Many of you have heard me say during a presentation or a podcast that I have a bias towards paying off debt, especially student loans. This bias stems from the freedom you are provided by being debt free and the health benefits that come along with it, mainly a lot less stress. This article is not a “step-by-step” guide to get you out of debt; there’s plenty of articles on the internet for that. Instead, this article discusses psychological biases that we may have which prevent us from reaching our financial goals. We will focus on student loans and discuss how we can overcome these biases in this specific context.
Being Financially Successful
You do not have to be a financial genius to be financially successful. Below is one of my favorite quotes from Benjamin Graham’s The Intelligent Investor. For those of you that do not know of Ben Graham, he is considered one of the most influential individuals in finance over the past 100 years. Graham’s most well-known “disciple” is Warren Buffet.
“For indeed, the investor's chief problem - and even his worst enemy - is likely to be himself…We have seen much more money made and kept by 'ordinary people' who were temperamentally well suited for the investment process than by those who lacked this quality, even though they had an extensive knowledge of finance, accounting, and stock market lore."
Although Graham said this quote in regards to investments, it can be applied to all areas of finance including student loans and repaying them.
Get Out Of Your Own Way: Understanding Your Biases
We all have biases whether we recognize them or not; some are good, some are bad. Understanding these biases and using them to your advantage are a few of the vital keys to financial success. The following are three biases and corrective actions you can take that I feel are important to your student loan repayment strategy (these can also be applied to other areas of finance).
Lack Of Self Control
Self control bias, or lack thereof, is exactly what it sounds like. You adhere to a theory such as paying down your student loans but allow short-term events to affect you. I have witnessed many investors, friends, and family members start a plan but not stick to it even though they rationally should.
For example, how many times have you heard someone say they are going to start a work-out regimen? Rationally, they should already be working out to stay healthy and continue this as long as they physically can. However, what we witness is that most individuals start a plan to get healthy only after a bad diagnosis. Once they start the plan, most stick to it for a few months, and then stop.
This is exactly what happens to many of us when it comes to finance. Primarily, this happens because we do not see the results of our financial strategies for a long time. For example, paying off your student loans may take six years, and within that time, there is no instant gratification.
There are three ways we can correct this bias.
Set your long-term goal (e.g. if I want to pay off my student loans in eight years, figure out what it takes to get me there). Then work backwards to set short-term goals. For example, let’s say if you make extra monthly prepayments of $500, you would have the first of your eight student loans paid off in four months. When you accomplish the goal in four months, recognize it, and celebrate it! The celebration could be something extremely simple or something more significant if it’s a big milestone.
Make it real. With this, I’m not referring to defining tangible goals, such as “I will pay off $X amount within Y months.” Tangible goals are good and you should definitely set them because goals should be measurable. However, what I’m referring to here is making your goals emotionally real. For example, you could tell yourself: “I am following this strategy to pay down my loans within four years because I want to have children. Being debt free allows me to have more cash each month in order to provide a better living situation for my family.“ This provides a reminder that your strategy and goals are tied to things that are greater than just dollars and cents. Find a positive emotional stimulant that is important to you.
Take Notes. After doing the first two steps, write everything down. If you find yourself swayed by some short-term event, go back and review your long-term goals. Put an emphasis on the emotional reason you were pursuing your strategy and proceed from there. For more information on why taking notes is so powerful, please see the guest article I recently wrote for UpDoc Media.
We are surrounded by framing bias every day and often do not realize it. While I can give many examples to illustrate this bias, I will focus on two of them.
The first involves advertising and surrounds us each and every day. From a TV ad for a shiny new car to a celebrity ad for a household product, we are constantly surrounded by them. These ads are effective because they play to our emotions and get us to respond to our short-term impulses to buy whatever they are promoting. The words, graphics, colors, and people are selected very carefully by the advertiser to frame a certain message that gets the viewer to take action.
The other framing bias I will discuss is one that most of you don’t realize you are surrounded by. Every day we surround ourselves with friends and acquaintances. We see these individuals going out and buying new cars, designer clothing, diamond rings, houses, etc… and we think to ourselves ‘why not me?’ However, everyone’s financial situation is different. Don’t be afraid to tell your friends you can’t afford it or simply that you don’t think you need it.
For example, I have friends who constantly upgrade their luxury car and are up to their eyeballs in debt. They constantly tell me I need to upgrade my 2002 Ford Explorer. I just respond by saying I don’t care about having a new car and have better things to spend my money on. Most of them just look at me confused because they’ve been sold on why they need a fancy car and don’t understand how someone can go against what they’ve been programed to think.
Overcoming framing bias is difficult because you have to be able to recognize it. Items number two and three above (making your goal emotionally real and keeping notes) are extremely important to overcoming framing bias. By making your goals emotionally real and taking notes, you can focus on what is important to you.
Inertia and Default
While this bias is typically associated with retirement accounts such as 401(k)s, it is widely apparent within our lives. This bias refers to setting a goal or strategy and letting those goals remain stagnant, or simply selecting the default choice because it’s easy or it’s what “everyone else is doing.”
When it comes to questions like “How much in student loans should I use to finance my education” or “How do I efficiently use my income to repay my student loans,” there are no one-size-fits-all solutions. More importantly, your plan and strategy needs to be reviewed from time to time because it can change. Below are just a few things that can cause your student loan repayment plan to change over time:
1. You may have gone into school thinking you didn’t have to worry about student loans because you were going to take advantage of public service loan forgiveness. However, the terms for qualification may change before you graduate;
2. Savings rates rise and are greater than the interest rates on your student loans. Therefore it may make financial sense to invest your money relative to paying off your loans;
3. You have a major life event such as having children;and
4. The list goes on and on…
In summary, when it comes to your finances do not be your worst enemy. Understand your biases and use them and their solutions to your advantage.
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