Cash flow can be more important than debt reduction
My wife and I talk about finances on a fairly regular basis. Recently during one of our conversations, we discussed the pros and cons of paying off a particular debt versus placing the earmarked money in our savings account. My wife was of the mind that we needed to pay off that debt immediately, however, I was concerned that paying off the debt might leave us in a precarious situation as far as our cash flow – the title of this post probably indicates who won that argument. My point is that paying off debt is a good thing and can almost be a bit of a rush. However, if you pay off a debt, but leave yourself with no surplus cash flow, no emergency fund or limited savings, you could be in worse trouble when unexpected expenses pop up.
This is a principle that can be missed, especially if you are a person who is working very hard to pay down debt. It is a given that we all dislike debt, but staying liquid is just as important as paying down debt and in some instances, liquidity is far more important than debt reduction. At times, debt and credit can be the only means that we might have for liquidity and used properly, credit and debt are an asset to help keep our financial state flexible and improve cash flow. The analogy is a little by like returning to the boat after a long, deep underwater dive. You see, deep sea divers – those going to extreme depths – must return to the surface gradually in order to avoid getting decompression sickness or “the bends.” Their goal is to get out of the water, but if they do it too quickly, they risk bodily harm. Therefore, they stay in the hostile environment (the water) a little longer in order to reach their goal more safely. The same principle applies to debt reduction. Our goal is to get out of debt, but to do so too quickly might result in greater financial danger than carrying debt a little longer.
Here are some factors to think about when balancing the priorities of cash flow v debt reduction:
- How big is the debt? If you are within six or seven regular payments of wiping away a particular debt, you should be more likely to use your surplus cash in order to pay off the debt. You will save interest and it will not take very long to replenish your cash flow. But if your debt is a year or two away, there is likely too much risk in using savings or emergency fund money to pay it off.
- How high is the interest rate? In the case of my wife and I, we were looking at paying off a debt that carried an interest rate of less than 2%. That was the determining factor in deciding whether or not to pay it down. Having cash on hand is more important than saving .00167 percent or less a month. It is also possible to carry debt with no interest . . .
- How much cash on hand do you have? Some people have large cash reserves. In that case, why continue to pay interest on the debt that you are carrying? A basic rule of thumb is this: you probably need an emergency fund about as large as your health insurance deductible or a much as it might cost to repair your car transmission. On top of that it is recommended that you have 3 to 6 months worth of your monthly budget in savings. If you have surplus cash on top of that, you need to seriously consider targeting that money for debt reduction.
For the rest of us who might not have the luxury of surplus cash, we have to concentrate on cash flow. Having the money to pay next month’s bills is a greater priority than paying off school, auto and even credit card debt. What is the secret to cash flow? Well, there are no secrets, but there are two ideas that will help:
- Keep a budget. Your budget is a financial snapshot in time. Without that perspective, you can never hope to accurately assess whether or not you should pay down debt v keep cash on hand. Proverbs 27:23 says, “Know well the condition of your flocks, and give attention to your herds” and goes on to say the reason for this is that riches (cash flow) do not last forever.
- Know what is coming up. In Proverbs 27:12 we read: “The prudent sees danger and hides himself, but the simple go on and suffer for it.” If you know that there are likely to be significant expenses in the coming months – vacations, Christmas, quarterly tax payments, balloon payments, etc., then, you must decide in favor of staying liquid rather than paying down debt. Anticipate, be proactive on known expenses so that you are not caught unawares by unknown expenses.