Most physicians are fortunate to have more income than expenses each month. With that excess cash flow (“ECF”), a choice has to be made whether to invest, keep it in cash, or pay down debt. Many people just compare their tax-adjusted interest rates on their debt in order to determine which one to pay off first. Some also adjust their interest rate for inflation to understand the long-term impact of their cash flow choices compared to building their emergency fund or investing. For example, ECF can be used to get the following tax and inflation-adjusted long-term returns:
- 401(k) match: 50-100% for the match plus a 4-6% investment return;
- Stock market: 4-6% return;
- Savings account or CD: -1% or 0% (but reducing potential future credit card debt)
- Paying down mortgage: 2-4%
- Paying down credit cards: 18%+
In almost all cases, paying off high interest debt and taking advantage of an employer 401(k) match are going to be the most efficient use of ECF. Beyond that, although comparing tax and inflation-adjusted interest rates to determine how to use ECF is great, there is still another level of thinking to consider. Specifically, rather than choosing a focus (such as building an emergency fund or paying down a mortgage) and sticking with it, we should be periodically evaluating our expected return on our investment options and comparing it to our tax and inflation adjusted rates on our debts and emergency fund.
For a U.S. investor, we should take a look at the U.S. and foreign stock markets every 2-3 months and see where they fit in the above chart. Although no chart or formula can predict what will happen, we can use the above chart to price an expected return on those stock investments (note that for bonds, the yield of the bond is the best estimate of its expected return) to determine the best choice for our ECF. If someone has a car loan with an inflation adjusted interest rate of 4% (no tax deduction) and the choice is whether to pay that off more quickly or invest in a taxable account in the U.S. stock market right now, when most of the above indicators are predicting a much lower return than 4%, then it may be best to focus on the student loan now. If the market drops 20% in the next few months, then perhaps the focus should switch to investing instead of the student loans.
With cash having a negative rate of return right now, why should it even be part of the analysis? The answer is that cash should be thought of in terms of opportunity cost. When you take your ECF and pay down 4% interest rate debt now, you are giving up the opportunity to apply it to some other use in the future. With some debts, such as your house, you can likely get that cash back, but not your student loans debt payments, and not readily car debt payments unless you sell the car. With investments, in most cases you can get your money back, but sometimes those investments decrease in value, and the investments may be illiquid. With an emergency fund, you are choosing to accept a negative 1% real rate of return to reduce the chances that you will have to incur debt, such as credit card debt, at a much higher interest rate in the future. Cash can also serve as a hedge against a large stock market drop, at which point cash’s negative 1% rate of return will look pretty good.
In running through the ECF analysis, the tax and inflation adjusted opportunities should be compared to cash, with cash getting some addition for its flexibility. As a result, in the present case where expected U.S. stock market returns are very low, and most non-credit card debts have very low interest rates, it may make sense to put ECF into an emergency fund. Then, when the stock market corrects, thereby bringing up expected future returns on investments, then the cash is available to obtain those better returns and not tied up in a lower-return situation.
Why do I keep adjusting for inflation? The primary reason is that it allows for comparisons of ECF opportunities across time, since inflation not only decreases the value of money over time but also inflation itself changes over time. This creates yet another dimension to the analysis and further emphasizes the role of cash. Not only are we looking at the best opportunity for ECF today, but also at the best opportunities for cash flow over the next few years and how inflation will impact those opportunities over time. I have written about this in relation to a home mortgage, and I think that the same analysis applies to low-interest student loans. Specifically, with both of them having tax and inflation adjusted rates near 0% for many people, then it makes alot of sense to put ECF towards investments and/or cash savings depending on the state of the investment markets. In other words, your cash may be costing you 1% a year right now compared to opportunities to get a 1-2% return (again, adjusting for inflation) by paying down debt, but if there is a good chance that the cash could help you get a 7-8% return or more starting a year or two from now, then it may be worth the wait.
None of this is a new concept, but Dynamic Cash Allocation is underutilized by investors and advisers alike. Just as paying off the correct debt first can save thousands of dollars of interest over a lifetime, implementing the above strategy should add even more wealth in the long-run.