Managing your cash and your debt

Inflation is a major risk if you hold large sums of cash permanently because it reduces the buying power of cash. Although interest rates are usually a little higher than the inflation rate, there may occasionally be periods such as now when inflation-adjusted interest rates are actually negative. Consider the latest Philippine data, which shows April 2005 inflation rate at 8.5% and the minimum interest rate for your savings deposit at 1%.

When inflation rates have been stable for a few years, people become used to them and behave as if they will never change. This, too, is dangerous from an investing point of view. Take the case of Mitch, a long-time government employee, who has regularly deposited a third of her monthly salary in her bank account for the past 20 years as a form of forced savings for the college education of her future children. Today, her savings less inflation is has only enough to cover for the first year of college of one child.

Whether interest rates are high or low, cash does not produce a good return compared with other investments. If you keep more than 10% of your wealth in cash, it is worth taking another look to see if you really need to hold such a large sum.

The proportion of your wealth that you should keep in cash depends on your individual circumstances and attitudes. As a general, just keep enough cash to pay for all your normal expenses for a given period of time–say, from three months to a year–and add to it a lump sum to pay for emergencies.

Shopping For Rates

After deciding how much to keep in cash, decide where to deposit it for the best interest rates. Generally, the longer you are willing to lock up the cash, the better the interest you will get. There are also a variety of time deposits available, requiring you to keep your money in the account for as low as seven days. Unfortunately, current interest rates are so low, even on time deposits.

To get a better interest rate for cash, you could opt to deposit a larger sum but remember that your money would grow faster if you deposit it in other ways. You could also deposit for a longer period of time but, at current interest rates, the difference will not be large. Another strategy is to open a savings account that requires regular deposits in exchange for slightly better interest rates.

A final, though not advisable strategy, is to bank with a low-quality bank, which may not be safe or may not give you good service.

Many people also divide their cash among several accounts held at different banks as a protection against the possibility that one might fall. Some countries like the Philippines operate a deposit insurance scheme to compensate depositors in the event of bank failure. In the Philippines, the maximum insurance coverage for each depositor, regardless of how many accounts he/she has in a failed bank, is P200,000.

Harness To Your Advantage

The essence of cash management is to be able to harness its full potential to your advantage. The same is true for credit and borrowing. Key to successful borrowing is to keep control of your cash flow and to plan ahead. If you know you have an overdraft by the end of the month, do something about it now, rather than at the last minute. Planning allows you the luxury of finding the best rates for your needs.

It is important to understand that there is a wide range of difference in both the prices of loans (interest rates and charges) and the borrowing terms. In general, the annual rate of interest rate on long-term borrowing is considerably cheaper than on short-term borrowing. For example, if you took out a 10-year loan to purchase a house, the annual rate of interest will be lower than if you borrow money over 36 months to pay for a car. For this reason, it is important not to use short-term loans to pay for long-term purchases–not only is it more expensive but you could have difficulty in paying off the loan or refinancing it when it becomes due.

Some people maintain constant short-term debt that charge high rates of interest while investing at the same time. This is known as the "separate pools of money fallacy." For instance, if you keep cash at 1% per annum but have credit card debt of 42% per annum (3.5% times 12 months), then you are actually spending more than you are saving. This is because the interest on your debt is compounding faster than the interest on your deposit.

When you will look at your monthly income and expenses, check if your short-term debt is growing. The solution here is to pay it off as quickly as possible and to exercise self-discipline so it does not happen again.

In all cases, be very circumspect when borrowing money. In general, you should only use money for things that will ultimately generate a better return than the cost of borrowing. This includes building your home, paying for higher education, and improving your business. Less constructive use of debt is to pay for consumer items since interest raises the prices of your purchase and slows the growth of your net worth. You should also not borrow money to go into high-risk investments.

Building Your Credit Rating

When borrowing, bear in mind that you are building your reputation for creditworthiness. The main way to do this is to repay debts on time or ahead of schedule and to keep your lenders informed when any problems arise. If you can demonstrate to a lender, such as a bank, that you:

1. keep accurate records of your income and expenditures,

2. foresee the need for borrowing before it arises,

3. have a good track record of repaying loans on time,

4. act promptly when an unforeseen problem arises,

5. understand the lender’s concerns and procedures, and

6. request sums that you can afford to repay,

the lender will tend to look much more favorably on your request for a loan. This is because you are showing the lender that you are a responsible borrower and that there is little risk that you will not repay the loan. Lenders price their loans according to how risky the borrower appears to be. A "risky" borrower will pay a high price for a loan or may be refused while a low-risk borrower will be offered better deals at lower cost.

(For more information on how you can build your personal wealth or to schedule a free financial check-up, you may call Citibank at 894-7162.)