Cash flow can be more important than debt reduction

By Stew

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:

  1. 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.
  2. 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 . . .
  3. 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:

  1. 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.
  2. 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.


13 Responses (including trackbacks) to “Cash flow can be more important than debt reduction”

  1. ERIN Says:

    Great post. Sometimes I think renewing our commitment to debt reduction by having these discussions is actually just as important as making the payments. It helps both partners be clear on the priorities of the other and make sure that we are all working toward the same goals. I know for our family, when my husband decided to speed up our debt reduction by taking an overseas position, that meant that I would be paying for things that he normally would have handled for free. That meant we needed to keep more cash on hand than “necessary”, so I wouldn’t panic at the thought of an unscheduled repair for anything that might come up. Yes, it slowed us down a bit, but the peace of mind it that extra money gave both of us, was well worth the delay.

  2. Gina Says:

    For some reason this theory feels wrong to me. It still feels like the lenders come out on top; they make money off the interest, while we are sitting around counting dollars, waiting for something terrible to happen. Isn’t there a Mark Twain quote about 80% of the things we worry about never happen?

    I say take the risk of something happening (have faith) and pay off the debt ASAP. Then take that money that you would have paid to the debt, and put it into the cash flow account. I wish I could put this in a mathematical formula to test it.

    I do agree w/Erin that these discussions are more important than the payoff but in the end, I want the debt G O N E!

  3. Mahesh Says:

    I have seen businesses running into trouble because of lack of cash flow. But sitting on idle cash when you have debt is also dangerous. Well, still everyone needs some amount of cash flow. Below that dangerous to anyone

  4. Jon Says:

    It’s an interesting discussion. For me I would actually agree with your wife about paying down debt first. I think that have an emergency fund is very useful but I would still edge towards paying down debt.

  5. Kevin Mzansi Says:

    Very nice discussion! For me, cash flow = flexibility. You have to take care of the past by paying down debt, but you also have to take care of the present by having the cash flow to not have to go into debt again to fund your daily life.

  6. Dexter Barnett Says:

    I am in complete agreement in Kevin. I think it is better to play safe and keep both in the safe side. You’ll never know where your trouble will will come from.

  7. justin Says:

    My wife and I have tried very hard to pay down our debt will all available cash flow. We got pretty close. Then the roof began to leak. We had been so busy trying to pay off the debt that we failed to realize that we might need money for an emergency.
    If we had been in a situation where we had cut up our credit cards and attempted to pay down our debt as quickly as possible it would have been very difficult to replace that roof and in the end would have cost more in repairing the water damage than the amount we pay in interest.
    I agree that debt is dumb, but an emergency fund is pretty important too.

  8. Brian T Says:

    I have had this money talk. It’s tough. I’m not sure if I won or not, but I believe that having cash flow is necessary.

  9. Natalie F Says:

    I definitely agree. I try to pay off as much debt as I can, but I don’t leave myself to tight on cash either. If any emergencies were to occur, I would’t be able to fix them, and sometimes they can’t wait until your next paycheck. I also always keep a stash pf cash, because i tend not to use cash when I have it on me, so I know it’s safe in my wallet.

  10. Harry S Says:

    I think we have to maintain a fine balance between the amount of cash we keep and the debt that we payoff. It’s probably best to spend most of the salary towards paying off your debt and keeping the rest as a buffer for any financial emergency.

  11. S. B. Says:

    This all boils down to liquidity versus leverage. There’s no easy answer to this question because debt redcution does come at the expense of liquidity. “Moderation in all things” may be the best advice.

  12. Joe Says:

    Cash flow problems can be so real that can take you to bankruptcy with plenty assets. Many businesses and homes fail to see this point and turn themselves into asset rich but cash poor. At least so feel the stress of lack of money.

    Cash in hand is extra important for people who are self-employed (irregular income). It really is something you pay close attention. Thanks for the article.

  13. Richard Says:

    From my own personal experiences with debt I would say that a key that I got into debt in the first place was actually a lack of cash flow. In some ways I saw my credit card as “bonus” cashflow. It wasn’t till the bills arrived and I realized I was going to struggle to pay them that I “wised up”.

    These days I maintain an emergency fund of easily-accessible savings and it’s saved my bacon on more than a few occasions. Indeed, having that “buffer” not only helps me sleep easier at night, but has also meant I haven’t had to rely on debt for anything for some years now – it’s a really nice feeling :-)