The Planner's Perspective: When Cash Isn't King

Paul Morrone |

By Paul Morrone CFP®, CPA/PFS, MSA

Cash is king, except when it’s not. You may be wondering under what scenario is cash not king, and that is when using it compromises your ability to do something else that may be more important from a long-term perspective. Let’s take the example of a young family who is actively trying to accumulate retirement. Their goal is to save $10,000 a year towards this goal and both spouses are about to make $5,000 year-end IRA contributions when they realize their car breaks down and they find out they need a new one.

A rash decision would be to rush to the dealer, cut a check for $10,000 and drive away in a new (used) car that afternoon. Problem solved, right? Well you can certainly make the argument that it was, at least temporarily. However, what if the success of their financial plan was contingent upon making that annual $10,000 investment, which they no longer can afford to because they spent the money on a car. Aside from this example highlighting the importance of maintaining an emergency fund to account for unexpected expenses, it emphasizes the fact that cash is not always king.

A better approach may have been to finance the car, assuming that a marginal amount of short-term debt service would not compromise the family’s long-term ability to save on a systematic basis. Skipping that one $10,000 investment today could mean a nearly $27,000 reduction in retirement savings 20 years down the road (assuming a 5% annual rate of return). With today’s low interest rates, a loan for the car may have cost a total of $10,500 in total principal and interest payments (over a 4-5 year financing period). With the interest portion (the extra $500) being the incremental cost of using debt over cash, this is a small price to pay when you consider the long-term impact of having an additional $27,000 in retirement. While these results are entirely hypothetical and rates of return are not guaranteed by any means, there is a compelling case to tactically (and appropriately) use debt as a tool to manage your financial future.

While I don’t advocate borrowing excessively, the prudent use of debt can allow you to manage your cash wisely and to extract the most long-term value from it. Evaluating the your current household balance sheet, income, interest rate, loan terms, prepayment penalties and total cost of the loan (principal, interest, fees) are all important factors needed to make an informed decision. Furthermore, the current and future cash flow impacts of using financing should be evaluated to determine the true cost of the loan and its effects on the big picture. Whether it’s for a car, home repairs or even college education, it may be wise to consider alternative sources of financing prior to simply draining the savings account.