Chapter Seven
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Cashflow is king
I feel like we got a little bit away from finances in the last 2 chapters, so let’s get back on track. Traditionally speaking, most financial books focus on interest rates, financial concepts, or debt amounts. I am here to say the truth is that one of your primary focuses in establishing a healthy financial foundation should be to maximize your cashflow above nearly everything. I don’t care what the interest rates are or the debt amounts. My main concern is how much cash flow is costing you on a monthly basis.
Falling back on our previous chapter, compounding interest is an immensely powerful thing and unfortunately if you have no cash to take advantage of this then you are out of luck. Financially speaking your goal needs to be having as much cash flow as possible which will ultimately allow you to buy the things you want and need as well as invest into assets that will allow your money to earn you more money.
What this means is we want to minimize expenses and maximize our income to maximize our cash flow and have more and more money at the end of the month.
Interest vs. payments vs. cost
What really irks my gears every time I hear it is when people say they bought someone with the excuse ‘well it is at 0% interest’. They often do this when they buy a new vehicle, couch set, or one of those 12-month interest free grace periods on some credit cards.
I’ve heard this justification so many times to rationalize vehicle payments of $500+ p/m or furniture sets for only $129.89 p/m for 24 months. A good financial habit to establish is to think less about the interest rate and more about the impact an item will have on your budget.
There is a reason that companies advertise their interest rates. It is because they know most people care about them. Well, here is a new lesson for you: stop caring about interest rates. They are meaningless, in most situations, and almost entirely irrelevant when buying consumer goods like vehicles and furniture.
What should really matter to you is the initial cost and the payment amount on a monthly basis. If you have a 0% interest car loan, with a balance of $30,000 with $500 p/m payments, you will be worse off from a cashflow perspective than an individual who buys a $15,000 car with a 10% interest rate as the payment would only be $318.71 p/m.
Many financial experts would disagree with me on this one, but no one can contest that the $500 p/m payment costs more than the $318.71p/m payment.
Cashflow maximization
So how do you implement this cash flow maximization process to eliminate debt? Well it is hard, because there is no 100% for sure answer to this as it depends on several factors outside of the math: your behaviour, your financial position, the stability of the situation, etc. but we can certainly take a look at basic theory.
Let’s assume an individual has the following debts:
• Line of Credit $10,000 < $100 min. payment, 8% interest
• Car loan $5000 < $500 min. payment, 4% interest
• Credit Card $3000 < $80 min. payment, 19.99% interest
The question becomes - how do you prioritize this if you have a bit of extra funds to throw at the debt?
By far, the two most popular methods are the Debt Snowball and the Debt Avalanche. Both concepts work similarly: you pay off one debt and then you take the minimum payment from the paid off debt and then use it to now pay off the next debt in the order of priority. The difference between these two concepts is how you prioritize what gets paid off.
The Debt Snowball lists the debts from smallest to largest and prioritizes the smallest first. The Debt Avalanche lists the debts from highest interest rate to lowest interest rate.
The Debt Snowball would list the debts like such:
• Credit Card $3000 < $80 min payment, 19.99% interest
• Car loan $5000 < $500 min payment, 4% interest
• Line of Credit $10,000 < $100 min payment, 8% interest
The Debt Avalanche would list the debts like such:
• Credit Card $3000 < $80 min payment, 19.99% interest
• Line of Credit $10,000 < $100 min payment, 8% interest
• Car loan $5000 < $500 min payment, 4% interest
Are these effective ways of paying off debt? Of course they are. But I believe they miss a critical component and that is the cashflow component. In both options, you are only freeing up $80 p/m in minimum payments at first. That won’t really assist you in paying the other debts off much quicker as $80 p/m won’t make a massive difference.
What happens if, one month, the individual has a few unpaid days off work? They are now stuck in the same situation they were prior to them paying off the small credit card.
In my opinion, a better approach would be to pay off based upon the cashflow cost to your budget. To calculate this, simply divide the payment by the balance owing and multiply by 100 to obtain the percentage of how much you’re paying relative to the balance each month and then prioritize from highest to lowest.
Let’s look at an example for the Credit Card $3000 < $80 min payment, 19.99% interest
$80 payment divided by $3000 balance = 0.0266 times 100 = 2.66%. So every month you are making a payment equal to 2.6% of the balance.
Now let’s prioritize the remaining amounts:
• Car loan $5000 < $500 min payment, 4% interest = 10%
• Credit Card $3000 < $80 min payment, 19.99% interest = 2.6%
• Line of Credit $10,000 < $100 min payment, 8% interest = 1%
You can very quickly see that the car loan is a significantly higher drain on cashflow than the credit card or line of credit. I would personally recommend, in this instance, that the individual focus on paying off the car loan as quickly as possible. This will allow them to save $500 p/m compared to what they were spending before. They would then make quick work of the small credit card and then allow them to clear up the line of credit very quickly.
In this particular example if something bad happened after the debt was paid off, the individual would have $500 p/m more than they would have had, had they focused on the credit card first.
Most people would be far better off using this method of prioritizing and paying off debts than they would ever be with the debt snowball or debt avalanche as it protects them in the future. It can also be a double-edged sword because it frees up cashflow a little faster than other options; it often leads to people then taking that cashflow and spending it elsewhere and not on the debt.
So always make sure to take what you were paying and continue paying off your debt.
Mathematically, the debt avalanche is always going to be your cheapest option overall, but in my opinion it can leave you vulnerable, especially if you have low interest debt that carries exceptionally large payments.
Cash is what allows people to make decisions and have choice and we want to ensure that we maximize our cash to ultimately achieve what we want to achieve.
Exercise – Go through your own debt, if you have any, and create a debt pay-off plan based upon the 3 options above. Compare them and determine what frees up the most amount of cash in the fastest amount of time. Use the calculation provided in this chapter to determine what to prioritize.