Hint: It’s not about your loan interest rates, nor is it just about socking away more money by cutting back or even just about saving money on interest.
As a financial advocate, I deal with this issue frequently with the clients we work with. You want to get out of debt so you can reduce your risk, increase your cash flow, and have greater peace of mind, right?
Unfortunately, in a zealous effort to get out of debt, too many people make critical mistakes that increase their risk and make the process much slower than it has to be. It’s not just a matter of prioritizing which loans should be paid off first. It’s also a matter of minimizing your risk throughout the process.
Here’s the fastest, safest, and most sustainable way to do it:
1. Build Savings First
It doesn’t make any sense to start paying extra on loans until you have at least three months of income, and ideally six months, in a liquid savings account.
If you have no cash reserves, what happens when you pay down your loans but then experience an unexpected cash flow crunch? You simply increase your loan balances again or even worse, miss payments and hurt your credit score, therefore getting charged more for future loans and you can miss opportunities to lower your interest rates.
So before you even get started with paying down debt, build your cash reserves first. This puts you in a much safer and more sustainable situation. Don’t worry if you are wondering where that money might come from, details to follow, read on.
2. Raise Your Insurance Deductibles
Once you have cash reserves you can raise your insurance deductibles and extend elimination periods, which decreases your premiums, an extra benefit of having money in savings. This increased cash flow can then be used to strategically pay down debt.
I recommend using your home, auto, and liability insurance to primarily cover catastrophic losses. With higher deductibles (again, assuming you have cash reserves to cover small losses) you’re less likely to make claims, which prevents increased premiums.
The larger principle here is that when you approach debt elimination the right way it affects almost every other aspect of your finances. This is a more comprehensive approach that takes every factor into consideration, rather than looking at your debt in a vacuum.
3. Restructure Your Non-Deductible Debt by Rolling Short-Term, High-Interest Loans into Long-Term Tax Deductible, Low-Interest Loans
Again, the goal is to minimize your interest payments and maximize your cash flow. Then you can attack your remaining debt strategically, using your increased cash flow to eliminate one loan at a time.
Another benefit of this strategy is that it improves your debt-to-income ratio, which then improves your credit score, which can then be used to negotiate lower interest rates and will result in increased cash flow.
Having a better credit score also gives you more negotiating leverage. You can look into a streamline refinance on your existing mortgage. You can call your credit card companies, for example, and tell them you’re considering canceling and switching. They may be inclined to make their interest and terms more favorable for you, especially if you have a higher credit score.
Assuming you have enough home equity and after improving your credit, refinance your mortgage and roll as much of your non-deductible loans (credit cards, auto loans, etc.) into it as possible. The tax deduction will also increase your cash flow.
CAUTION: Do NOT do any of this if you’re undisciplined and your spending is out of control. If you’re just going to charge your credit cards back up again, you’ll just sink deeper into debt.
4. The Secret Sauce: Cash Flow Index
Here’s where the rubber hits the road. After minimizing your payments and maximizing your cash flow, you’re now prepared to focus on one loan at a time, thus creating the “snowball effect” until you’re completely debt-free.
Most financial advisors and pundits will tell you to pay off your loans with the highest interest rates first. My advice is to ignore the interest rate and use my proprietary Cash Flow Index to determine which debt to pay off first.
To determine your Cash Flow Index, take all your various loan balances and divide each of them by their respective payments. Whichever one has the lowest number is the one you should pay off first.
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.
5. 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.
6. 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?
- 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.
7. Increase Your Production & Cash Flow
Unfortunately when it comes to paying off debt, most systems train people to cut back. This limited, scarcity minded thinking leads to eliminating productive expenses like hiring key employees, implementing marketing programs, or other important areas within the business. It oftentimes removes the focus from the mission of the firm and shrinks the vision to survival and minimizing.
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 in your business: hire a new employee, employ a marketing program, develop a critical skill, buy technology that would open up new revenue or increase retention.
In other words, find ways to provide more value because dollars follow value. Take time to analyze your business and identify the best ways to serve at a deeper level.
Consider the following questions as you strive to increase your productivity:
- How can you hire people and create processes and procedures to stop doing the things that drain your energy?
- Where do you need to release control and replace your physical involvement with processes and procedures?
- To double your profits, what things would you have to stop doing today?
- To double your profits, what things would you have to start doing that you’re not currently doing?
- How can you leverage your vision (inspire and build a team) versus increasing your personal labor?
- What things could you do in your business that 1) are the highest and best use of your time, and 2) would produce the greatest long-term ripple effect?
Now, with the increased profit in your business, 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.
[Ed. Note: Garrett Gunderson is a financial advocate and the author of the New York Times, Wall Street Journal, USA Today, and Amazon bestseller Killing Sacred Cows: Overcoming the Financial Myths that are Destroying Your Prosperity. www.garrettbgunderson.com]