While everyone’s financial plan differs in some way, we’re still united by the common goal of growing our net worth so that we have enough capital to fuel the lifestyle we’ve planned for. Assuming you have excess cash flow net of day to day lifestyle expenses and commitments, there are only three things you can do: save it, pay down debts, or invest it.
Having a cash buffer of savings is the top priority because life’s uncontrollable events can be potentially devastating to any progress made toward the financial plan and can even cause bankruptcy, forcing you to start over. These are events like losing an income or unexpected expenses like repairs or health care costs that aren’t covered by insurance. To mitigate the amount of damage and quickly recover, it’s important to have some dry powder (cash or cash equivalents) on the side. My old roommate in California liked to keep $10,000 as reserves, while a wealth advisor may tell you to have 3-6 months of living expenses saved up – it’s really up to you and your unique situation. In addition to random “what if” scenarios, you should also consider large, planned expenses upcoming in the next 6-12 months and ensure you are going to be able to satisfy those goals with a high degree of certainty. Having some dry powder to the side allows you to be more opportunistic about making larger purchases (whenever a deal too good to pass up comes up) or investments (huge market correction that allows you the opportunity to buy in again at lower prices) as well.
You should be comfortable about your savings buffer, however, you don’t want to be overly cautious and hold too much cash. This is because cash has a negative return when adjusted for inflation and it will be more difficult to increase your net worth to a level at a rate that’s required by your plan. When thinking about the buffer that’s right for you, consider the following:
- What sort of risks does my financial plan face? Quantify this answer in terms of costs in dollars and duration.
- How quickly can I recover from these financial risks?
- If some event requires capital in excess of my savings, how can I make it up? What are the long term implications of this?
- How much can insurance assist with uncontrollable damages? (Please don’t go buying insurance for every imaginable risk to your plan, insurance is much more complex than that)
Debt vs. Investments
After you’ve established a savings buffer, you have just two decisions to make with excess cash: pay down debt faster or invest. As an impact to your financial net worth, they can be thought of similarly. Any debt you have carries an interest rate, also known as the cost of borrowing. While investments help increase your net worth, accruing interest from holding debt decreases your net worth. That being said, not all debt is bad. Any debt that you’ve taken on to purchase assets likely to appreciate in value can be worth it if the interest rate is lower than the expected asset growth rate.
Take a look at the liabilities section of your Personal Financial Statement and dig into the interest rates. For example, revolving debts (credit cards) typically carry an interest rate of 15%-20% (if you don’t pay down your card every month). This is higher than the expected return on most investments and so it should be paid down before investing. As of June 2020, 30 year mortgage rates in Texas are 3.51% while Texas real estate has been appreciating at 6.74% annually in the last 5 years – this makes the mortgage worth keeping. The decision to pay down debt or invest cash is all about opportunity costs as you attempt to maximize the return of limited resources (cash).
Figure out a cash buffer first and then optimize the line items that maximize your net worth, whether that’s investing or paying down debts.
Just remember, I’m not your financial advisor so the information may or may not best apply to your situation and you should get formal advice prior to doing anything. The information/data that is shared should be double checked by you and any conclusion that is driven based on past data is not to be interpreted as my advice for your future. I will do my best to only write what I think is true and right, but mistakes happen and we’re all learning together – this is meant to be a conversation. My employer has nothing to do with this blog – in fact, they’re probably upset I’m writing here instead of working.
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