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.