I’ve given up on using interest rates to dictate which loans to pay back first. I use cash flow index instead. Why?
Several years back, before I got hooked on all things Mustachian, and consequently got the itch to retire early, I read the book Killing Sacred Cows: Overcoming the Financial Myths That Are Destroying Your Prosperity by Garrett B. Gunderson. I highly recommend reading this book.
The reason? Oddly enough, it isn’t because most (or even half) of what’s laid out is really worth following. Instead, the book gets you to thinking about your financial outlook in a whole different way. The main tenets are as follows:
- The 401K stinks. It can’t be counted on to generate enough wealth over the long haul. The market is too volatile, and administrative fees will eat you alive.
- Real estate is king. You need to get in on the real estate game for serious wealth generation.
- Full life insurance is hard to beat if you want to protect yourself and your family’s interests, while also having an invested source of capital for, you guessed it, real estate.
- With an abundance mindset, anything is possible. You need to shed the scarcity mindset if you want to get rich.
As for me, I follow 2 and 4, and ignore 1 and 3. I figure that a 401K invested in low-fee index funds, at just enough per cent to meet the employer match, is a safe enough bet. As for life insurance, I hold a term policy through work at the moment. I may add one after early retirement. But for now, I’m not convinced a full life insurance policy is worth it for anyone, frankly.
How to Pay Down Debt Quicker: Cash Flow Index
One of the neat little devices Gunderson suggests for managing cash flow is called the “Cash Flow Index”. To determine the Cash Flow Index (CFI) for each of your debts, divide a loan balance by its minimum payment.
For example, assume your car payment is $450 a month, and you owe $30,000. The CFI is $30,000 / $450 = 66.666. You can make that 67, rounded up. The interest rate on this loan is 1.0%. Because you got suckered into that sweet Labor Day weekend sale at Jimmy’s Auto World, didn’t cha?
Now, let’s take your student loans for a similar spin. Assume you owe $85,000 and the payments are $120 a month. Oh, and the interest rate on this loan is 4.5%. But CFI calculations ignore interest rates, so we get $85,000 / $120 = 708.
Quite a difference, eh? Guess which one you should focus on paying down first? Not the one with the higher rate, like you may have heard before. Nope. Always tackle the debt with the lowest CFI first – the car payment, in this example.
Application in Real Life
I’ve used the CFI for every debt we’ve held for the last ten years or so. There have been a few:
- We use our home equity line of credit to cover the down payment on rental properties.
- Auto loans. Both cars have since been paid in full.
- Student loans. Who doesn’t have those?
- Primary mortgage.
In each instance, I compare the CFI of all our debts and make extra payments on the lowest scoring one first.
The reason CFI prioritization works well for us is it frees up cash flow much more quickly than otherwise, by simply using interest rates as a guide. There’s a bit of a snowball effect when you go from lowest CFI, to the next, and the next.
Gunderson proposes that a CFI of 100 or higher is an “efficient” loan. These are the kinds of loans you can ignore for a spell, until you have tackled your lower scoring obligations. Our home mortgage is at a CFI of 165.
A technically smarter move would be to put any extra income towards higher yielding investments, as opposed to paying off the mortgage. But this is a long-term cash flow play for us. At early retirement, we plan to avoid as many recurring monthly payments as possible. Which is cash flow smart.
I’d love to hear from you if CFI is something you’ve tried, and whether you agree with this approach.
In other news…
I hope you noticed the fancy new logo atop the website today. I got inspired by my friends over at Financial Panther and The Mastermind Within. We met for a few beers last week and shared some ideas about blogging and money. And about the superiority of Michigan State athletics.
I asked about their spiffy logos, and they referred me to Fiverr.com. The experience was pretty good. For $40, I got a spiffy new look. At the very least, I have a design that’ll look kinda cool on a future tee-shirt offering.
One thing I do is to try to lowet the cost of any debt and increase its CFI at the same time. Using HELOC and Real estate linked loans at prime – 0.65 % variable rate that can be paid over 15 years. This way I transform a short term debt with bad CFI and high interest into “ideal” debt. After paying faster or not is a choice based on having better use of tjat money or not.
Wow – great tips, Karim! Thanks for sharing!!
This is one post that I do not agree with you 🙂 I can see the rationale behind using CFI – to free up your CF to purchase more investment properties. But, over the long run, you ARE paying more in interest on your debts with higher interest rates. That’s just math. I’ve put up a detailed analysis on this post => https://networthanonymous.com/2018/03/29/the-cfi-falacy/
Hello, NWA-non! Thanks for dropping by. I love that you’re pointing out some flaws with this approach. Indeed, interest generally rules. What I think often happens though, is higher interest debt tends to have higher payments to balance ratios. Except with the devil of course – credit cards. I look forward to reading your analysis – thanks for the link!
NWA-non is correct. I’ve been comparing these two methods for a while and it is true, you would pay more interest by following the CFI method.
HOWEVER, we should consider the bigger picture. These two methods have very different intents. By electing to pay off the higher interest loans first, you’d pay less interest over the course of all your loans and pay off your loans the fastest (but not by much). The CFI method is about reclaiming cashflow as soon as possible so that you could have more money in your pockets every month.
Based on my analysis of my personal situation ($180k over 39 loans [my wifes’ student loans, my student loans, a car, and a couple of credit cards]), the CFI method would allow me to gain nearly $1,000/month at its peak in available monthly cashflow versus paying off the high interest loans first. That’s a lot of money per month that I could invest or simply not have to worry about committing to a loan in case of an emergency or if I wanted to do something fun with the family.
In my analysis model, I pay off the lowest CFI loan first and progress my way up to those with a higher CFI. I take the recuperated cashflow and apply it to the next lowest CFI loan.
At the end, I project I would pay an extra $3,000 spread over 33 months (an average of $90/mo) in TOTAL interest for this added monthly cashflow peaking at nearly $1,000/mo. The total gain of non-commited cashflow is a little over $17,000 spread over 33 months(an average of $515/mo)). In terms of schedule, I lose only 1 month to finish paying off in comparison the higher interest rate method.
So what’s the benefit? A noticeable difference in available cashflow for the majority of the debt period. It’s also peace of mind and the freedom to have more available cash per month. Is that worth $3,000? I suppose it depends on what you are trying to achieve.
To maximize this even further, I would look at how much it costs you to get into an investment that provides positive cashflow. Calculate its CFI. That will tell you when you should stop the CFI method to pay off debt and start investing for cashflow. For instance in the Chicagoland area, if you can invest $18k cash to finance a rental rehab property, you can expect $125/mo after ALL expenses. That’s a CFI of 144.
Here’s a link to the spreadsheet: (the graphs in the comparison tab tell the whole story)
https://docs.google.com/spreadsheets/d/1kYgWTN6SQ9w4qAVPpOHbIXoxs7rYTq8klVm8FciAlnU/edit?usp=sharing
Wow, J Money! That’s an excellent analysis you’ve provided us! Really appreciate the thoughtful comment and real-life example.
I think in general, you can smell a good CFI comparison a mile away. Often the higher the interest, the higher the payment to balance ratio as well. Just need to be cautious of any interest-only minimum payment loans.
The CFI Index is new to me. I generally look at interest rate first, then the length and amount of terms on the loans to payback. Fortunately at this point we just have the mortgage to worry about. Nothing against Mich St, but Go Noles! 🙂
PS- The new logo is awesome!
Hey Mr. DF! Yep – mortgage it is for us as well. At one point in time we had a car loan and HELOC to pay as well. The CFI kept us on the auto loan first, then HELOC.
Oh, and thanks for the compliments on the new logo! ????
Hey Cube! This is how we pay off our debt extremely fast! Instead of focusing on small balances and interest rates we look at the loan or debt that will provide the most cash flow to funnel into our HELOC acceleration. For example, just like you said, even though my car was at 2%, we were spending about $185 a month on payments vs one of Lauren’s student loans was at 6%, but it was only about a 8$ minimum payment !
By paying off my car we had more money to roll into the line !
Exactly! Thanks for sharing this, Josh. It’s always nice when someone else can share his or her experience to validate a point like this.
I keep a section in my budget to tack CFIs for our current debts – Student Loans (over 300!) and the mortgage (165 and decreasing all the time)
I have never heard of CFI, but I may start implementing it next month. I did the math after reading your post, and… you guessed it, the car is definitely the worst. It drains the largest chunk for debt pay-off every month. Even though CFI ignores interest rates, I find it reassuring that all of my interest rates are under 5% and very similar. Looks like the car is the next thing I need to tackle!
Thank you so much for writing this post! It definitely created new insight for me!
Hey Liz! Thanks for stopping by. I’m glad you found this post insightful! It’s funny how a book like “Sacred Cows” can inspire a new way of thinking, even if later, you chuck over half of the premise. i.e., I still use a 401K, and I avoid full-life insurance. Good luck with those car payments – and please tell me it’s not an SUV or Truck (or worse, BMW!!!)
It is an SUV. It’s a dang GMC Terrain and it is financed over a stupid amount of time *whispers* 6 years….. I have definitely decided to kill this debt and I’m actually writing about it in my quarterly debt post tomorrow.
Again, thank you so much!
I’ll look out for that post in my Feedly! Good for you taking that four-wheel debt head-on.
Very interesting, I never heard of the CFI index, but it sounds like a great tool to use. And I am putting “Killing Sacred Cows” on my reading list.
Nice logo 🙂 I like it!
Thank you (on the logo!)
Yes, give that book a read and let me know what you think. Much of it flies in the face of our FIRE basics but there are some good pearls.
I had never heard of CFI, but it makes since. It is best to focus on the debts that are draining most of your cash flow so you can pay them off and apply that extra cash flow to more productive uses. It’s like a more efficient debt snowball. I can also see how this would be useful for real estate investing. I’ll give it a try! Thanks for sharing it.
The new logo looks great! Nice style.
You bet! I probably made it sound more radical an idea than it really is.