Cash reserves protect you from financial and emotional disasters

After reading a story about how a couple got stuck between a rock and a hard place, and ended up taking out two loans against their 410K, I knew where the story would end without reading. They would hate debt with a passion and vow to never take on another nickel of debt.

This is a common story I see in many places. The real problem this couple suffered was two-fold:

  • buying more than they could afford
  • not having adequate cash reserves to handle life’s bumps in the road
People like Dave Ramsey and Suzie Orman are always banging the drum on setting aside emergency funds and cash reserves. They are right! When something critical hits you like replacing a roof or paying for a new truck because they one have just died, and you have no cash reserves, panic ensues. Your need for cash NOW will cause you to make rash decisions like taking on bad debt, such as payday loans or 401K loans. These are expensive and come with onerous requirements.

Bad Debt

Payday loans have high expenses, a side effect of buying ultra-convenient money. The lenders realize the people coming to them are panicing and willing to pay the fees. Many states have clamped down on payday loans to make them not as outrageous. Emphasis on “as”. However you feel about them, you can be sure that people with wealth building plans don’t use them. They are only sold to people in critical need of money and lacking cash reserves.
401K loans have a heap of issues as well. For one thing, they come with short time windows. 401K loans must be paid back in five years. That’s just the beginning. If you leave your job, the loan becomes a permanent withdrawal you can’t repay, including the harsh penalties. This means you have to pay income tax + 10% penalty on the balance of the loan. Ouch! This is another reason I don’t like stockpiling money in a 401K. It forces people to hunker down in their current job, even if a better prospect opens up, due to not wanting to lose any money, especially if their funds haven’t recovered yet from the 2008 downturn.

Good Debt No Longer an Option

Suffice it to say, once people dig their way out of such a dire situation, they hate ALL debt with bitter angst. The emotional scarring is pretty strong. At that point, the thought of taking on debt for cash flowing assets like real estate is off the table. Just how bad does debt taste to these people?

Imagine this: what if Space Mountain at Disney World was suddenly up for sale for $100,000 with a promise to pay to you a piece of every ticket sold totaling $25,000/year? Your favorite bank will write you a note for just 10% down financed at 3.0%, 30-year fixed with no closing costs. Would you take it? I would, but these people would turn it down in a heartbeat because of the evil debt involved.

What used to be intangible fear of a potential risk has just become real and crystalized in their minds as a permanent fixture.

Ask them if they would consider taking a reasonable mortgage with plenty of cash to cover the risks. They will quickly reply, “It happened once, it will happen again. Not for me!” I don’t know any financial instruments that work to build retirement when all you have is fear.

The Real Lesson

In this situation, the lesson this couple should have learned is to take a serious look at spending habits. Either cut back until enough cash reserves can be built up, or look at creating a new stream of cash flow. They could create some side business or buy a cash flowing asset. With reserves available, they would have been able to buy the new roof, replace the truck, and then start rebuilding cash reserves without the shock. The reserves would also help protect them emotionally, because they would not be driven into such a troubling loan. They would instead be hit with a more annoying loss of reserve funds that must be rebuilt. That’s why this is the most important step. After taking a dent in reserve funds that is much easier to recover from, it’s not so hard to entertain the chance of buying rental property. 
But sadly not for this couple. The shock of what they suffered has pushed the idea of real estate off the table. It probably means they will focus on paying off all their debt, including their home, and eventually saving something in their 401K. Most people 55-64 years old have less than $88,000 in retirement savings with their home being the principal source of equity. Go ahead and calculate what 4% of withdrawal of that will be, and tell me how you would survive on that. Pretty grim, ehh?
They may own their home free and clear, but what good is that when it doesn’t generate a single nickel of revenue? Free and clear rental property would be a much better place for such equity at the time of retirement. You think this couple experienced a major panic today? Wait until they figure out they can’t retire, but must instead start their new career saying, “Welcome to Walmart.”

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