In Part I we discussed the importance building savings and how to then save money on insurance once those savings are built. Then we gave the strategy for how to structure loans and unveiled the Cash Flow Index. Let’s start here by giving examples and more insight on the Cash Flow Index.
The Secret Sauce: Cash Flow Index Continued:
In the previous article we shared the overview of the Cash Flow Index, let’s take a deeper look and give some examples so you can be empowered to do this on your own.
Home Loan Balance: $228,000
Interest Rate: 7%
Monthly Payment: $1,665
Cash Flow Index: 137 ($228,000 ÷ $1,665)
Auto Loan Balance: $16,500
Interest Rate: 8%
Monthly Payment: $450
Cash Flow Index: 37
Credit Card Balance: $13,000
Interest Rate: 12%
Monthly Payment: $260
Cash Flow Index: 50
Student Loan: $107,000
Interest Rate: 3.9%
Monthly Payment: $650
Cash Flow Index: 165
In this example, it seems to make sense to pay of the credit card first because it has the highest interest rate. But the Cash Flow Index reveals that the auto loan should be paid off first.
The trick is to pay off debt that gives you the greatest cash flow with the least investment. A high Cash Flow Index means your loan balance is high relative to the payment, while a low Cash Flow Index means your balance is low but with a high payment. Knock out those high payments first and you free up cash to work on other debts.
In this case, by paying off the auto loan first, you free up more monthly cash, which can then be applied toward the credit card balance. Paying off the auto loan first means you can pay off both faster than if you started with the credit card.
Address the Risk Factor
Again, this strategy isn’t just about paying off debt faster and saving money on interest—it’s also about reducing your risk.
Banks and other financial institutions tell you to pay off debts that lessen their risk while increasing yours. For instance, if you lock yourself into higher payments, which increases the equity into your home, but also simultaneously increases your risk for being foreclosed on. The more equity you have the greater the incentive for the bank to foreclose, plus you would have less money to build your savings when forced to make higher payments.
The rule here is do NOT directly pay down loans that keep you in the same payment (as opposed to loans for which the payment reduces as you pay them down). Rather, save the money that you would have paid on the loan balance in a separate account until you have enough to pay off the loan in full.
In those types of loans, you’re worsening your Cash Flow Index with every payment. It doesn’t give you immediate benefit, and it increases your risk by reducing your liquidity.
To make this concrete, if you have a 15-year mortgage, consider refinancing to a 30-year loan. Instead of paying extra to the bank, which increases your risk in the pay-down period, save those extra payments in an extra account. You’ll have the money to pay off your mortgage in 15 years with extra assistance from the government (tax advantage) and interest that you earn on the side account with the difference between the payments.
Also, as stated earlier, another side benefit of lowering your payments by extending your loan periods is that it improves your debt-to-income ratio, which helps your credit score.
Of course, this strategy requires systems of support and financial responsibility.
Get to the Roots
As I explain in my book, Killing Sacred Cows, without a fundamental change in consciousness regarding debt, none of these strategies will work long-term. Identify and solve the root causes of debt, rather than hacking at the byproducts (interest and bondage).
Before you employ these techniques, ask the following questions:
- Why did I incur each of my debts? What was the purpose? Was my desire to consume or to produce?
- Did I have inadequate insurance and an unforeseen event created the debt?
- When I’ve incurred debt, how did I justify it?
- Do I seek consolation in material things? If so, what could replace the feelings I receive from borrowing to purchase material things?
- Was my debt caused by investments that were actually more like gambling—putting money into things I didn’t understand and couldn’t control? If so, what can I learn from this and how can I be wiser in the future?
Getting—and staying—out of debt requires a fundamental shift. You must change how you view money and value creation, then what you do flows from that change. Debt can come from bad relationships, faulty philosophies, and slow course correction in the business (not firing an underperformer soon enough, not executing on programs you purchase, taking on too much at once and becoming overwhelmed, etc.)
If you’re struggling with debt, focus on creating value for others by increasing your knowledge, protecting your confidence, and eliminating destructive relationships, expenses, and distractions.
A simple guide moving forward: Do not borrow to consume. Use cash for luxuries and only borrow for productive assets and resources or necessities.
Increase Your Production & Cash Flow
Ultimately, the best way to get out of debt is to increase your productivity, and therefore your cash flow.
Let me give you an example. Add this one step to the Cash Flow Index suggestions above to velocitize your money and pay off your debt even quicker.
The money that you are currently paying extra to loans, you would instead use that cash to improve something that you are certain will perform and create a return. In other words, find ways to provide more value because dollars follow value. Take time to analyze your life and identify the best ways to serve at a deeper level.
Now, with the increased profit, attack the lowest CFI loan that you have. This will give you more resources and allow your dollar to stay in motion rather than going directly to debt.
To recap, debt elimination isn’t simply a matter of prioritizing the order in which you should pay off loans. It’s not just about saving money on interest.
The wise and sustainable way to do it is to reduce your risk and create more safety throughout the process. Not only will you become debt-free more quickly, but you’ll also enjoy peace of mind.