Every now and then I catch myself opening my wallet and having way too much cash in it… it gets me to thinking about how efficiently we are using our money, and what difference we could see from holding it vs putting it to work. Having pondered this for some time I have gone through a cycle of thoughts and will explore them here. And I also want to share a cautionary word on trying to work it too much.
Some cash is good
When a country has inflation Money is always devaluing, so holding cash in your wallet means that to a degree, it is losing value every second. However, if you didn’t hold it in your wallet there would be a time where you needed access to cash for a purchase and it wasn’t there. Keeping a zero balance would therefore be inefficient and require multiple side trips to obtain cash.
So, having some cash is good, too much is bad. Too much is subjective based on your habits. I would say that greater than the risk of lazy money is the risk of loss/theft when you hold too much cash.
Depositing that money into Checking
I have a number of bank accounts (into double digits) but only one of them is a Bricks and Mortar bank – Citi. Therefore if I want to deposit cash I tend to go to the local Citi ATM and insert bills. Psychologically, this feels better to put the money in the bank, but with current market rates is it even worth it? I have a Citigold account, offering the most interest from their retail banking options, and even that is a paltry 0.05%
Let’s say I was carrying $500 too much in Cash, over the course of a year having that in Checking would yield 25 cents in interest (which would be taxable) so we are talking about 15 cents lost by being ‘on top of my money’.
In a low interest environment is it worth the effort to chase percentages?
Excess wallet cash fluctuates – you might receive a gift, require cash for travel, sell something etc several times over the course of one year. If we simplified the inflows and outflows to a nice, $500 in, $500 out, say 3 times over the year you have 6 transactions in order to reap that 15 cents. Ideally we would have more inflows than outflows, but with cash being a transaction tool it wouldn’t be uncommon to see more evenness. So now we are down to being paid 3 cents to take that money to the ATM. The term penny wise, pound foolish springs to mind.
The next level – tapping Equity
The majority of middle class American wealth is in home ownership and retirement plans. Common arguments for the reason for this is that they are forced saving schemes. While these can be considered assets that are appreciating, to an extent there is the same concept of lazy money happening here too.
Home Equity – if your home has appreciated in value it is easy to find equity to tap into. HELs and HELOCs are tax advantaged (up to the first $100,000) for many people, and $100,000 of equity is certainly more notable than the $500 that was yelling at me from my wallet. Due to the value of the money in discussion now, checking accounts wouldn’t be the location for this, rather a more attractive yielding investment, but for descriptive purposes $100k in checking (assuming I now take the time to transfer it to a high yield account like CapOne 360) would kick off $800 per year.
Of course, tapping a HEL/HELOC would cost at least 2% in tax advantaged APR, so you would be paying about double the $800 in fees.. not a money maker, yet. However, a 30 year treasury bond is currently paying about 3.4%, which would offer a low risk investment at a profit.
Don’t fund long term investments with short term debt
The problem with the Treasury idea is that you are locking in 3.4% for the duration. If interest rates rise (and they will) the face value of your bond devalues. That means you pretty much have to hold at 3.4% even when the market is offering higher. The real problem here is that the interest rates on the short term borrowing (HEL/HELOC) are not fixed for 30 years, they are variable rates, so as rates rise you pay more to float a crappy investment, and soon are underwater.
Higher Risk, Higher Rewards
There needs to be a correlation between higher risk strategies and higher rewards. It is the basic premise behind the Capital Asset Pricing Model (CAPM) simply put you know you can earn $800 from Checking, why would you take on additional interest rate risk for a marginal reward? The simplified value calculation that you need to make is what is the suggested rate of return minus the risk free rate of return and then decide if the risk is worth the product of that.
Simplified Example of $100,000 Equity Leverage
- Cost to borrow 2% APR $2,000
- Risk Free annual Rate 0.8% APR $800
- 30 Year Treasuries 3.40% APR $3400
Treasuries offer $3,400 – ($2000+$800) for $600 upside
The amount of upside offered is then measured against risk, both in its likelihood and its severity.
If interest rates rise 1.5% then cost of borrowing becomes 3.5% (for illustration) and the bond pays a fixed 3.4%. Therefore you are losing 0.1% on the spread (ignoring tax) and you are holding a bond that nobody wants (the new issues will pay more) you will see the inverse relationship between bond prices and interest rates at play.
Please note at this time that there is an extra variable at play – if you are borrowing on the HEL/HELOC at 2% then you have the underlying interest rate plus the banks profit in there, so if the rate of underlying interest should raise by 1.5% the banks lending rate won’t increase 2% +1.5% it will likely increase at a higher rate than that in order to maintain margins.
The severity of the change here would mean that if you locked up your $100,000 in the Bonds you would have to sell at a loss, the face value would have dropped from $10,072 per $10,000 to $8,774. So you have two choices:
- Keep the bonds for 30 years and be losing the spread between the HEL/HELOC and the Bond each year, which could easily be 2-3% of $100,000,
- Cash them out, and take an immediate hit of about $1,300 per bond, use that to pay down the $100,000 HEL/HELOC and be in debt to the shortfall.
Calculating the likelihood of this event is a lot harder to predict, and would require a careful eye at both Micro and Macro economic trends, plus a lot of crystal ball gazing.
Why is this in the Travel Section?
It’s here due to a conversation I had in The Forum. I build a resource that explains Roth IRAs for reference. A reader wants to tap into something much more risky than this in order to leverage money. There is a very narrow window within an IRA withdrawal (60 days) where you are supposed to be ‘rolling over’ from one provider to another. My reader wants to pull out this money and put it to work, then replace it within 60 days.
I used a financial example of the HELOC/Bond Aribitrage to show the risks involved and how to think about things. In the IRA example the risks are worse.
If the money is not replaced in time, the account will be penalized, the penalty would be 10% and there would be ordinary income tax on the distribution also. What’s more, the money can’t be replaced, so it would have to be rebuilt over years, making a massive difference to compound interest growth. The severity of the risk is huge. What’s more the likelihood of the risk is also huge, because money is frequently locked up during manufactured spend. That makes it an awful decision to make.
While this is an extreme example, I have had many people come to me and ask if they should hold off putting money into an IRA and use the money as a manufactured spending float – the answer NO WAY!
You have to realize your limits and stop getting wrapped up in seeing other people ‘earning’ more than you. I know of folk who are putting 7 figures through manufactured spend every month, if they have the float then good for them, but you need to realize the relationship between wealth and ability to leverage it safely.
Too much focus on squeezing pennies not earning pounds
As your wealth grows you start to learn that chasing after pennies is less important. I certainly think you should make your money work for you, but every decision you make needs to factor in the real upside, and the real risk involved. The first few hundred thousand dollars or net worth are going to come from hard work (or an inheritance) you can’t achieve the things others are achieving if you think you can dial down the work front after accruing a $100,000 IRA or $300,000 house.
Getting that far is awesome, but squeezing pennies out of it too soon, especially without truly ranking in risk is a recipe for long term disaster.
What’s more- it is totally unnecessary, unless you have bought into the bullshit of bragging and envy. If you are still on the way up the financial ladder then aim moderately today, the real goal isn’t if you can be like some idiot blogger flying First Class, it is true financial independence. Building that takes time, caution, and calculated risk. Don’t waste your time chasing your lazy money, use your time to earn more, and don’t start slacking off the earning and looking to tap into long term equity to support a short term fix. You need that wealth to really hit the big time, don’t waste it following the crowd. The average person doing average manufactured spending can easily travel for much more than they have time for (when holding down a job) in very good style. There is no need, nor sense in going bigger – especially when the risk is serious harm to your net worth.
I fear that people are losing sight of the value of the strategies I discuss. They can compliment a holistic, value driven lifestyle, very nicely indeed. But they are not the replacement for going out there and working hard. It is no different from the people who think they can quit work at 30 with $100,000 in the bank and day trade… just don’t do it!