Friends Don’t Let Friends Pay Cash

The Truth About Financial Arbitrage

Paul Bock, 2025

The conventional wisdom championed by personal finance experts—”Pay cash for everything”—is excellent advice for financial discipline, stability, and risk aversion. For anyone with high consumer debt, uncertain income, or a low risk tolerance, this simple rule is the foundation of peace of mind.

However, for the sophisticated investor whose capital is dedicated to income production, this advice is financially backwards. It ignores the market arbitrage principle known as positive financial leverage (also., colloquially  known as “use other peoples’ money). For these individuals, paying cash is not prudent; it is an opportunity cost—the sacrifice of potential wealth for unnecessary or undesired safety.

The Problem with the Conventional Wisdom

The argument against financing is rooted in the fear that investment returns will not cover the cost of debt. However, this concern dissolves when investing in Closed-End Funds (CEFs) under specific conditions:

• The Arbitrage Condition: The guaranteed cost of debt (the loan interest rate) must be lower than the expected yield of the CEF investment. Our example of a 6% mortgage funded by a 10% CEF yield creates a powerful, systematic arbitrage.
• The Capital Preservation Rule: If the CEF yield temporarily falls to match the loan interest rate, the sophisticated investor simply breaks even. The only true loss occurs if the CEF principal (NAV) declines, which is a risk inherent to all markets.

The CEF Advantage: Minimizing Downside Risk

Critics often claim the risk is too great because a company can go bankrupt. This is where CEF prove their unique value:

• CEFs don’t go bankrupt like operating companies. A CEF is a financial trust, not a consumer goods corporation. Its failure is measured by NAV erosion, not corporate bankruptcy. Its assets are held by a custodian, and its liquidation returns capital to shareholders, a scenario that limits total loss and preserves the segregation of assets. /2/.
• Resilience of Income: As demonstrated in the Dividends Rule book /2/, during the major crises of 2008 and 2021, while the market value of many quality CEFs dropped dramatically, most maintained their income payout, proving the resilience of the cash flow stream when managed appropriately.
• Active Risk Management (Rotation): If a CEF cuts its dividend below the required loan payment, the sophisticated investor does not passively accept the loss. They have the ability to rotate their investment into other CEF with higher, more sustainable yields, actively managing the income stream to cover the shortfall. /1/.

The Tax Reality and The Final Profit

The ultimate test of the arbitrage is the net cost after factoring in taxation, a non-negotiable obligation. Using the example of the $525,000 home in a 30% tax bracket:

The investor generates $52,500 in annual dividends. Even after paying the full $15,750 tax burden and the $37,771.68 mortgage payment, the net annual cash flow deficit is only $1,021.68.

The conclusion is staggering: the investor is paying a negligible amount—just $1,021.68 per year—to service the debt on a half-million-dollar asset while keeping their full $525,000 principal invested in an asset designed to compound and grow over thirty years and beyond.

The choice, therefore, is simple: Pay cash and force your capital to stop working or leverage the market and pay a marginal annual fee to keep your capital invested in a productive CEF engine. For the financially robust and disciplined, the decision is clear: Friends don’t let friends pay cash for big purchases.

The above example is valid in most cases of long-term financing, like a mortgage to purchase a home. The reason: due to the long term, the monthly mortgage payments are less than the monthly dividend income.

In case of shorter loan terms, typical for automobile financing, monthly loan payments are higher than the dividend stream, and there is a shortfall, as the dividends do not fully cover the monthly loan payments, therefore out of pocket money is needed to cover this shortfall. In our example of financing a $50,000 car in a 30% tax bracket, the investor generates $5,000 in annual dividends, ($416.67 monthly), and payments are $11,049.91 annually, ($920.83 monthly). The investor has to cover the monthly shortfall of $504.16 out of pocket, relying on other funds. At the end of the loan term, the investor bought and owns a $50,000 car for $30,249.57 (before taxes) or $37,749.57 after taxes for a $50,000 car. This is a $12,250.43 savings, and the icing on the cake is that she still owns the original capital of $50,000, which will continue to  produce a $5,000 income in perpetuity. Almost like having your cake and eating it too.

Those who are interested in the detailed math and desire proof, please refer to the included spreadsheet, which analyzes four cases.

References:

/1/     Paul Bock: Let Your Money Work for You – The Wonderful World of CEFs, available at amazon.com

/2/     Paul Bock: Dividends Rule – The Secrets of CEFs, soon to be published on amazon.com