Financial Advisor Malpractice?

In light of how badly millions of Americans were burned in last year’s financial meltdown, there’s an eager audience for personal financial guidance. But consumers should take pains to ignore one particular piece of advice that’s been making the rounds of late.

I first heard about it in an October email from a Consumers Digest reporter who was writing a piece about financial planner Robert Pagliarini’s new book, “Plan Z: How to Survive the 2009 Financial Crisis.” Pagliarini urges his readers to employ the following strategy: Pay only the minimum payment on your credit cards, and deposit the difference into a savings account that can help you cover expenses in case of financial emergency.

Almost exactly the same advice was offered today by Nancy Langdon Jones, a “certified financial planner” from Claremont, California. Quoted in an article on RealSimple.com, Ms. Langdon Jones told consumers that “if you don’t already have an emergency fund, pay just the minimum on your credit-card bills and start one now.”

Having an emergency fund is a good thing. But creating one by carrying additional credit-card debt is a staggeringly dumb idea.

If you’re lucky, a $1000 deposit in your savings account might earn you an additional $15 in interest this year. But you’ll carry unpaid credit-card balances at 19 percent interest or more. So creating a $1000 emergency fund by not paying off credit-card debt ends up costing you $175 a year or more.

The best investment opportunity most families have, by far, is paying off credit-card debt. A family that chooses that option not only ends up well ahead financially, it also enjoys greater security against unexpected hard times. After all, if it reduces its credit-card balance by $1000, it not only saves a lot on interest payments, it can also borrow an extra $1000 on that card if it needs to.

Mr. Pagliriani admits that his proposed emergency fund strategy is a crazy solution for crazy times, but says it all boils down to this: Which would you rather have, no debt, or cash to pay for food, shelter and other essentials? “No debt” is the uniquely correct answer to this question.

Author: Robert Frank

Robert H. Frank is the Henrietta Johnson Louis Professor of Management and Professor of Economics at Cornell's Johnson Graduate School of Management and the co-director of the Paduano Seminar in business ethics at NYU’s Stern School of Business. His “Economic View” column appears monthly in The New York Times. He is a Distinguished Senior Fellow at Demos. He received his B.S. in mathematics from Georgia Tech, then taught math and science for two years as a Peace Corps Volunteer in rural Nepal. He holds an M.A. in statistics and a Ph.D. in economics, both from the University of California at Berkeley. His papers have appeared in the American Economic Review, Econometrica, Journal of Political Economy, and other leading professional journals. His books, which include Choosing the Right Pond, Passions Within Reason, Microeconomics and Behavior, Principles of Economics (with Ben Bernanke), Luxury Fever, What Price the Moral High Ground?, Falling Behind, The Economic Naturalist, and The Darwin Economy, have been translated into 22 languages. The Winner-Take-All Society, co-authored with Philip Cook, received a Critic's Choice Award, was named a Notable Book of the Year by The New York Times, and was included in Business Week's list of the ten best books of 1995. He is a co-recipient of the 2004 Leontief Prize for Advancing the Frontiers of Economic Thought. He was awarded the Johnson School’s Stephen Russell Distinguished teaching award in 2004, 2010, and 2012, and its Apple Distinguished Teaching Award in 2005.

14 thoughts on “Financial Advisor Malpractice?”

  1. I'd suggest that the critical premise is here: "…it can also borrow an extra $1000 on that card if it needs to.:

    Not if the bank, which has much better access to real-time credit-scoring information than ever before, takes away your credit when you really need it. (Which is to say, when you might not be able to pay it back."

  2. Yes, it generally makes sense to pay down debt as fast as possible, especially credit card debt. But as trotsky says, credit cards are not rock-solid, government-insured sources of money. They are promises to allow you to borrow money, but these promises can be revoked at any time the lender likes.

    I'd modify the columnist's advice to say that even with a large difference in interest rates, having a month's worth of bare-bones expenses on hand, or even only $1000, beats paying down that debt by that amount because that money is YOURS. Once you have that nugget, paying down your debt makes sense, but you have have to have even a minimal emergency fund. (Can you pay rent by credit card? I don't think so. And if you borrow $1000 at cash advance rates, you're REALLY in the hole.)

    I'm a single Canadian freelancer with a mortgage whose clients kept me surprisingly busy in the first 9 months of the year, then my business dropped off a cliff in September, and it's only now seeing a few signs of recovery. Previous foolish financial decisions with my ex-husband have left me with $10,000 in credit card debt – moved to a line of credit at 4% interest — that I had hoped to finally pay off in full this year. Instead, I managed to save about 4 months of emergency funds, paying double the minimum on my debt at the same time. My savings have gone into a tax-free savings account at 3%, so while I am down somewhat, I have real liquid assets I can depend on. Plus, if things pick up as they should this month, I should be able to pay off the debt this year from the savings and interest and rebuild my emergency fund to a comfortable level. If I had paid off my debt this year instead, I'd have been a gibbering mess for months, and there's still a chance that the next few months could be rocky indeed.

  3. After all, if it reduces its credit-card balance by $1000, it not only saves a lot on interest payments, it can also borrow an extra $1000 on that card if it needs to.

    As noted above, this assumption is entirely without basis.

  4. Anyone with decent credit whose only credit card options carry 19% (or more) interest rates needs to find a good credit union.

  5. I think you miss the point here.

    Previous to the recent unpleasantness with the credit markets, people could consider their available credit as their emergency fund. They might have an unused credit card or a line of credit with the bank or something similar. What we've seen is that banks and lending institutions can cut or eliminate those credit lines if they get into crisis mode. Then your "emergency fund" is gone with the wind. This happened a lot in 2008/2009 and there were a lot of people who got burned when they went to dip into their emergency credit and found it was gone and they had no way to pay the bills or get groceries.

    Obviously, keeping cash in a savings account instead of using that money to pay down a balance on credit card is a sub-optimal strategy, but having no emergency money at all presents a significant risk, especially if you're living paycheck to paycheck.

  6. If you’re living paycheck to paycheck, the first thing you should do is cut your expenses. If credit-card interest is among them, it likely will be low-hanging fruit. Once you cut your expenses, you can start saving money.

    For flexibility everyone should have a line of credit with their credit union. Open it today if you don't have one. Then if you pay off all your balances and half the issuers cancel or lower your limits, just laugh.

    As for credit cards, I fear everyone should be using them a little: because FICO owns the world. Maximizing FICO is smart. To maximize FICO you need to have credit and use a little of it regularly for as long as possible and, of course, pay all your bills religiously. Shoot for average balances around 5-10% of your limits. Always call and ask for lower limits instead of closing longstanding accounts (average account age is important).

    Ugh, Fair Isaac. How I despise what they represent.

  7. I have to agree with the general consensus here, While it's true that you should, generally, pay down debt in strict declining order of interest rate, and only accumulate assets once they earn higher interest than your most expensive debt, accumulating at least a SMALL cushion does take precedent. Short of having a line of credit on a tangible asset, you can't really count on retaining the ability to borrow in the event trouble strikes.

  8. As I pay off a portion of my Amex balance, the company lowers my limit by roughly the same amount, Mark. You're behind the curve. Or rather, the companies are way ahead of you. And 19% is a good rate. I pay more. And I know people with 750 credit scores whose rates have jumped from 12% to 19%. Maybe things are different in California.

  9. What everybody is saying, in effect, is that the world financial system is still in meltdown. Not really news, but still sobering and an important counter to all the blather about "recovery". Next: the importance of gold coins under the mattress and a solid supply of canned goods in the basement.

  10. Wobbly, but not still in meltdown, I think. My general advice would hold even if this was 2005 (that is, if I had been as aware in 2005 as I am now). It's always worth eating a difference in interest to make sure you have an appropriate source of immediate funds for your environment. In 2005, while I was still married and before I bought this house, saving one month's expenses, then paying down debt aggressively would have been a good plan. An emergency fund covering four months makes sense for me now just because I'm on my own and my risks are higher.

  11. And here we have Reason #135a it's so hard to break out of poverty. File it under "long-term economizing would be possible if you could pay the startup costs". Moving from a hotel to an apartment—huge savings month-to-month, if you can pony up the deposit and two months rent. Paying off a credit card debt—huge savings on the interest, if you can get the principal. Break free of payday loan sharks—fine if you can get a week ahead on expenses just once.

    But this one's even worse. The difference between Prof. Frank's advice and Pagliarini's advice has nothing to do with (e.g.) "the credit card company monetizing the risk of default on the principle" or some such thing. (Not even their normal extortionate rates have that defense.) The difference is "Credit card company policies are too opaque and capricious to be part of a financial plan" Is there an economics term for that? Not just "Deadweight loss" but "Jerking-around loss."

    And this is from finance megacompanies that themselves complain that *they* mustn't be subjected to regulations or they won't be able to run their companies efficiently. Spare me! Regulate them into the ground, I say. Make every card adhere to an ironclad, published-on-the-web policy for the exact circumstances under which cards will be renewed, rates changed, etc. If they say they can't run a profitable business under those circumstances—well, their stockholders will replace them with someone who can.

  12. That's not quite right, Ben. I'm perfectly happy to say bad things about credit card companies all day long, but in this case they were no different than any other type of lending or credit-granting institution.

    During the worst parts of the crisis, everyone was slashing unused credit lines left and right, credit cards, personal credit lines, home equity lines, whatever. Even large business customers would turn around and find that their long-standing lines of credit were drastically reduced or even non-existent. Some business decided to simply take their lines of credit and bank the cash as a hedge against the line being pulled without warning.

  13. What's this thing called credit card debt? What for that matter is a credit card? They don't look like ideas I should go for.

    OK, I've lived a sheltered life: debit cards, bank loans for cars, HP for white goods only if the shop offered zero interest. My credit rating is probably mud. But half a billion unsheltered and poor Chinese think like me.

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