Wednesday, July 4, 2007

Thoughts on Cash Flow

Looking at the change in my debts over the last month, I thought it might be a good idea to go through how I've decided to structure my cash flow.

From May 31 to June 30, my credit card balances rose from $1,056.55 to $3,945.72, while my line of credit (LOC) balance decreased from $25,298.84 to $22,647.79. That is, my LOC balance went down by approximately the amount that my cards increased. The reason for this is that, every time I make a purchase using a card, I make a payment in the same amount to my LOC. When I receive my credit card statement, I then use the LOC to pay the card balance in full. This has two results:
  • My credit card balance always has 0% interest, since I pay in full

  • I pay less interest on my line of credit, since for the duration of the month, the amount of my card purchases is not accruing interest on the line of credit
Essentially, what I'm doing is using a credit card to make a temporary payment against the LOC, thereby reducing the amount of interest that accrues on the LOC. Given that my LOC has an APR of 6.25%, this represents automatic earnings equivalent to 6.25% APR on every dollar I spend on the card. For as long as I have a balance on the LOC, this is the method I will use for managing credit card purchases.

Here's an example to illustrate the process in action:
Suppose I have a LOC balance of $20,000 (6.25% APR) at the beginning of the month, and make a $100 credit card purchase. If I wait until the end of the month to pay the credit card, then my LOC balance at the end of the month will be

$20,000 x (1 + 0.0625 / 12) = $20,104.17

However, if I immediately pay the $100 against the LOC, and use the LOC to pay off the card at the end of the month, then my ending LOC balance will be only

($20,000 - $100) x (1 + 0.0625 / 12) + $100 = $20,103.65

Either way, the credit card charges no interest, since the balance is paid in full at the end of the month. The savings in this example only amount to $0.52, but with hundreds of dollars in credit card purchases each month, this can add up.
Obviously, the major assumption here is that income for a given month will, at the very least, cover the purchases made on the card. If I spend more than I make in a given month, this approach runs off the rails, as I end up increasing my LOC balance at the end of the month. This happened for me in June, although it's only temporary, as I'm waiting for travel reimbursement which will more than cover the $238.12 gap. Also, it is important to remember to make a "real" LOC payment in addition to all the "temporary" payments throughout the month; otherwise, the LOC balance will continue to grow as interest accrues.

When I have paid off my LOC, I will most likely continue this approach, but by temporarily socking each purchase amount away in high-interest savings instead, so that I effectively earn interest on my credit purchases.

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