Payment Deferral Fallacy

If you think nobody cares if you’re alive, try missing a couple of car payments.

– Earl Wilson

The symptom: Costs do not seem like they are incurred until you pay them.

The example: Your goal is to pay off an extra €1,000 on your student loan at the end of each month. The payback requires a sustained effort each month, but you feel the sacrifice is worth it to get the debt monster off your back. Near the end of some months, it appears you will not be able to make your goal, but you are determined. During the last week of the month, you usually stop paying for anything with cash, and start using your credit cards for everything. That way you will have the money on hand to pay extra on the student loan. You also delay some utility bill payments a few days into the next month. Even if you have to pay a small late fee, it is worth it to keep the paybacks on schedule.

You know the drill. Examine when expenses are actually incurred. Examine what happens to net worth.

First, realize that the extra €1,000 loan payback is neither income nor expense – it is merely an account transfer. Second, determine the effect of the transfer. The typical interest rate on a student loan is about 5%. Thus, applying the €1,000 to a student loan balance saves you about €50/year. So far so good. But the other side of the coin is the source of the money. If the money was just sitting around in a checking account earning nothing, then applying it to the student loan balance is probably reasonable. In the example, however, there was a shortfall of current cash that was made up by temporarily ignoring current bills and by increased credit card use. Both of these actions can be shown to be unwise.

When did you incur the utility expenses? You incurred them when you used the electricity or water or gas. Not paying the bills does not change the fact that you have already incurred the expenses. Not paying the bills does not make you more wealthy, and paying them does not make you less wealthy. The payment is just an account transfer. You became less wealthy (i.e. your net worth decreased) when you used the utility services. However, not paying the bill on time indirectly costs you money through late fees, interest, and lower credit ratings!

The strategy of paying for everything with a credit card also does not really help the situation. At best, it postpones the cash outflow of your spending by a few weeks. Assuming nothing changes, the next month you will also be short the extra money you want for the loan prepayment, plus now you will have an additional credit card bill for the items you purchased on credit last month. For example, suppose you were short €200 last month and resorted to borrowing €200 on your credit card to come up with the money for the student loan prepayment. The next month you will be short €200 again plus you will have a €200 credit card bill due. At that point, you have two options:

Option #1

  • Pay the €200 credit card bill.
  • Realize you are now €400 dollars short for the prepayment.
  • Only pay €600 extra on the student loan.
  • Realize that €1000 last month plus €600 this month = €800 per month.
  • Learn that you cannot game the system by paying down more than your real monthly savings.

Option #2

  • Do not pay the credit card bill.
  • Borrow another €200 dollars on your credit card.
  • Pay €1,000 extra on the student loan.
  • Do not realize that you are simply borrowing money on a credit card at 10% or 15% to payoff a loan at 7%.
  • You are gradually replacing student loan debt with credit card debt. This is horrible financial management.

In the above example, also note the inclusion of a controversial item often discussed in the blogosphere: the artificial cash-flow crisis. No one is forcing you to pay back the student loan early. A conscious choice is being made to create an artificial cash-flow crisis each month. Although these devices are popular with many bloggers, generally speaking, We are not fans of these contrivances. The usual argument is that an artificial cash-flow crisis will motivate you to do what you otherwise could not bring yourself to do. Personally, we think it is highly debatable whether people who do not otherwise have the motivation to follow through on unpleasant austerities will be able to do so by simply manufacturing a crisis. It does not sound logical, but people are not entirely rational and so there may well be instances where this can change motivation. Thus, we are not really sure how well this works as a motivator.

But what we are much more certain about is that when people encounter a cash-flow crisis, whether self-inflicted or otherwise, they tend to make a lot of bad financial decisions. The fact is that it is usually very easy to temporarily alleviate a cash-flow crisis. For most people in most circumstances, there are many, many ways to temporarily shift money around to fulfill your obligations in the short term. However, many of these ideas reduce your net worth and/or create a much bigger cash-flow crisis later.

Here is an example. One person says it is mathematically better not to get an income tax refund at year end because that money could have been invested during the year. Another person comes along and says that although the math is correct, as a practical matter, they will spend all that extra cash flow each month. They claim that if they have it in their pocket, they will spend it. Hence, rather than having €500 of extra cash flow each month, they claim it is better to get a €6,000 refund, which will supposedly then be recognized as a significant amount of money and not frivolously spent. We suppose this might work for some people. Maybe some people would blow the extra €500 per month but they will not blow a big lump sum. We do not know.

But, what concerns us is whether the person is making a lot of really poor decisions by not having that extra €500 per month. When people do not have much cash sitting around and they want things, they resort to ideas that might be worse than simply spending cash. In other words, it might be better to let the person have the €500 each month and blow it, rather than have them move their money around in order to spend the €500 from other sources. The €6,000 refund will not be such a great idea overall if the person ends up spending €500 extra each month anyway by borrowing it on credit cards or raiding retirement accounts or not paying bills or the many other ways that people can temporarily circumvent the absence of cash in the pocket. After all, someone who already claims to have no discipline about handling €500 each month would seem to be able to find a way to blow €500 each month even without the cash sitting in the checking account.

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