My 90+ Year Old Dad. Working On His Finances.
Do You Really Have To Know This? My Dad did a great job based on his instincts and many people can. I have to know more about how things work because I don't have sufficient instinct. Whether or not you know how to manage by instinct, a knowledge of cash flow vs income can be valuable. Many years ago, I helped people plan their retirement by making projections about how to collect sufficient assets and how much you can draw from those assets to assure that you have enough to last for your remaining life span. In order to do this well, you need complex software and the ability to use it. You also need to have the ability to explain it to your clients. While it isn't all that difficult you also need to make certain assumptions as to the rate of inflation, the anticipated return on investment from the different categories and the projected lifespan of the potential retiree. You might come up with an accurate projection but there is so much potential error in the assumptions that, no matter how good your software, an erroneous assumption can totally invalidate your projection. I concluded that these were a waste of time.
Retirement is All About Cash Flow. It all boils down to a matter of replacing the cash flow you earn from work with cash flow from other sources. It can also be about reducing your expenses. A strict definition of cash flow is cash-in-minus cash-out. You can manage your cash flow by increasing your income or by reducing your expense. Either way, you are producing cash to fund your life. Although cash flow can be equivalent to income and vice- versa, it isn't always.
Cash Flow That Isn't Income. Suppose you are refinancing your house and considering borrowing $100,000 at 3.75% for fifteen years. Your payment will be $727. per month. Instead you can get a 30-year loan at 4.25% for 30 years. Your payment will be $492. The 30-year loan improves your cash flow by $235 per month. That extra $235 per month is yours to spend with no effect on your income for tax purposes. Which is preferred? Suppose you are 70 years old with little other retirement cash flow except for social security. That extra 235 per month may make a huge difference in your life. You will receive little benefit from the shorter-term loan until it's paid, at which time you are 85 years old. Many of those I counsel need the cash flow now and not when they are nearing the end of their lifespan. I am not saying that 30 year loans are better for everyone but choosing the short-term loan just because you are getting the benefit if 0.5% lower interest rate without considering the cash flow implications isn't always the best idea.
Income That Doesn't Produce Cash Flow. Suppose I own a commercial rental property. The rent is $4,000 per month and operating expenses are $1,000 per month. I have a loan of 400,000 at 6% with 20 years remaining. Payments on this loan are $2,865. My cash flow is $4,000 minus $2,865 payments minus $1,000 operating expenses or $135 per month. Because only the interest on this payment is deductible, my taxable income is higher by $890 per month. I have a tax obligation with no cash flow to pay it.
Suppose I can't continue making the payments. If this property goes into foreclosure, I am relieved of the monthly cash flow drain but I still might have income with no cash flow. How can that be?
Suppose I paid $300,000 for the property. Since foreclosure is considered to be equivalent to a sale at the mortgage balance, I have a gain of $100,000 with no cash flow to pay it.
This Post Is More Complex Than I Intended. What I set out to do when making this post was to show you some differences between income and cash flow. In doing this, I have committed the biggest sin, b o o o r i n g. On the other hand, if you slogged through this and came away with only the knowledge that you have to examine both the income and cash flow characteristics those financial decisions you make, I have accomplished my objective. Perhaps I can make my next post more interesting. I have written a booklet that discusses a number of financial issues facing those nearing retirement. It is called "Fifty Tips For A Secure Retirement." I wrote it almost 10 years ago, but 90% is still useful today. Send me an e-mail at Pstorms@AOL.com with your address and I will mail you a copy.
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