There are many important factors to consider in personal finance. Opportunity cost, rate of return, interest on loans or investments. But if you asked me to select the single most important factor in making decisions, what would my answer be?
My answer would be cash flow.
This is really what all of our efforts boil down to. Generating the largest amount of free cash flow so that we can retire when we want to. Now there are really three ways to increase your cash flow, assuming you have debt. One is to decrease reoccurring expenses, another way is to invest, and lastly pay off your debts. So lets go over some of these areas and talk about the advantages and disadvantages of these things when trying to increase the spread in cash flow.
Decrease Reoccurring Expenses
You may wonder why financial articles always seem to poke fun at weekly lattes and a monthly cable subscription. It is not that the single expenses are expensive in and of themselves, but cumulatively they are very expensive. Take the weekly Starbucks, or whatever brand you may prefer. Say you spend $4.00 a week that is just $208 a year. Not too bad! But lets consider what it costs to maintain that habit.
Assuming a 4% yield after inflation on your investments, you need an extra $5,200 ($208 divided by .04) saved to maintain this habit. And really most dividends and the S&P 500 index are not yielding near this amount currently. So lets look at Vanguard’s S&P 500 index fund, the yield is currently showing 1.95%. So lets say 2% for simplicity, you would need $10,400 dollars in the S&P 500 index to fund your weekly coffee without worries.
And this gets worse with more expensive habits like cable or satellite television. Say you have some combo deal for $100 combining TV and internet and the internet will cost $35 without the combo pack. So you are looking at $65 a month, or $780 a year. Using the base of 4% yield you need $19,500 to keep your TV indefinitely.
It is important to note that these numbers above do not take in account the costs of taxes for your income, so it is possible that you may need even more to maintain these in retirement. This is why when I find ideas to decrease expenses I like to try them out and if it worked for me I feel no shame in sharing. Such as switching to a prepaid phone, making my own laundry soap, and cutting my own hair. I read articles about people using Amazon prime, or how their membership works for them at Costco. I cannot emphasize enough that this is one of the more important areas and why so many articles focus on it. When you make changes in this area not only are you decreasing your future cash needs but you immediately increasing your cash flow allowing you to save more now as well.
Increasing Cash Flow Passively
Investing in Dividend Stocks
This is probably my personal favorite way to increase cash flow presently. My favorite example of how this strategy works is the blog Dividend Mantra. Jason has built a six figure portfolio on a middle class income in a small amount of time. This is now generating a decent cash flow that will in time meet all of his finance needs. There are many who argue that index investing is superior, and I would say that the overall returns are more than likely to be superior, but when you look at this form of investing from a cash flow perspective dividend investing is king. You have a more stable stream of income and as a result a change in the stock prices will more than likely not result in a change in your lifestyle.
Land-lording or Real Estate Investment Trusts
I am no where near an expert in this area, but I must admit it is intriguing. There are alot of blogs and resources that focus solely on this area of building income, one of which is No Nonsense Landlord. This is an area that someday I may want to try out, but really I am not sure if it is for me or not. Some of the risks include damage done by tenants and vacancy and I don’t desire to jump into this realm while having to rely on steady cash flow. I think it is something you can either start early to get a feel for how things are running in your personal rental, or start later when the cash flow would be a bonus. Personally I would like to try it out later when I don’t need the cash flow to live off of.
That said, you can still invest in real estate without directly owning a rental unit. With Real Estate Investment Trusts, or REITs. This can be a way to invest in a diversified market and remove yourself from the issues of repairing a unit and dealing with a vacancy.
Interest
Interest returns are not that great in the current environment, but that does not mean that will last forever. Besides earning a respectable interest on your checking account, you can invest in bonds. Bonds have different classifications upon their risk level, with ratings done in letters (the highest rank depends upon the agency). Usually the higher the interest rate, the riskier the bond.
Now the odd thing about bonds are, in a rising interest rate environment, the value of present bonds decrease. That is because in order to make themselves competitive with the current market rate, if you are to sell a bond then you must less it for less. On the other hand, when the interest rates are decreasing the value of your bond increases to adjust to the current market interest rate. If you buy individual bonds are hold to maturity you will receive the face value back regardless. When interest rates begin to increase I may consider investing in some bonds to diversify in this area.
Paying Down Debt
The last area to improve your cash flow is to pay down debt, if you have any. The thing about paying off debt is you will probably get the higher return on your cash flow in doing so, because part of your monthly payments include principle. This does not mean it is the best investment, but it is more than likely the fastest way to increase your spread in cash flow. That is why the method of snowballing is so effective for people paying off debt. It is not that they will be paying the least amount of interest in this method. But it is that they see perhaps the fastest result in decreasing their monthly obligations.
For example using my own debt, I showed a car loan in my last Net Worth update. At the end of August it had a balance of $10,100 and an interest rate of just 2.75%. The interest portion, or expense, is quite low so I would get a better long term return by investing the money instead of paying off the debt early. But my payments are $2,400 a year, or just over 23% of the loan balance annually. So by paying off the loan early, I obtain a much quicker return on cash flow. So for someone who is in a dire situation cash flow wise, paying of even low interest debt can perhaps have the biggest impact for them on a monthly basis.
I am not advocating for everyone to pay off low interest debt instead of investing, but what I am saying is that it can be the right thing for someone to do who is struggling on a monthly basis to get some air.
What about you, what do you consider the most important aspect of personal finance?
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The most important aspect of finance for me is to save for a rainy day and keep your spending in check. I know many people that make more than me have no assets. They spend just as much or even more than they make and are always playing catch up to their lifestyle.
Saving an emergency fund is very important as well! The lifestyle issue is one that needs to be addressed if people want to start building their cash flow.
All great tips. Generating positive cash flow is very important. I think another important concept is pay yourself first. By paying yourself first you can use the money to invest and grow the passive income.
Very true Tawcan. By paying yourself first you can start to build a stream of cash flow to help yourself for years to come!
Kipp,
I remember getting asked this question not long ago as a big compilation over at White Collar Freedom.
My answer was basically living below your means. If you’re unable to live below your means then everything else becomes moot and you’ll never be able to cash flow your way to freedom anyhow.
But cash flow is incredibly important. Once you create a sizable gap between income and expenses you can use that capital to start building cash flow-producing assets for you, allowing your money to work for you (rather than the other way around).
Thanks for the mention!
Best regards.
Hey Jason,
I think living below yours means and cash flow are closely related. If you are spending all of your money then you have no cash flow to improve your finances. So I think it is one part of the cash flow picture which is what I mentioned while discussing decreasing expenses to increase cash flow. So I would almost say, living below your means could be a sub category of increasing cash flow.
No problem on the mention, keep up the good work!
Nice discussion Kipp. I would say free cash flow, I think. That way it takes into account how much you spend as well as cash flow. I know we’re looking to get out of the rat race, and to pursue our interests/passions. Being cash flow positive is about the only sustainable way to do so.
-Bryan
Hey Bryan,
Yes free cash flow is important, and I indirectly discussed that when talking about paying off debt. The expense portion, or interest, may be small but the cash flow needs could be high, espically near the end of the debt repayment when the majority of your payments are going towards principal. So for someone near retirement and just needs to free up cash flow, paying off those debts even if at a low interest, may help that individual to be free quicker.
Cash flow is pretty important. If you have a pile of cash and you spend all then you’ll have to earn it all over again. With cash flow, it just keeps flowing in. I need to develop more ways to increase my cash flow, it’s too low haha!
I think you are doing better than me on the cash flow front, your portfolio has been growing very nicely! I guess I am working more on the debt front while still getting some investments. So a little bit of both here, slowly and surely building up that free cash flow!
My most important personal finance concept is this – live below your means. Theres no sense in worrying about anything like dividends or interest if theres no money to invest because its all being spent each month. People who live below their means are able to achieve a high net worth in the long run
I agree Dan, living below your means is a way to increase your free cash flow. Jason mentioned this well and I think the concept works hand-in-hand with cash flow and it is part of understanding how cash flow works. Because not only do you get more free cash when decreasing an expense, you also can invest and build up other sources increasing your cash flow. It makes a huge difference!
I like Dave Ramsey’s phrase “live like no one else so you can live like no one else”. Living significantly below your means while keeping your eye ever on the future.
I agree Kirsten! If you spend 100% of your income, or worse, over 100%, there is no way you can even start building your cash flow! That is why I also talked about decreasing expenses and why it is extremely important – on two points. First it immediately increases your cash flow, and second it decreases your future cash flow needs. And I guess third would be you can use that to also build future cash flow. It is a very good way to go!
Have to agree with the other comments, living below your means to have cash flow. Since becoming debt free we now have the cash flow to build wealth, take advantage of deals, sales etc that without cash we could not have done previously. We are no in the position to help others more often. Its a great feeling.
Hi Brian,
I am a big fan of living below one’s means, and I am in agreement with everyone on this. I feel it is just one subset of mastering your cash flow.
Thanks!
Kipp
I’m all for paying off low-interest loans. Interest rates won’t stay low forever, and I believe there will be a rude awakening when the hikes occur. I’m hoping the rates stay low at least until we’re debt-free, but if they don’t, I feel a satisfaction in knowing that we’ve lowered our debt significantly enough that any rise in interest rates will not be a huge burden to us.
Not many people argue for paying off low interest loans, more so if they are fixed rate loans. What types of low rate loans are you referring to, like an ARM mortgage, or a student loan? Everything I have is fixed so I do not have to worry about rate increases, but from a cash flow perspective, you can really free yourself by paying even these loan interest loans off.
I’m still not used to the amount of cash flow that has opened up since I finished paying off the student loans. ~$1500 a month that used to be going towards debt repayment for over 2 years is free. Like I said, still not used to it!
That is alot of debt Steve! My total monthly payments don’t even add up to that much, although, I have paid off some student loans already. But even if those were not paid off, I don’t think my mortgage, car, and student loans would have added up to that much. Great work getting that paid off! I do struggle internally with the need to invest and the desire to pay off lower interest debt. Long term investing should win out, but with no debts you could weather just about any financial situation.
I’m a fan of reducing expenses and simplifying life in general. If you don’t need to buy much, you don’t need to make much. It works pretty well for us and I like the challenge of not spending money :)!
I like not spending money either! But I should say, I do not mind spending money on doing something I enjoy or going to visit friends out of town.
This is huge, IMHO. The more cash flow you have, the more choices you have to grow wealth the way you want to grow wealth.
Thanks Laurie, I agree! More cash flow means more options! Some people aren’t that comfortable in dealing with rentals (such as myself) while others may not be too comfortable investing in the stock market. Everyone needs to find the method of generating cash flow that works best for them.
I’m definitely less of a numbers guy when it comes to paying off debt. I used to think I could outsmart debt(balance transfers, low interest rates, etc), but it turns out I got distracted with outsmarting debt and instead chose to focus on paying off debt for many of the reasons you mentioned above, Cash Flow primarily. Student Loans 3.63% interest rate, invest, invest right? Nope I’m going to pay it off and have an extra $200 cash flow, that and all of that extra money I have been throwing at my SL is mine, all mine and I can choose to do whatever I want.
I feel the same way you do Steven, I just am not a big fan of debt overall. Although you may receive a better long term return on investing, you will make out on the cash flow side by paying off your debts early which also reduces your current needs for income. I am leaning even more in this direction nowadays, I desire to work doing something that provides true happiness, and that is much easier to do without a noose of debt declaring you must make so much money to maintain your lifestyle.
I’ve had friends come up to me and tell me that they don’t really need to think about personal finance because they don’t have much savings and don’t have much debt. While reducing debt and increasing savings is basically 95% of personal finance, my friends can still practice increasing savings and maintaining zero debt.
That is true Mark, they can really do well by practicing personal finances and turning those small savings into cash flow for years to come. The great news is that you say they have small amounts or no debt, that is a solid foundation and alot better than where others start their journey.