Look at the latest articles on the wire about paying off debt and you’d think we’ve stumbled across the greatest discovery since Einstein declared that e=MC2. How do I determine which loan to pay off first? The good news is the cash flow index method is a tool that makes the process simple and effective. Read on…
Debt sucks. And anymore, we get saddled with negative figures for a whole host of mainly well-intended things. Mortgage? Good. Student loan debt? Good.
Getting by for a spell after a layoff or health issue? Good (assuming all other options are exhausted.) We then have the mix of dumb debt that gets us into a spiral, like fancy new cars, jet skis, trips to Cancun, and shopping mall mania credit card debt.
How to Pay off Debt If You’re Living Paycheck to Paycheck?
The psychology of the matter is far from easy. This is where your brain gets in the way of, well, your brain. Many of us stumble quickly out of the gates after college or starting fresh in the workforce. We have a low paying hourly job, or, a collection of part-time jobs that pay just enough to allow us to share rent with a roommate or two.
Life is still good because we’re young, and we subconsciously operate as if the future will take care of itself. This is a common trap and one that I’ve personally fallen into. It’s the reason I’m cramming for early retirement in my mid-40s, as opposed to my mid-30s.
I have to believe a lot of the “advice” the personal finance community pushes is a hard pill to swallow for many. We’re not all in our 20s or 30s anymore. Indeed, it’s never too late to start, but the golden period of opportunity is when your driver’s license age starts with a 2 or 3 (and is double digits, unless you’re Baby Boss).
If you are starting late on this journey, and you’ve figured out how to chuck the silliness of consumerism out the window, you can, as J.D. Roth would say, “Turbo Charge” your situation. When I got my head out of the sand about five years ago, my “turbocharge” was to fire up a rental property business.
And wouldn’t you know it, the lessons and discipline I gained there came in handy at work, where I started to apply pragmatic problem solving on the job. Raises and opportunities to move up the ladder soon followed. Notice I said “opportunities” right there. I’m still angling hard on that elusive promotion…
Bottom line: Paying off debt is a straightforward exercise that requires persistence. Stick with it. No hole is too deep to climb out of. Patience and consistency will get you to the finish line when it comes to paying off large sums of debt. Others have done it under very difficult circumstances. Learn from their example.
How Can I Get Out of Debt?
Sometimes homeownership does not suck. That one time back in 2001, when I got laid off for being a punk of an employee? Thank goodness I was able to take out a home equity line of credit for $30,000. Were it not for that, I’m not sure how I would’ve paid for groceries, much less the mortgage (during a year of nothing but grad school tuition bills).
What I soon learned after landing my next job, was that I could use a home equity line to pay down other, higher interest debts. A lot of people assume you can only use a “HELOC” for home improvements. Honestly, the bank doesn’t care what you use it for, because they have your bee-hind in a sling already with that anchor of a primary mortgage. “Go ahead, good sir, take a cruise with that HELOC. Just be sure to make your monthly interest-only payments!”
At any rate, I started to consolidate some of my stupid credit card debts and higher interest student loans on that HELOC. The interest rate was much lower. And double-bonus, the interest in HELOCs is tax-deductible. (At least it used to be. I think the new tax law of 2018 scrapped this deduction?)
Long-term, the ideal strategy is to keep your HELOC open but untapped, like your emergency fund. If you’re a crazy son of a gun like me, you could bend that rule a little and use it to make the down-payment on a rental property or five. This is the fun leverage part of the debt that you should tread lightly into – but it is a pretty lucrative approach if you do your homework.
What Is the Cash Flow Index?
I’ve given up on using interest rates to dictate which loans to pay back first. I use the 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 worth following. Instead, the book gets you to think 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 percent 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.
Super Simple Cash Flow Index Method
It’s quite simple, even in the most complicated circumstances. You figure out which debt is forcing you to pay the highest percentage of its balance in minimum payments. Slay those first.
In other words, if you have a $10,000 car loan balance with a $400 monthly payment, that’s a score of 25. This method is called the cash flow index and I use it myself.
If you have a $100,000 mortgage balance with a $900 monthly payment, that’s a score of 111. You just divide the balance by the payment. The lower the score, the more aggressively you attack that particular debt.
But what if the interest rate on the mortgage is 5.4% while the car loan is only 2.9%? Sigh… It doesn’t matter. You’re not going to benefit by arbitraging marginal rates when you need CASH FLOW.
An overriding rule in all of this: Pay off credit cards FIRST. They are the devil. You can practically smell the brimstone when you open a new statement envelope. In most cases, the interest rate is 12% or higher.
Set aside the cash flow index for now, and tackle each credit card in order of descending rates. Those bastards come pretty close to billing interest-only minimum payments, at 2%-5% of the total balance.
For non-credit card debt, use the Cash Flow Index. For credit cards, pay those first, and prioritize by interest rate. That’s it, folks. All there is to it.
Why Ignore Net Worth
One of the fairly ironic aspects of “early retirement” (read, “aspires to lazy?”) is the hard work, dedication, and sacrifice required to reach the goal. Your company doesn’t want to see its best and brightest walk away unexpectedly. Even the ones peeking at his or her financial spreadsheet while on conference calls. And on that spreadsheet, the focus is all about cash flow vs net worth.
Following the early retirement community, you might get the sense that Net Worth is the only key indicator. Some even publicize their net worth as a means to keep feeding their audiences some sort of magic marker for success.
Don’t get me wrong, Net Worth is a helpful indicator of how well-positioned you are from an asset vs. liability perspective. However, you’d find it difficult to live off of assets that don’t produce income streams (automobiles, homesteads, jewelry, 401Ks, 529s, etc.) in retirement.
From Investopedia.com:
Cash flow is the net amount of cash and cash-equivalents being transferred into and out of a business. At the most fundamental level, a company’s ability to create value for shareholders is determined by its ability to generate positive cash flows, or more specifically, maximize long-term free cash flow.
How’s that for laying on the business-speak?!? I always suggest you operate your personal/home finances like a well-run company. Create value by maximizing YOUR cash flow.
Cash Flow Is What Pays the Bills!
If you wanted to share something interesting with your early retirement community friends and audience, share this. I’m holding back on sharing all the details of our balance sheet. My view is that it’s less relevant than the tools and themes essential for jumping ship.
Let’s just say that if you can retire early, you’ve probably had success at saving a large chunk of your income since your 20s. You’ve avoided unnecessary luxuries (giant homes, boats, two golden retrievers in the yard, private schooling, and annual trips to Paris.)
Part of our plan is to sock away about 18 months of income into taxable index funds towards the end of my corporate career. We would then withdraw those dollars slowly over the next 13 years until age 60 when the 401K can be tapped.
This cash flow is our “bridge funding” that allows some amount of flex in our budget. Unlike Mr. Money Mustache and other extremely frugal early retirees, we expect to need close to $40K annually to cover our expenses and allow for certain luxuries along the way.
There are also side gigs. Yes, this is technically considered “work”, but even retirees are known to hold down part-time jobs to supplement their retirement income. Mrs. Cubert will likely continue to teach a few classes each week at the gym.
She’ll also work part-time as a sole-proprietor health care professional. I intend to find a part-time job that fits my interests: real estate, property management, and “building.”
Real Estate Investments as a Source of Cash Flow
My main effort to build cash flow has centered on real estate rental properties. We have four single-family homes in operation that each yield about $500 per month in net income. At tax time, the depreciation on each rental is treated as a deduction, as are maintenance costs.
The rentals we own are fairly close to us. We’re willing to learn and apply our elbow grease, so we’ve been able to avoid property management costs. In a future post, I’ll share how we manage our rentals in a highly passive manner.
One of the best reasons to get into real estate in the first place is the cash flow it can generate if done RIGHT. There are several options to explore, whether you go with single-family home rental (my preferred, for passive, low hassle tenants) or even vacation rentals (more intensive because you’re the host, but highly lucrative if located in high-demand areas).
Examine your budget and what do you see? Most of the line items fall on the “expense” side. You’ll be hard-pressed to whittle that list down too far. There are discretionary categories that can be eliminated or reduced.
Even the basic needs deserve a healthy amount of scrutiny. It can be easy to fall into a lull when it comes to monthly recurring expenses. After many months of simply paying the internet and cell phone bills without a second thought, I finally took the time to call our Internet provider to get a reduced rate.
We switched our cell service to Ting. That $50 a month in savings comes in handy when your cash flow is dramatically reduced at retirement. Stay vigilant.
While I do my darndest to ignore net worth, I plan to employ four cash-flow building tools: a business (rentals, blogs, etc.), part-time jobs, investment income, and cost avoidance. Some interesting decisions could come your way if you choose to focus on cash flow over net worth. For instance, is it more important to pay off the high-interest loan first?
Or, the one with the highest impact on your cash flow? Consider this when the competing rates are within a few percentage points, and you know you need the cash.
Where the Debt Monkey Fits In
A very good read this week that complements my little ditty can be found over at my neighbor’s, Apathy Ends. Apathy hits us right over the head with a very similar message: There are not a million ways to pay off debt.
The message is underpinning his post is all about persistence. That’s not rocket science, my friends.
If you wanted to be clever about all of this, you could draw up the classic evolution ladder to depict the stages of financial independence. The monkey, in the beginning, is more illustrative of the monkey on your back.
Then, after our worst debt is paid off, we get to evolve into neanderthals. Loincloth and furry knuckles.
The only thing holding us back from evolving into full-fledged financial Kardashians is our need for that hamster wheel day job to support our living expenses. We reach fully erect Kardashian when we’ve saved 25 times our annual living expenses.
Getting from monkey to neanderthal is the part that drains our psyches the most. In those years, I was worried about trying to make more money to stay ahead of mounting debt payments. Paying off credit cards, car loans, and student loans are huge first, second, and third steps.
Acquiring the freedom to say “F You!” to the day job? What comes next, if you find yourself if in a job you despise, complete with a killer commute.
Do you have tips you’d like to share on which loan to pay off first? Please comment below!
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.
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.