Suppose you have a loan that you desperately want to close. Is it worth dipping into your emergency fund for this purpose?
I can find convincing arguments on both sides. If you take this step, you get an immediate return on your investment (equal to the interest rate on the loan) but you expose yourself to the terrible risk of a cash crunch. And if you don’t, you’re safe in the short-term but you end up paying a whole lot of interest to the bank.
What should one do?
My advise is quite simple:
Closing a loan is never an emergency and should never be done at the cost of dipping into your emergency fund. The safest way to close a loan lies in utilizing your free cash flow. If your loan allows penalty-free prepayments against the principal, then use whatever free cash flow you have at the end of each month towards prepayment. Else accumulate your free cash flow until you can make a significant dent. This way you achieve your objective — albeit slower — without putting yourself into undue risk.
What do you think?
In fact, I’ve actually been in this situation recently. When I got very very close to closing the loan on my Swift, there was this strong inner voice that kept urging me to dip into my emergency fund and bridge the gap. Instead, I stuck by my rules, cut my spending further, increased my free cash flow, and finally closed the loan. It works!
You might also find this worth a read: Pay Cash or Not? Cash Flow Versus Liquidity.
You’re trying to spend/save/invest money that you don’t have.
Given this definition of free cash flow, a negative value can mean:
- Your income is too low, or
- Your expenses are too high, or
- Your goals (and hence savings/investments) are unrealistic.
Cut-back first on #2 and then on #3. Even better — increase #1.
Tip Tuesdays is my initiative to share practical personal finance tips — every Tuesday. I’d be delighted if you could share a tip or two from your own experiences. Drop a comment to submit your tip. And, as always, do spread the word if you find this useful.
Each Monday morning, I plan to post my thoughts on Organizing Your Finances. Through this series, I hope to share a tip or two that address a common problem that many of us face in our daily lives — that of organizing our finances. I’d love to hear your thoughts on this initiative and would love it more if you could share a tip of your own. And, as always, do spread the word if you find this useful.
I have written before on the concept of having a single source of truth for your finances. The basic idea here requires you to have:
A savings account from which you conduct transactions across the four core financial categories — income, expenses, investments, and savings — each month. At the end of each month, you review this account’s statement and you have a clear idea of your financial dealings.
I’ve been following this system for quite some time now and have found that it works very well. I now have a clear picture of where my money is coming in from and where my money is going out to. Further with this system in place, I also know what my free cash flow is each month. I simply calculate my free cash flow using the formula:
Free Cash Flow = Free Cash Flow (brought forward from the previous month) + Income – Expenses – Investments (for medium and long-term goals) – Savings (for short-term goals)
I can now use this free cash for anything that I want to — since all my expenses and goals have been monetarily accounted for. It’s honestly liberating to see a positive number here.
How about you? Do you have such a system in place? Do you know what your free cash flow is?