Difficult talks about a pleasurable finance topic (Part 3)

November 21st, 2008 · No Comments

In a previous post, I mentioned how we had recently received a relatively large, lump sum, cash amount from a life insurance payout and how this caused “analysis paralysis” as we debated what to do with the money to maximize how it worked for us.  In the end, we realized there were two time periods we had to deal with.  In this post, I’ll talk more about the decisions we made for the second of those periods, the long term plan.

Bye-bye car loan

Bye-bye car loan

So now that we had completed our emergency fund check-up, my wife and I had a number of discussions to figure out the next best way to use this unexpected cash.   The floor was pretty much open to any idea at this point and we’d brainstormed alot of them — everything from bury it in a steel box in the backyard to buy or start a fast-food franchise (In’N’Out in Texas interest anyone else?)  However, all of our ideas tended to break down into two vary large categories which I’ll call the “Sure Thing” and the “Speculative”.

A “Sure Thing” is a use of the money where the result is pretty close to guaranteed, say putting it in a CD where it will earn a fixed yield for a period of time, or paying down debt where you’re guaranteed to have saved yourself the cost of interest and/or increased your future free cash flow.  “Speculative” meant that there was some risk involved, such as the risk that a start-up business would fail, or an investment would sour, etc.  To be clear, we’re classifying here on the risks directly associated on the stated goal and not on the surrounding environment’s risk.  For example, there is always a risk that your CD yield won’t be larger than inflation and thus you will have effectively lost money by the time the CD matures.  That risk is not what we’re classifying by.

As we talked things over, and over, and over again, we eventually came to the conclusion that we had too much other financial risk in our lives (one of us works for a small tech company, the other does individual consulting projects, and given the current economic market most of our investments were shrinking in value) not to put a large percentage of the money toward a “Sure Thing” or two.  Our thoughts at that point were to put somewhere around 50% of the money toward the “Sure Thing” category.  The final amount would depend on what concrete actions we identified to take within that group of ideas.

You might think that the decision on what “Sure Thing” to act on came down solely to analyzing the rates of return (including tax consequences, of course!) of each idea, but you’d be wrong.   While that was indeed a significant factor, my wife was quick to point out that we should also be concerned with maximizing our free cash flow — this would allow us to do something like “snowball” debt payments or give us the flexibility to take advantage of future opportunities when they arise.  To help illustrate the cash flow point, consider the following hypothetical, non-revolving debts:

Name Balance Interest (APR) Payment
Home Loan $35,000 7.00% $250
Car Loan $25,000 4.50% $750

If you had $25,000 to use and were solely interested in maximizing cash flow, you’d choose to pay off the car loan as that would free up $750 for each of the following months. Whereas applying it to the home loan would save you more in interest paid, but you’d have no change in payments due for a great many months yet.   The difference in cash flow change is fairly obvious: $750 vs $0, so what’s the difference in interest paid?  When calculating this, it is important to realize that there are tax differences between these two loans.  The interest on the home loan is an income deduction (for those not hit with AMT) for tax purposes but the interest on the car is not.  This reduces the effective interest rate you’re paying on the home loan by a percentage equivalent to your tax rate.   For example, if you end up paying 25% of your income as tax at the end of the year, then the interest rate you’re paying on your home loan is really:

7.00% – (0.25 * 7.00%) = 7.00% – 1.75% = 5.25%

There isn’t quite as big of a spread between interest rates for these two loans as there had originally looked to be.  Only 75 basis points!  This amounts to a savings of only $187.50 for the first year on interest paid between your two choices of where to send your $25,000.  (Assuming your tax rate doesn’t change during that year.)

So let’s summarize and see which makes more sense.  If you make a $25,000 payment to the home loan, you’ve saved yourself roughly $190 (I rounded up) in interest during the next year when compared to paying the auto loan but you’ve had no change in cash flow needs for the following months.   If instead you paid the $25,000 to the auto loan, you’ve cost yourself $190 in extra interest you have to pay during the following year, but you now have $750 extra each month to do something with, and you could change that something every month if you wanted to.   By the way, if you invested that extra $750 each month in something with a 3% APY, you’d have earned $147.60 of that $190 back.

In the end, our next decision was to use some of our “Sure Thing” money to pay off our outstanding auto loan.   Given that we’ve already worked hard to be in a situation where we maintain no credit card debt, we now find ourselves without any debts beyond the house mortgage and student loans.   What a feeling of relief!

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Tags: Loans · Personal Finance

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