Pay Cash or Not? Cash Flow Versus Liquidity

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Let’s say, hypothetically, I have $50,000 in cash just sitting in my savings account. I need to replace my car and I’ve decided on a model that costs $20,000. I can get a very low interest loan for that car from the dealership – 0.0% or 2.9% or something like that.

What do I do?

You can really make a compelling case for either just buying the car with cash or keeping the money in checking and using the low-interest loan. In fact, I often go back and forth on that very question, and you’ll see differing opinions on this from different personal finance folks, including answers that vary depending on the interest rate of the loan.

The issue comes down to one of personal finance philosophy: cash flow versus liquidity.

Cash flow simply means the amount of cash you have going in and coming out each month. Your income versus your expenses. The fewer expenses you have, the greater your cash flow and the easier it is to save for other goals or survive economic twists and turns.

Liquidity means that you have easy access to cash or the cash value of something. Your baseball card collection has really low liquidity. The home you’re living in has pretty low liquidity. On the other hand, the cash in your pocket is very liquid. Liquidity means you have flexibility because you have cash in hand.

The usual argument against improving your cash flow is that you have to sacrifice liquidity to get it. In other words, to buy that car, you have to sink $20,000 in cash into that car. Suddenly, you have a lot less liquidity. You have a smaller cash reserve to deal with emergencies that come your way.

The argument against liquidity is that it requires discipline to maintain it. If you had $50,000 in the bank, would you not be tempted to buy something that you wanted? If you did, you’ve lost that liquidity for something you don’t really need.

My belief is that liquidity is better if you assume that your future is full of positive opportunities. If tomorrow is going to bring opportunities to get ahead, investment opportunities, business opportunities, and the like, liquidity will open those doors for you.

On the other hand, cash flow is better if you see a future with significant risk. A future with significant risk translates into a future with reduced income or with increased expenses – in other words, a crunch on your monthly cash flow. A long illness. A job loss. A new child. An ill or dependent parent. Having collateralized debt – like a car loan or a mortgage – means that the item can be repossessed, leaving you not only with reduced cash flow, but without transportation or a roof over your head.

The problem? We can’t see the future. We do not know what’s coming in the future. Is it a future loaded with opportunity? Or is it a future with significant risk?

black swanIn the excellent book The Black Swan, the author, Nasim Nicholas Taleb, argues that we often use mental tricks to disguise the randomness of the past from ourselves, turning our very random lives into a coherent and understandable story. We often do the same thing with the future, imagining not the chaotic future we’ll likely have, but a smooth road leading to some destination.

Lately, I’ve found myself hedging my bets more and more. What if I become ill? What if my income level drops? The better my cash flow is right now, the more room I have in my cash flow to deal with these challenges.

My conclusion is this: once you have a certain size of emergency fund (I usually use two months’ of living expenses per dependent), your focus shouldn’t be on further liquidity. Your focus should be on improving your cash flow. Not only does this protect against longer-term problems, it also creates a future where you’re more able to tolerate the unexpected in your life.

In simpler terms, get an emergency fund, then shoot as hard as you can for debt freedom. That might sometimes involve additional savings (like saving up to pay cash for a replacement car), but the goal is to keep your cash flow as healthy as possible.

Coincidentally, just an hour before this article went live, I got into a Twitter discussion about this very topic.

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36 thoughts on “Pay Cash or Not? Cash Flow Versus Liquidity

  1. You also need to consider how much your money is making. If you can get 8% in an investment and pay 3% on a car loan, taking out a car loan may make sense as you are in effect getting cheap leverage. It’s a risk return call.

    When considering the liquidity argument one should also consider their credit score. for those with good credit it is fairly quick and easy to tap into a car’s equity by refinancing should the need arise.

    So I think the considerations should be cash flow vs true liquidity vs expected rates of return.

  2. What about improving liquidity for potential purchases beyond emergencies in this rocky future? Wouldn’t it be a good idea to save up additional money outside of your emergency fund (similar to how you use SmartyPig) to save for expected expenses, especially if you expect a rocky future? So instead of just paying toward debt, I might save money above my emergency fund toward Christmas presents or a potential furniture purchase. I think this kind of liquidity is a good goal, even in the face of an uncertain future. If all I do is pay off debt, when it comes time to make these necessary purchases, without liquidity, I will just end up using debt once again to make ends meet.

  3. This is a very interesting and informative article on the difference between cash flow and liquidity.

    Personally, if I happen to be in this situation, I would pay cash for that car I needed. The reason being, that I have the money right now to handle a purchase like this and still have a healthy amount for emergencies and liquidity. My cash flow may become an issue down the road when something in the emergency category happens thanks to that thing called life. I would feel better about the purchase knowing I paid for it while I had the ability to, and knowing that I could take that amount off my cash flow, thus allowing me to use the payment amount I would have had for something medical. It would also give me the duration of time on the loan to put the loan amount back into the liquidity amount I took the car from.

    Evidently I hedge my bets on the side of the what if as well. Truthfully, given the current state of affairs in North America, it would be nice to know I own that car and a bank or company couldn’t come back to take it away because of the loan on it.

    A great post with a thought provoking question!

  4. Recently my husband and I were idly looking at new cars (we’ll be in the market for one in a couple years) and noticed an interesting trend in that “ultra-low financing” deal: the cash purchase price is often up to 20% lower than the price if the buyer opts for any financing.

    Seems like sometimes, cash is still king.

  5. Trent,

    My wife and I are in a similar situation right now. We’re looking to buy a new car (although for less than your example) and we have enough cash to write a check and not touch our emergency fund. We’re planning on buying a used car and we can get a rate under 4% through our credit union.
    Having said all of that, we’ve decided to just write the check when we find the right car. Why? We agree with you that once you have a reasonable emergency fund there is no reason to focus on further liquidity.
    If you’re scared that once you write the check you will suddenly need this money…you probably shouldn’t be buying it in the first place! If you can’t afford to take that $10k or $20k out of your savings account, then you should bump up your emergency fund and look for a cheaper vehicle. Just my $.02
    Martin
    ImpactYourMoney.com

  6. You’ve got it backwards. Liquidity is the risk-averse play. If you buy a car for $20k in cash today, and tomorrow lose your job, which would you rather have: no car payment; or a car payment and enough money in the bank to pay that payment for years to come – or the car payment plus all your other living expenses for the next few months to a year while you look for a job?

  7. Cash flow, liquidity, leverage, opportunity cost, net worth, liabilities. Sure we can throw out these terms to justify ourselves. But what matters is that the resources are available to meet your needs. Cash flow is not what you want, its available resources. I’d rather have 10K in the bank with $10/mo going out than be 10K in the hole with $10/mo going in. I think you are looking at the issue in an awkward way. Even the cash flow is for a limited period of time, and assuming that the terms allow it, you can pay that loan off anytime as long as the money is still in the bank.

  8. When we last went to buy a car (Feb 2009), the dealership offered us 0% financing immediately at our offered price – but when we said we wanted to pay cash, then our price was too low. I don’t know if this is typical, although I know friends have run into it too: sometimes the finance side of the business is motivated to hit THEIR numbers, and so you can get a lower price if you finance than if not. You can then pay off the loan in the next month (make sure you READ the contract as not all loans are written that way!) A bit off of your point – but just something else that may come into play.

  9. I guess I would say that if you have $50,000 cash sitting in the bank and no debt you are probably very good at managing your funds and have good self-discipline. Whatever choice you make will probably be a good one.

  10. I’d probably transfer that 20K to a separate account, get the 0% loan, and set up a monthly payment, then try and replace that 20K dent in my savings.

    Best of both worlds in my opinion, but banking can be free in the UK so maybe it’d not be worth the cost elsewhere.

  11. Trent,
    Yet again another great post. I’m a big believer in keeping FIXED costs low, so that might mean financing $10k of the car to keep a small car loan while keeping $40k in the bank. Liquidity is important, but cash flow allows liquidity to fluctuate (both positively and negatively) very quickly, so I think it’s important to have a mixture of both.

    Elaine Huckabay

  12. I used to think that debt was ok as long as you managed it well. I’ve since changed my mind. No debt is good as far as I’m concerned. Pay cash or don’t buy.

  13. Without surprise, I deal with this decision more often the more I save/pay off debt. Currently, with 2 months of living expenses under our belt, rather than put all my eggs in the debt repayment basket I am saving a Slush Fund (while also saving for our next auto purchases) to be used as a lump sum payment on debt in the future – most likely. There is a very high chance I will use it to make a large bulk payment on my debt, but having the extra cash flow gives me options… and I like options.

  14. I think the key point here is that if you first buy the car with credit and then have a large amount of money in the bank you might be tempted to spend that as well on something else and in the end have both negative cash-flow and liquidity effect….Althogh the math might at times say differently I think for the most part you should pay in cash…it hurts just that little bit more to spend your hard earned cash and as such you hare more likely to think about it one more time…!

  15. @Josh (#1):

    “If you can get 8% in an investment and pay 3% on a car loan,”

    Where can I get a guaranteed 8% return on my money, Josh?

    The 3% interest I’m paying on the car loan is GUARANTEED. But the 8% return is highly volatile (and, in my opinion, unlikely in the current economic climate).

    You’re ignoring the huge disparity in risk between the two numbers. You’re talking about taking money borrowed at a fixed 3% and gambling with it.

  16. Trent wondered: “Let’s say, hypothetically, I have $50,000 in cash just sitting in my savings account. I need to replace my car and I’ve decided on a model that costs $20,000. I can get a very low interest loan for that car from the dealership – 0.0% or 2.9% or something like that. What do I do?”

    First, let’s assume that you actually need the car. If it’s a necessary purchase rather than a splurge, the trick becomes how to make the best use of your money to make your purchase.

    For the zero-interest loan, this is one of those cases where you can have your cake and eat it too. Determine the loan period (how many months you want to use to pay off the entire purchase cost), then withdraw that amount from your savings each month to make the monthly payment. By the end of the loan period, you own the car free and clear without having paid a penny of interest. For most of that period, most of that $20K remains in your hands, earning interest for you. You should invest conservatively because you want to ensure the money will be there when you need it, not disappeared by a stock market crash. For example, you could invest the $20K in laddered bonds or CDs to optimize your earnings, and then invest the remaining $30K in a more balanced portfolio of index funds and suchlike to provide some growth.

    If you have to pay any interest rate, even a low one, the problem becomes how to calculate the total cost of the loan versus how to calculate how much you could earn by investing the money. The first part’s simple: you just add up the monthly payments to get a total. The difference between that total and the cost of the car equals the amount of loan interest you paid. The hard part is determining whether you can earn more than that amount through your investments. If so, you should take the loan. For example, if you could purchase an annuity or similar investment that lasts for the length of the loan and that pays out more money than the interest payments, go for the loan and make that investment. You’ll end up with more money in your pocket at the end of the loan.

    Details of the latter are a bit complicated, but a good investment advisor can walk you through the calculations to figure out how you could do this.

  17. I too have always assumed if I can get a higher return in the market, certain debt is ok. However, I’ve really been rethinking this as the market has gone sideways ever since I started investing over ten years ago. I also have a lot of savings in cash right now which is earning practically nothing.

    I find the peace of mind to be worth any potential higher return I could earn in the market. Especially on something like a car loan, where if you take the 8% market return vs 3% loan @ Josh uses in his example, on an after tax basis, assuming a $20,000 car loan an and 30% tax rate only equates to $520/year. I’d much rather have the guaranteed 3% return @Kevin is referring to.

    The one exception in my life right now is mortgage debt as I know we will not be in our current home much longer. But once we move, I’m going to be all for paying down our mortgage early!

  18. @Steve #67: Actually I believe what he meant (and could have phrased better) is if you believe the future to be bright and you income in secure, put your money towards increasing your liquidity (i.e. take the low interest loan). If you are worried about the future, put your money into better cash flow (i.e. pay for the car in cash, so you would have less in monthly expenses if you got laid off, etc.)

    At least that is how I approach the situation. I currently only have a mortgage payment for debt. While my job is mostly secure, it’s not that hard to believe that I could still lose it in some fashion. Therefore I am sending extra money with my mortgage payments (putting my money towards cash flow improvement). I actually am still setting aside about 25% of what I take home to rebuild my emergency fund (which became my 20% down payment on the house back in April) but once I get to 3 or 4 months’ worth of savings, I plan to shift that money to paying off the mortgage. Hopefully my 15 year loan will be cleared out in less than 8.

  19. I guess I see having liquidity as an extension of an emergency fund. If you have fixed expenses of $2000 per month and $20,000 in the bank, you have a 10 month EF. If you took out $10,000 to buy a car in cash, you have now only have a 5 month EF ($10,000 left in the bank). If you take out a car loan that costs $200 per month, you fixed costs go to $2200 per month, and the $20,000 still in the bank is now a 9 month EF. You are paying interest on a car loan to have an additional 4 months in your EF. If were seriously looking at a potential layoff, I’d rather pay interest on the loan and have an extra 4 months in the EF.

  20. @Robert (#17):

    That makes total sense. I just want to make one subtle distinction: Paying down your mortgage does not reduce your risk at all.

    Paying OFF your mortgage does.

    There’s a difference. If I shovel $50,000 in extra payments at my mortgage over the next 2 years, then lose my job (with $150,000 still owing on the mortgage), my cashflow is unchanged. I still owe the same monthly mortgage payment I did before. The bank doesn’t care that I just lost my job, or that I’ve been paying extra. They still want the same monthly payment, regardless.

    @Sara (#18):

    If you are “seriously looking at a potential layoff,” then you probably shouldn’t be car shopping in the first place. ;)

  21. @Robert: No, Steve is right (and Sara explains it well too). If you’re worried that you’ll lose your job or be met with some unexpected expense, the best thing to do is to maximize your liquid savings.

    Look at it this way: If you lost your job today, would you take all your savings and put it toward your mortgage? Of course not. (Or maybe you would, but it would be a terrible idea.) If you have no job, you need to rely on your savings to meet your monthly expenses. If you have no job and no savings, you are up the creek.

    This is a simple concept, so I don’t really understand why people so often get it wrong.

    Back to the original question about a 0% loan: If the amount you’re spending is the same in either case, there is no financial advantage in any situation to paying cash rather than taking a 0% loan. And there’s little financial advantage to paying cash rather than taking a very-low-interest loan. The disadvantages of the 0% loan are that it might not really be 0% (read the fine print), or that the amount you’re spending is *not* the same – either because the loan is loaded with fees, there’s a “discount” for paying cash (equivalent to a fee for taking the loan), or because the promise of a “free money” loan entices you to buy more than you’d otherwise be able to afford.

  22. @Kevin (#19) – Agreed. My point is that everyone who wants to buy anything with a loan (car, house, education, whatever) and asks for advice is immediately hit with “Well, what if you lost your job?” – so I wanted to keep my comment on target.

  23. @Kevin: Even paying off your mortgage does not necessarily reduce your risk enough to justify the extra payments.

    If you shovel $200K in extra payments toward your mortgage and pay it off, you don’t have a mortgage payment anymore. Yay! But you still have an insurance bill, an electric bill, a property tax bill, a grocery bill, and various other expenses. If you lose your job, you have to pay all those bills out of savings.

    If you’d put the $200K in savings rather than paying it toward your mortgage, you’d be able to pay your mortgage and all your other expenses for *years*.

  24. My take would be to pay cash for the car, and then make payments to the savings account (including interest) that I would to the bank; pretending as if I had gotten the loan. This would also assume that this savings is money specially for car replacement. Saving should always have a goal/purpose; otherwise it’s just hording wealth.

  25. Johanna:

    Good point. I imagine we can agree that there’s a mathematical “tipping point,” where your worst-case income would still be enough to meet your minimum monthly obligations. If you lose your job, you’ll still have income from unemployment insurance. If you’re injured, you’ll get social security disability payments. Maybe you’ve got a spouse that works. Or rental income.

    This “number” will of course be different for each individual or couple, but I think objectively, if you can get your monthly obligations down below your worst-case-scenario monthly income, then it makes sense to pay off your mortgage (and whatever else necessary to reach that level). Otherwise, you’re right, and it makes more sense to sit on the cash and make it last as long as possible.

  26. I haven’t see one person mention the fact that the car (if bought and paid in cash) is an asset (even if it is depreciating). While yes the car will lose value ever year you could still rather easily convert that car to cash for the right selling price. If you own the car outright there is no reason within a day or two you couldn’t sell it for cash.

    If the worst happened you lose your job, and you see no prospects for getting rehired you could away sell your car even if you only got 14K if “Priced to Sell”. Then purchase a car for a grand or two again in cash and add the remainder to your e-fund.

    The reverse is if you’re loan balance is still 17K on that car. The most you can get for it is 14K (right away) your now not only out your car, you’re 3K upside down and you need to purchase something cheap to drive still.

    I agree however that if someone has stashed away 50K in cash assets, outside of any retirement accounts they likely have a pretty solid handle on their finances and will likely be ok either way.

    @Johanna – Likely if you have paid off your 200K mortgage you expenses are so low that even with minimal income you could pay taxes, insurance,… Why pay hundreds of thousands in extra interest to the bank while holding onto that cash. Even a modest e-fund would sustain a family for a long time with no debt or mortgage.

  27. Cool topic; I was in on that twitter topic and so yes, we needed a new car since we outgrew our last with an extra kid. We landed at a $25K model (judgments aside for not buying used LOL!). I had the cash, but I figured since we had an 800 credit score and were able to get 0.9% financing from Honda, I simply financed the whole thing in a 3 year loan and put the $25K in a 3 year CD yielding 4.5%.

    In a sense, I did “pay for the car in cash” since the funds flowed out of my savings account, BUT – I was now earning a spread of 3.5% annually (which is great since it encompassed a 50% market crash with other funds I had invested…glad I didn’t add fuel to the fire).

    As far as liquidity, that isn’t of great concern since the surrender charge was something like 3 months of interest or something to that effect. In a dire emergency, it wasn’t like I couldn’t “get” the funds, I’d just have to give up some of the interest I made.

    So, everyone’s situation is different, but I’m definitely glad with how my situation worked out. Seeing the interest rate in a savings account continue to decline monthly would be rather annoying over the past 3 years.

  28. I’m more like Elaine 11. My goal is to have low fixed expenses, so that if I lose my job, my emergency fund can go a lot further.

    However, one other point to think about is what would mentally drive you to rebuild that $20K faster? Risk aside, are you more encouraged by positive or negative reinforcement?

    For me, I would fixate more on making a negative number go down (car loan) vs a positive one going up (bank account).

  29. We just faced this situation in May where we bought a brand new car somewhat on a whim. Our local dealer was selling off Pontiacs at really low prices and we got such a great deal we bought a car a year earlier than we were planning. Our current car was 11 years old and was starting to cost a lot of money to upkeep. We decided to pay $11000 in cash instead of financing. My husband’s job has always been perilous – he was hired for a two week stint seven years ago. So we decided to keep our monthly cash flow freed up and not have another legal obligation. Our savings account took a big hit (considering we bought a house last year) and that small balance is a big motivator for me to save money. I want $35000 in the bank again! If my husband loses his job we should be able to function without using our savings too much and it is nice to only have our mortgage as debt.

  30. @Jason: I just used $200K as the number because that’s what Kevin used – the same holds true for a loan of any amount. And the hypothetical case we’re considering is one where the interest you’re paying is negligible *and* you know a job loss is likely (or has already happened). In that specific case, it’s always better to hang onto your cash.

  31. Change your mind about the $20,000 car and buy a 10 year old Geo Prizm for $999. Now you’ve got a car and 19,000 in cash.

    All jesting aside, I’m not sure that the issue here is really cash flow vs. liquidity. I would rather put is as investment return vs. liquidity. Using all you cash to immedieately invest or to pay off debt may maximize the value of your money in the end. However, it leaves you at serius risk of not having immediate funds available to take care of whatever unexpected thing may happen.

    So, in the end, I agree–get your emergency funds in place, then start maximizing your investment returns. If you have debt, it is very likely that your best guaranteed return on your money will be paying off that debt. However, it could also be that the best return is a business investment. You really have to know yourself and your situation and what the opportunities are.

  32. @ “Our current car was 11 years old and was starting to cost a lot of money to upkeep”

    I dont care how much upkeep a car requires, it wouldn’t have cost the 16,000 that a new Pontiac cost.

    @ ABQBrent, “But what matters is that the resources are available to meet your needs. Cash flow is not what you want, its available resources. I’d rather have 10K in the bank with $10/mo going out than be 10K in the hole with $10/mo going in.”

    This is how I see it as well. YOu said it a lot more clearly than I (didn’t)!

  33. I know that the car purchase itself wasnt’ really the point of the article, but I’m going to go ahead and say this: I don’t think that anyone who isn’t already financially set should be spending $20,000 on a car (unless it’s on a car that I am selling them, of course!). Spend $2000-$3000 on a car and keep it and maintain it. There’s no reason today’s cars can’t last 18-20 years without extraordinary measures. (Maybe my view is skewed, but my car is 18 years old and I know many people who have cars this old that are reliable. Yes, you do need to replace things due to wear and tear on older cars but wouldn’t you expect that?) Unless you are fully on track for your retirement funds and whatever other savings you need for yourself and your family, why would you seriously consider taking $20,000 of after tax money (or more, if you are financing) just to buy four wheels and a motor to get you across town? And you’ll need to insure that new car to the hilt to protect its value in the event of an accident, which tags on an ongoing expense on top of the purchase itself.

    Of course if a lot of people actually followed this advice the car industry would be half of its size. Which is why Toyota is currently running an ad campaign for twentysomethings which explains that buying a new Toyota makes you a grownup with a glamorous and hip lifestyle..

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