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Everybody knows the phrase Cash is King, but even bright, smart financial advisors seem to forget that everything else is subservient to the king. Everything. I've often seen advice doled out that flies in the face of this one simple rule. What is it about this rule that people just don't get?
If you look at every bankruptcy, whether it is personal or a business, the fundamental problem always comes down to one simple fact: they ran out of cash. Sure, there are always reasons why they got into that situation. Many consumers run up huge bills that they ultimately can't pay. Or in the case of a company like General Motors, they didn't produce enough good models to generate positive cashflow. So there are always the underlying reasons, but in the end, it comes down to being done in by a lack of cash. Cash gives you enormous flexibility, and without it, you limit your options.
Let's take an example to show how a financial advisor gets this penultimate 'King Cash' rule wrong. The following example is real, but I'll exclude any names or the company of the advisor. A recent engineering grad three years out of school had $10,000 in student loans that were accruing at 6.5% interest rate. Although he had a good paying job, he was given a 12 months notice to find a new employer because his work was being outsourced to India. Fortunately, this engineer had managed to put aside $12,000 in his savings accounts. The financial advisor looked at his situation and recommended that his client pay off the student loans since there was no way to earn 6.5% interest rate on his savings. The rationale being that paying off the loans would save $650 in interest over the course of a year. There's no doubting the financial advisor's math skill or his ability to use a calculator but he missed out on the big picture - our engineer needed enormous liquidity to cope with his impending loss of employment.
To begin with, our engineer's $12,000 savings was already woefully inadequate. Generally speaking, one should have an emergency fund equal to six months expenses and preferably a year - especially in these turbulent economic times. Second, the engineer should be using the next 12 months to boost up his cash reserves in case getting the next job takes longer than expected. Since the loans were student loans, there was no risk of the interest rates spiking as with a credit card.
The pain of paying 6.5 percent interest while earning 3.0% on your savings is dwarfed by the pain the engineer will have if he cannot make his rent or credit card payments. Once you run out of cash, everything begins to unravel. Late fees and interest penalties pile up. Interest rates soar. Your credit score plummets. Debt collectors start harassing you. The chain reaction starts and it gets harder and harder to navigate your life.
If you keep the Cash is King maxim in your head, you'll avoid life's most difficult situations. Day to day living is a cash flow problem and you'll be better positioned to smooth out the bumps in the road and deal with almost any situation you encounter when you have a comfortable cash cushion to lean back on.
If our financial advisor were to give the best advice, it would have been to leave the student loan alone and work on reducing costs as much as possible to boost the emergency fund. Once the dust settles and the engineer lands a new job, he can always go back to rebuilding his emergency fund and start working on getting debt free.
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