A critical look at the “Cash Flow Index”-based advice a financial counselor gave to a woman who felt like she was slowly drowning in debt.

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Last time, I summarized the advice Tim Cardon, an advocate for Dale Clarke’s “Cash Flow Index,” ¹ gave to Liza, The Girl with Three Loans. He told her to use her IRA to pay off her car loan. It would give her much-needed cash flow. When she heard his advice, Liza was thrilled.

Today, I want to critique Mr. Cardon’s advice.

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A recurring drumbeat in Mr. Cardon’s “argument” for CFI: Liza had a tremendous need to increase positive cash flow. She was making monthly payments on

• a car (3.9% interest; $11,000 balance; $325 payments each month);
• a credit card (14.9% interest; $7,500 balance; $150-a-month payments); and
• a student loan (exact details not discussed, but interest and monthly payments somewhere between the car and the credit card).

Liza was in desperate need of increased positive cash flow, said Mr. Cardon. The best thing he could urge her to do was pay off the car loan.

When Mr. Cardon first told me Liza’s story, he only mentioned the cash flows. He didn’t say anything about where she was going to get the cash to pay off the car loan.

I had already done the kinds of calculations I shared a few weeks ago. So when I heard his story, I asked him the following question:

You Would Never Give Her Such Counsel if She Didn’t Have a Loan; So Why Would You Give it Now, After She Has the Loan?

“Suppose Liza came to you and had no debt,” I said. “But she needed to borrow $10,000.”

For the sake of making this easy, let’s say she needed $10,000 to buy a car. (The car will make it possible for her to get a wonderful job that, without a car, would be unavailable to her.)

Because she doesn’t have enough cash on hand to make the purchase, she must EITHER borrow from a car finance company at 3.9% OR borrow from her credit card at 14.9%.

Due to the way these things work, the car finance company will require stiff, $325-a-month payments for 32 months . . . while the credit card company will let her remit much “easier” $150-a-month payments for 80 months.

Beyond these rather stark differences, you and Liza both recognize that borrowing from the finance company would be a hassle. Lots of paperwork. Credit checks. Waiting for approval. . . .

On the other hand—supposing she had a high enough credit limit and the dealer was willing to absorb the approximately 3% in “processing fees” that VISA or MasterCard would charge him—all she would have to say is, “Please put this on my credit card” and she could have her car in no time, no questions asked, no paperwork. So easy!

So which of these two methods of payment would you recommend, Mr. Cardon?

Despite the ease, and despite the MUCH “nicer” cash flow “deal” of the credit card, somehow I am sure you would NOT suggest she use her credit card to borrow $10,000 to buy a car. Instead, you would implore her to negotiate the lowest-cost purchase price and find the best-rate car financing opportunity she can get . . . and then use the car finance company’s money.

Yes?

Yet when Mr. Cardon suggested Liza should pay off the car and continue to hold the credit card debt, isn’t that exactly what he urged her to do?

Why?

“Well, she already owned the car, so I couldn’t recommend that she buy a less expensive one,” he sputtered.

Okay. But how does that time differential make any difference?

You urged her to pay off the car so she wouldn’t have to endure any of those nasty $325-a-month negative cash flow payments to the car finance company. That saved her a whopping $35 or so per month of interest—down to $25 a month in a year (and the entire loan paid off in just under 36 months) if she “merely” paid off the loan at her current rate.

But you left her owing $7,500 on her credit card. And that meant she had to continue making $150 monthly payments to her credit card company, $90 of which payments are interest alone! That $90 will decline . . . but only by $5—to $85 a month after a full year.

And at $150 a month, she will be paying that loan for over six and a half years. . . .

She is in almost the exact same situation she would have been had she held no debt and you had told her to use her credit card to buy a car.

Which leads me to ask once more: Why? What gives?

He never gave me a fuller answer. But he did tell me about her IRA.

The Hidden IRA

He told me that Liza had $15,000 in IRA “savings.” He called her attention to these funds and noted that she could use them to relieve her stress. She would have to pay income tax and a 10% penalty to access them, but the funds in her IRA would enable her to pay off her car loan.

Recognizing Hidden Assets

We’ve already discussed this problem in the past, and, I’m sure, we will discuss it again in the future.

One of the major problems with so many government-sponsored investment plans (IRAs, 401(k)s, 529s, 125 FSBs, and so forth) has to do with how they lead you to silo your money. They discourage you from thinking of these various funds as valuable assets in your financial arsenal. So, as happened with Liza, it is easy to “forget” that they are there. You overlook their value to you when you might best use them.

So for this one piece of insight, I give Mr. Cardon an A+.

He not only suggested she could do such a thing, it appears that he actually calculated the post-tax and post-penalty benefit to her: $11,250.

I could quibble with his calculations. It turns out that the 25% marginal tax bracket kicks in when your taxable (post-deductions and post-exemptions) income hits $37,650. Liza was already making $40,000 a year pre-deductions and pre-exemptions. And if she accessed all $15,000 from her IRA, her gross (pre-deduction, pre-exemption) income for tax purposes would go up to $55,000.

Now, the current standard deduction and personal exemption for a single person is just over $10,000. So her taxable income would likely be more in the $45,000 range, making the net value of her withdrawal somewhat less than $11,250. (A bit closer to $10,800.)

But for back-of-the-envelope calculation purposes, Mr. Cardon’s number is good enough and certainly ought to show Liza a way to relieve her stress and acquire the breathing room she so desperately longed for.

After that, however, I am deeply troubled by Mr. Cardon’s counsel.

He Failed to Help Her Recognize the True Value of Her IRA

Liza’s IRA gave her a huge chunk of margin (“breathing room”) even if she never paid off her car loan.

While Mr. Cardon helped her see those funds, he didn’t help her see them for what they really were.

• It is true that paying off her car loan immediately would save her 35.9 months’ worth of $325-per-month payments (and $672.36 worth of interest). But she could have continued to make her monthly payments solely with the cash from her IRA, and the IRA would have covered 34.6 months’ worth of those payments!²So, besides saving 1.3 months’ worth of payments, what was the great advantage to Liza of “giving away” all that money up front? . . . And were there any disadvantages?Quick answer: no, there were no additional advantages, but there were many disadvantages.
• If Liza “merely” continued to pay her regular $325-a-month payments using funds from her IRA, the IRA could have still offered her a cushion in case of emergency.
  • That cushion disappeared, however, when she paid off her car loan!
    • She had only $250 left over from her IRA plus the $900 or so available in her bank account to cover any ongoing or emergency cash flow needs.
    • And if a true emergency came up? She would be unable to claw back any of the funds she had used to pay off the car.
    • At best, she might sell the car at some kind of fire sale price for maybe 60 or 70 cents on the dollar.
  • By contrast: notice that, supposing she paid off her credit card debt,
    • She could turn back to her credit card at any time, if she truly needed to. No penalties. No pennies-on-the-dollar fire sales. “All” she would owe is the 14.9% annual interest fee on the balance. MEANWHILE,
    • She would still have more than $3,500 of AFTER-TAX and AFTER-PENALTIES money available in her IRA to cover any additional ongoing or emergency cash flow needs.
  • Cardon noted that Liza was spending about $100 a month more than she was taking in. He said she needed additional positive cash flow, and by paying off her car loan, she would acquire the greatest amount of additional cash flow: $325 a month. That’s fine. But did she need the entire $325? Would $150 have “done it”? What about $100? Or $200?
  • By having Liza pay off her car loan, Mr. Cardon saved her somewhere between $25 and $35 a month in interest charges she would otherwise have had to pay during the next 12 months. (At the normal payoff rate, she would have racked up $366 in interest expenses during the next year.)By contrast, if Mr. Cardon had encouraged Liza to pay off her credit card balance, her interest expenses would have gone down between $85 and $95 a month during the next year. (At the normal payoff rate, and assuming she added no new debt, she would have racked up over $1,069 in additional interest expenses on her credit card during the next 12 months.)
• Mr. Cardon failed to show her any of these realities.

There’s more, but that will have to wait for a future post.

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¹ “Cash Flow Index” or CFI is calculated by dividing the Remaining Unpaid Principal on a loan by the Minimum Monthly Payment. So a loan with $10,000 of Unpaid Principal and a $350-per-month Minimum Payment (Liza’s car loan) yields a Cash Flow Index of 28.57. A loan with $7,500 Unpaid Principal and a $150-per-month Minimum Payment (Liza’s credit card) yields a CFI of 50. —Return to text.

² $11,250 = 34.6 months’ worth of $325-per-month car payments. ($11,250/$325 = 34.6)

Notice, however, that $11,250 is also equal to 112+ months’—more than nine years’!—worth of $100-per-month “supplements” to one’s income (supposing Liza merely felt the need to break even).

And $11,250 would provide somewhere between 34.6 months’ and 112 months’ worth of cash flow if she chose to supplement her regular income at some level more than $100 but less than $325 per month.) —Return to text.