Cash over Credit – Cash is King

I was browsing through Yahoo when I saw this article on Credit scores hitting new lows.

I started thinking, people see credit as an important vehicle to achieving personal financial goals, but if the recent recession should teach us anything; it is that maybe “cash is king”.  Right? When I was younger, my first goal was to achieve a great credit score, my father told me to stop worrying about my credit and save my money. He dead on, here is why…

I believe in most environments, cash flow and liquidity can be more important than the touted stance of “proper leverage” to maximize income or your IRR. Ask many individuals how leverage worked out 3 years ago. Leverage means risk, and not always the kind that leads to high yields and more money in your pocket. Especially when it occurs across the masses.

When I speak of leverage, I think about the ability to utilize a loan at a fair interest rate, which frees up your capital so that you may earn a higher interest rate. Think about taking a loan on a $200k house instead of paying for it in cash.  What is the true cost of that loan? Let’s assume a 6% interest rate, a 25% marginal tax bracket and the ability to fully utilize the interest deduction on Schedule A.

That leaves an after-tax cost of about 4.5%.  So to properly take advantage of that leverage, you would need to have $200k earning more than 4.5%.  Essentially, your net income between the two would be (net-tax interest revenue on investments – net-tax interest expense on house). Interest rate environments will be highly influential on whether this is feasible and advisable. You also have to consider the risk of earning that rate of return, what if you fail to achieve a positive rate of return? There is no risk factor in you borrowing the money, you have to pay that fixed 6%. There is risk to the bank that you default, but when investing, you must pay that interest rate amount no matter what.

Now, think about cash flow.  Let’s say $200k was used to pay off the house and now there is no savings (or a smaller savings). The difference of course is that a major cash outflow is now gone, and all income (cash in flow) can be used to invest at opportune times. More money can be put away for retirement. If your investments don’t perform as well as expected, YOU WON’T BE HANDCUFFED by your debt. It may take some time to accumulate $200k again, but the benefits may outweigh the detriments. You also remove the risk of negative equity in a house if markets decline. Your risk on your investments is not tied to debt obligations that can turn your financial health upside down.

Incoming cash flow from earnings and investing is now redistributed towards self-directed investments, instead of paying that big mortgage. When the time comes that investments become cheap, you will be the happy guy on your block. Look at the current environment; everything is valued low, from equity and debt instruments to real property. The guy with cash now, is sitting pretty. The guy that was leveraged before, may be part of the foreclosure statistics.

The cost of capital is high and the people with cash will benefit while the people without it may suffer. Many wealthy people preach that “you should make money work for you instead of working for money yourself.” This mostly revolves around the ideology of having cash and not having it tied up in debt.

So let’s bullet point some of the advantages:

• More flexibility
• Less stress
• Ability to sustain recessive periods
• Easier access to investments
• Financial agility in every market cycle
• Easier to take advantage of compounding interest at younger ages
• Stress discipline over frivolous spending
• Not at the mercy of a lender and manufactured credit score
• In the long run, possibly even higher yields than proper leverage
• More intuitive management of risk factors

The reality is that people with cash are not so worried about credit, while the people without cash, need credit. Ironically, it is the people with cash who probably have better credit, while people without cash are having credit problems. This only compounds their money problems. Would you rather have cash, or be begging for credit to pay your bills?

Don’t ever discount the power of leverage, but consider the context of what you are doing and how powerful cash can be in different cycles of the market.

Stop worrying about our credit, and think about making financial decisions that favor cash in your pocket and not someone else’s pocket. This will indirectly improve your credit while giving you the opportunity to invest when the right opportunities comes knocking on your door. My father was right, maybe cash is king.