When it comes to personal finance, most people are very familiar with the concept of cash flow. They know that their monthly pay represents cash flow in and checks written and automatic draft payments each month are cash flow out. As long as cash flow remains positive (the more positive the better), everything is great. However, most individuals do not realize that improving cash flow does not necessarily equate to improving overall savings and increasing one’s net worth. This is because interest expenses can reduce the accumulation of wealth, even though financing purchases (at higher interest rates) may improve cash flow.
What exactly does that mean? Perhaps the easiest way to explain it and understand it is with a good example. Here’s an example inspired by a post David at MyTwoDollars made in which a reader asks whether to pay off a car loan or increase the down payment on a new home:
My husband and I are selling our house and will be netting a profit of $52,000. We are building a $300,000 house and were wondering if we should pay off a Tahoe for $12,000 so we can get rid of a $600 payment or should we put all $52,000 into the new house. I guess I’m asking what the pros and cons would be. Thanks
Unfortunately the reader did not include additional information necessary for my example, namely the interest rates on the car loan and mortgage. I will take the liberty of fabricating the interest rates and some other information. Here are the assumptions we will make for the first part of the example:
- Auto loan balance: $12,000
- Auto loan interest rate: 0%
- Total monthly auto loan payment: $600
- Auto loan total term: 36 months
- Auto loan remaining term: 20 months
- New home purchase price: $300,000
- Down payment on home: $52,000
- Amount borrowed for home purchase: $248,000
- Interest rate on mortgage: 6%
- Mortgage term: 30 years
- Total monthly mortgage payment (principal and interest): $1,486.89
- Auto loan is paid off and money is not used for down payment on home purchase
- After auto loan payoff, monthly cash outflow is $1,486.89
In order for my example to work, I had to make the rather outrageous assumption that the vehicle was purchased with 0% financing. So if the auto loan is paid off the monthly cash outflow will be $1,187.11. Now let’s see what happens if we keep making payments on the vehicle for the remaining 20 months, and use the $12,000 to increase the down payment on the new home:
- New home purchase price: $300,000
- Down payment on home: $64,000
- Amount borrowed for home purchase: $236,000
- Interest rate on mortgage: 6%
- Mortgage term: 30 years
- Total monthly mortgage payment (principal and interest): $1,414.94
- Auto loan monthly payment: $600
- Monthly cash outflow: $2,014.94
Most people would tell you that paying off the car loan will help save $528.05 every month and over the course of 20 months would save a total of $10,561. However, I say that paying off the car loan will actually cost a total of $1,188.30 in terms of overall savings and accumulation of wealth. Certainly I will agree that cash flow will improve by $525.05 every month. However, by reducing the down payment on the new home by $12,000, it will actually cost more to pay off the car loan:
- Total interest paid on a 30-yr. loan for $248,000 @ 6% over 20 months: $24,558.27
- Total interest paid on a 30-yr. loan for $236,000 @ 6% over 20 months: $23,369.97
- Difference: $1,188.30
Keeping the car payment results in a higher net worth after 20 months, because the interest rate on the car payment is lower than that of the mortgage (now you see why I made my outrageous assumption of 0% financing on the vehicle). In terms of accumulating wealth, keeping the car payment is the more prudent decision. However, the majority of people would prefer to improve their monthly cash flow and pay off the vehicle. More often than not, individuals will sacrifice accumulating wealth in order to improve cash flow. Consequently this is the reason why most people never achieve financial independence.
The bottom line: if you ever have the opportunity to pay down loan balances, you should pay balances with the higest interest rates first. You may be tempted to pay off the balance on a loan with a lower rate if the monthly payment is higher than the payment on a loan with a higher rate. Afterall, it would result in better cash flow to do so. However, it would not result in the most favorable net worth to pay off a lower rate balance first. Let’s look at another example with some smaller numbers:
- You have a 36-month personal loan @ 10%
- Monthly payment on personal loan is about $260.
- Original personal loan amount was for $8,000.
- Remaining balance on personal loan is about $3,000.
- Remaining term on the personal loan is 12 months.
- You have another credit card with a $5,600 balance @ 18%
- Credit card has a monthly payment of $120.
- Total monthly payment for both loans is $380.
- You receive $4,000 for your annual bonus. Which balance do you pay off/pay down with the $4,000?
I contend that most people would probably opt to pay off the personal loan, because it would result in a better cash flow improvement. However, paying down the credit card instead would result in a higher net worth. Let’s compare the difference in interest paid over the next 12 months (the remaining term of the personal loan):
| |
Paying Off Personal Loan |
Paying Down Credit Card* |
| Personal Loan Interest Accumulated |
$0 |
$161.46 |
| Credit Card Interest Accumulated |
$969.82 |
$180.17 |
| Total Cost |
$969.82 |
$341.63 |
| Remaining Credit Card Balance |
$1,121.77 |
$249.48 |
* – Although paying down the credit card balance would likely result in a lower minimum payment, assumption is made that the credit card payment is maintained at $120/mo. Even if the payments on the credit card are reduced after paying it down, the results would be similar and still result in a more favorable net worth.
As you can see, by paying the lower interest balance first ends up costing more in the long run. Although cash flow improves over the next 12 months, you pay more in interest expenses and are left with a higher debt balance in month 13. A higher debt balance means you have a lower net worth. Not only do you pay less interest in months 1-12, but you will pay less interest in subsequent months and debt will be eliminated faster. So remember, if you can afford to do so, pay down your loans with the highest rates first.
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