Wednesday, June 1, 2011

The High Price of Smooth Cash Flow

Most people cannot handle irregular pay and expenses very well. They have a strong need for smooth, predictable incoming and outgoing cash flow and they pay a high price for this predictability. This need is apparent with car purchases, once per year expenses, employer supplemental health insurance, and other areas.

Cars

The best way to buy a car in most cases is for cash, but few people do this. Even car loans don’t smooth out the costs enough for many car buyers because the monthly payments last for only the first 3-6 years of the car’s life. Car leases offer a way to reduce periodic payments now and defer part of the car’s cost until years later.

Car leases are sufficiently complicated that few people really know how much they pay for a leased car. When the customer doesn’t understand the numbers, this gives dealerships a big negotiating edge. We pay a high price for low lease payments.

Yearly Expenses

For many types of yearly expenses like property taxes and car and house insurance, we have the option of paying monthly instead of yearly. However, the monthly payments typically add up to more than the yearly lump-sum amount. The implied interest rate is often very high, but this matters little for those in a perpetual cash-flow crunch.

Employer Supplemental Health Insurance

The primary purpose of insurance is to cover very large losses that have a low chance of happening. This is not what is covered by supplementary health insurance provided by Canadian employers. These plans only cover fairly small costs and the total benefit amount usually has a number of different caps so that there is no protection against major health care costs.

It would be much more efficient to simply pay workers more so that they can pay for the own glasses and dentist visits and have the employer offer insurance against only very large expenses. The overhead of running small expenses through an insurance company is very high. But the problem is that even the cost of new reading glasses can tip the cash-flow balance for many people. These people need the costly insurance for cash-flow reasons even though they’d be better off having their pay increased by more than their expected insurance claims.


Too many financial decisions are driven by short-term cash flow considerations rather than total cost. We are better off when we are solvent in the short term so that we can make better long-term decisions. The simple ability to build and maintain a cash buffer can be very profitable.

6 comments:

  1. Good post. I've noticed the cash-flow question as well, often with people justifying purchases because they can afford the payments (and not whether or not the total price makes sense).

    ReplyDelete
  2. @Anonymous: Thanks. In the case of car leasing, I doubt that most people even know the total price.

    ReplyDelete
  3. My goal has been to have my fixed large ticket expenses covered a year in advance, i.e. have the next year's property taxes, homeowner's association dues and insurance payments in a cash account on January first so that I don't have to make decisions based on cash flow. It's taken diligent savings to get to that point, but it sure does make life easier.

    ReplyDelete
  4. @Tara: I agree that maintaining a cash buffer makes life a lot easier. It also makes it easier to focus on total cost rather than monthly payments.

    ReplyDelete
  5. Your post made me think about my property taxes. I pay them monthly because when I was buying my home, my realtor, my banker, and my lawyer all said it was the best way to pay. Now that I think about it, though, I recall my municipality giving a 4% discount if the taxes are paid ahead of time. I'm going to look into that.

    ReplyDelete
  6. @Gene: Depending upon the exact timing of your payments, the implied yearly interest rate may be quite a bit higher than 4%.

    ReplyDelete