to execute the transaction.

Within a few days I saw that one of the Fidelity accounts was empty and the Vanguard had increased my almost the same value. Almost? you ask? Yes, Fidelity took a $50 “cash out” fee out of the money that was transferred. After researching this point for 30 minutes or so, I was unable to find this fee stated, explicitly, anywhere on Fidelity’s website. It does say that the law allows them to charge one, but they don’t say what the charge will be.

So I guess this is just Fidelity’s way of saying, “Don’t let the door hit you on the way out.” And this is yet another reason that I can’t, in good faith, recommend Fidelity to any potential investors who might seek my advice on the matter, even if it is the home town favorite in my neck of the woods.

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I participated in my first blog carnival this week at the Carnival of Personal Finance. I submitted my article about the parallels between losing weight and growing wealth. You can see it and all the other great articles at this week’s host Gather Little By Little. This week I also joined the conversation on a number of topics at other blogs. Some of the blogs that mentioned me or in which I participated were:

• Lynnae at BeingFrugal.net solicited the best financial advice that her readers had ever received. My words of wisdom were 1.Pay yourself first and 2. Anything you can measure can be improved.
• Glblguy at GatherLittleByLittle.com wondered why he still has to carry cash. I don’t usually carry much cash, and it tends to sit in my wallet for a long time. In the comments I shared my strategy for using my rewards credit card for everything I can.
• Frugal Dad at FrugalDad.com wondered whether it was cost effective to buy a new car for the explicit purpose of saving on gas mileage. I suggested that for people who continually carry loans, the cost of gas is minor compared to the other operational costs of a car.

Another article that caught my eye today comes from the Boston Globe’s Personal Finance Section which reported on a new study being conducted at my alma mater which will “explore how people make decisions about their money, and how technology can shape and assist in these choices.” This study is part of a new Center for Future Banking that seeks to understand how changes in technology will affect banking. This study will explore many of the questions that fascinate my about the social psychology of money decisions. It is a bit dubious, however, that Bank of America is providing the financing for the study… Lastly, I made some updates to my Blogroll at the right this week. Check out some of my fellow bloggers sites if you haven’t already. b

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Editor’s note: After being alerted by Sharp Reader Steve, I went back and checked my numbers. I have included my corrections below.

In my earlier article on this topic, I wondered whether it made sense to pay down low interest debt, like car loans and low, fixed rate credit card balances. Last week, I finally sat down and ran the numbers. and contrary to my conclusions in the previous article, I found out that it actually makes sense to attack the debt as aggressively as possible and then put money away to save, almost regardless of what the interest rate on the savings is. My numbers confirmed my theory, but also additionally show that even if the interest rate on the investment is less than the interest rate on the debt, you may still make out better in the long run by investing rather than most aggressively paying down the debt.

To figure this out, I made a Google Spreadsheet with 2 sheets of 6 columns each. I paired the 6 columns on each sheet into 3 groups of 2 columns each. The first two columns represented my car loan. The next two represented my credit card balance, and the last two columns represented my savings. The first column of each pair represented the running total of the account and the second represented the monthly contribution to the liability or asset:

In the first cell under each of these I entered the initial condition. The running total was calculated by:

Rt = Tp*(1+i/12)-Mp

Where:

Rt = running total

Tp = previous total

i = annual interest rate (expressed in percent or decimal, 5% = .05)

Mp = monthly payment

In the case of the savings account, I added the monthly payment rather than subtracting it.

This is probably not exactly the right formula, especially depending on how frequently compounding occurs, but it’s close enough for our purposes.

Sheet 1 took the case where I put all of my extra money into savings and paid the minimums on the liabilities. The credit card account pays 2% of the balance each month, and as the monthly payment reduces, the difference from the initial payment gets applied to savings.

Sheet 2 took the case where I put all of my extra money into paying down the liabilities in the order of highest interest rate to lowest. When all debts were paid off, the total was applied to savings. In this case the savings doesn’t start for nearly one and a half years from now.

I set a savings goal of $80,000 (a down payment on a new house), and Sheet 2 Sheet 1 beats Sheet 1 Sheet 2 by about six four months in reaching this goal at any reasonable a 6% savings interest rates. It wasn’t until the savings interest rate exceeded 20% that Sheet 2reached the goal faster than Sheet1. Unfortunately, I don’t know if I can generate a 6% interest rate on such a short term cash goal. I originally used the 6% rate because it is higher than the debt interest rate and I was trying to see what happens with a rate higher than the debt rate.

In either scenario, the Sheet 2 won in the very long run by a few percent.  This is a bit surprising.

So there you have it: Pay down low interest debt (aggressively) and THEN roll the cash that you had been spending on debt payments into savings and investment.

Conclusion: If you are trying to save for something in the short term, then it can still be  real toss up between investing (saving) or paying down the debt.  You will get to your goal faster by saving rather than paying down the debt, but when you get there you may still have the debt.  However if you are saving for the long run, then even when the savings rate is less than the debt rate, you can still achieve overall savings by investing while you reduce your debt.

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