Ever wondered what behavioral finance is? This is a great example:
As I signed the check to my most recent car payment, I noticed the current balance on the loan and my emergency fund were almost exactly the same. ”I could pay off the car now and save some money” I thought. I would save money because I wouldn’t have about 3 months of payments still to make. I have the money to pay it off, but I won’t. Mathematically it makes sense.
If my emergency fund is giving me $10 a month in interest, I’d rather just keep it there and get interest. The mathematical complications arise when I realize I’m paying about $25* a month in interest on my car. It has the same balance as the emergency fund, but higher rates on the car gives me a net loss of $15 a month in interest. Logically, I should take the money out of emergency savings and just pay off the car. I could build up my e-fund again over the months I now have without car payments.
So why then am I not doing this? And why would most people not do this? There is no change in net worth, it’s simply shifting funds from one account to another. The answer is two fold:
1) Liquidity. While my money would just be shifted into the value of the car, getting my money out of the car is not so easy. Having quick access to cash is important to Americans. Because of my financial set-up, draining my emergency fund right now would leave me with no cash. I’m confident I’ll get my next paycheck, and I would be fine again then, but running a tight ship like I do leaves me vulnerable for as much as a month. Corporations generally run a tight ship too. Running out of cash is exactly what hurt our banks, I don’t want to be like our banks.
2) Insurance. Insurance is nothing but paying someone to bear the risk of something happening. I am of course doing the paying. The risk is that something will happen to me and I won’t be able to make my car payments. Chase, the holder of my loan is bearing this risk. Ignoring special financing offers, if there was no risk of default I would only pay 2-3% in interest instead of 7%. The 2-3% is the liquidity premium, the rest is the risk premium.
I’m paying 2-3% to Chase each month to have access to my own cash in my emergency fund. This is because my options are to pay off the loan and get not interest/pay no interest or not pay it off and get interest/pay interest.
Why is 2-3% for liquidity? A simple way to get close to what the liquidity premium would be is the savings rate at ING Direct (currently 2.75%). Chase would tie their calculations to something like a 5 year treasury bill (Currently at 2.63%) or some other government note comparable to the term of your loan. Since I’ve elected to have access to my cash, I’m receiving and paying interest at the same time. But I’m also paying for insurance on default.
The rest of the interest rate is 4-5% for the insurance. I’m getting extra interest from my emergency fund, so this balance comes out of my pocket. It works out to about $15 a month I must pay for the insurance or risk premium. This is how it works:
Emergency fund pays $10 in interest. My car payment requires $25 in interest ($10 for liquidity $15 for risk premium). Net loss is $15.
As previously stated, I could save $15 a month by just paying off the car. But because I want access to my cash, I’m willing to fork over $15 a month for that convenience. It also gives me peace of mind, knowing I can take a little longer to pay off the car. This is paying for peace of mind. This is my cost of cash.
*Note these figures were made up to make the math easier
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. |
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