Updated on 02.25.07

The Biggest Risk Of All: You

Trent Hamm

Whenever I make calculations on this site, I usually involve some calculation in which a person contributes some dollars a month each month to savings in order to make an even comparison of which option is a better deal. Quite often, to the chagrin of my readers who are looking for a “deal,” I recommend the solution with the higher monthly payments.

On a fundamental level, most of us strive for lower financial requirements each month so we have more money to “play” with. The truth is, though, that people we are indebted to are going to want to get their money back with interest, and the longer you keep their money, the more interest you’re going to pay on it. Thus, smaller monthly payments in fact mean that you pay significantly more in the long run.

Even given that, many people argue that this can be recovered if you simply save the difference between the lower monthly payment and the higher one, and thus they use that to justify a worse deal. There’s a big problem with this plan, one that I don’t usually discuss, and that is human nature.

On a monthly basis, almost all of us pay our required bills and then spend what we have left. Even though we “promise” ourselves that we’ll save some, the majority of Americans simply do not, even though it’s incredibly simple to do with automatic deductions and the benefits are quite clear. In fact, many people actually start off saving diligently, but after a month or two, “something” comes up, the savings plan goes in the trash, and you’re stuck with a payment plan that costs you extra money in the long run.

Whenever you evaluate a loan payment, ask yourself honestly how likely you are to actually save the difference between the high and low payments based on your past performance. This is risk evaluation at its most simple: are you a risk? If you’re not wholly confident of your ability to save that difference, then quite often you should go for the higher payment? Why? You’re making that difference a requirement, rather than something you don’t have to do – and probably won’t.

This is why I’m planning on getting a 15 year mortgage. Not only is the interest rate lower than a 30 year, the higher payments ensure that I’ll be putting that money into equity each month instead of merely “hoping” that I’ll invest it in something worthwhile. Even though the payments are higher, I’m reducing my biggest risk element: me.

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  1. Mark says:

    We don’t understand risk its the not the instrument its the person behind the instrument of choice for investment. If we just throw our money with out understanding the risk of loss then when do have a loss we should not complain about because we never understood the risk in the first place.

  2. jake says:

    I agree Trent,

    There are so many plans that maximize profits and potential of things, but the problem is they require financial discipline. Which of course most people dont have. I am talking about the average person that is mostly in debt.

    We can give the best possible plans to save money and gain wealth, but it all comes down to the individual being in charge of his/her money. The more you put it to yourself to do things the more you risk encountering the human nature factor.

    Its easy to say I can write an extra check at the end of the month to go towards my mortgage, but will we? I dont think so. Its easy to say we can write the extra payment at the end of the year. Will we? I dont think so, Christmas and New Years is too much of a force.

  3. db says:

    This is so true. I just blogged about my own encounter with myself as Risk Enemy #1 on my blog here: http://debtblitzkrieg.com/?p=24.

  4. plonkee says:

    This is so true.

    I am not remotely disciplined. Its more a case of laziness and forgetfulness than anything else. I mitigate this by saving automatically (pay yourself first) and setting a cap on the amount of fun money I can spend every month.

    I’m always open to new sugestions though.

  5. Kirk Wylie says:

    This is very similar to a common technique of Private Equity investors in companies when taking them private.

    Essentially the strategy is to load the company down with a lot of debt, to make it stronger. While this seems counter-intuitive, because the company has to make a lot of debt repayment schedules, it has a very strange effect that the debt payments:

    1) Focus the mind of the company (no matter what, we have to pay that monthly/quarterly/semiannual repayment coupon) so that there’s a higher level of operational efficiency;

    2) Focus the mind of the company that they are no longer judged internally by making a profit of any level, but making enough of a profit that they’re able to make the debt repayments and STILL make a profit (e.g. “we have to make a 5% return on investment just to break even; that means that we have to do better than that in the future”).

    3) Limit unnecessary capital investment, which is particularly important where you have a company which is really cash strong and should focus on just maintaining its cashflow rather than growing the business (a mature industry is prone to this): fishing expeditions for new investment ideas often just waste money because the company just can’t invest that easily and profitably, so the debt stops them because they don’t have the spare money.

    Of these three, #1 is definitely applicable to personal finance (you have to make that mortgage payment no matter what; you don’t have to get a latte no matter what); #2 is definitely applicable to the self-employed where you can raise your income directly through working harder/more hours (you have to work harder just to have enough at the end of the month to afford that latte); #3 is definitely applicable to personal finance (if you’ve got a higher mortgage payment, you don’t have a lot of money left at the end of the month to splurge on things you really know you don’t have the money for).

    So what my long comment boils down to is that you’ve hit something that the private equity guys have known for a while: higher non-discretionary monthly payments can also focus your mind quite a bit and keep you “on track” financially by limiting your options for deviating from the right path.

  6. Why not take a moment and set up an automatic investment program right now. It takes the risk of “you” out of the equation. You really only have to do this once at the beginning of your mortgage. There’s also a good chance that in 15 years you’ll do better in these investments than you would in paying off your loan. Too each their own, I suppose.

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