Look at the latest posts about paying off debt and you’d think it’s the next big breakthrough. Which loan should I pay off first? The cash flow index method makes that choice simple and practical. Keep reading.
Debt stinks. These days we take on debt for many well-meaning reasons: a mortgage, student loans, or to get by after a layoff or health problem. Those can be sensible. Then there’s dumb debt — new cars, jet skis, Cancun trips, mall-credit-card sprees — that puts you in a dangerous spiral.
The psychology is tricky. Your brain gets in its own way. Right out of college or starting a job, many of us have low-paying work or multiple part-time gigs and share rent with roommates. We’re young and assume the future will sort itself out. I fell into that trap, which is why I’m aiming for early retirement in my mid-40s instead of my mid-30s.
A lot of personal finance advice is hard to swallow. We’re not all in our 20s or 30s. It’s never too late to start, but the biggest window of opportunity is when you’re younger. If you’re starting late but you ditch the consumerism, you can still “turbo charge” your progress. For me, that meant starting a rental property business about five years ago. The discipline I learned there helped me at work; I started solving problems better and got raises and new chances to move up. I’m still chasing that promotion, though.
Bottom line: paying off debt is straightforward but takes persistence. Stick with it. No hole is too deep to climb out of. Patience and steady effort will get you through. Others have done it under worse conditions — learn from them.
Sometimes homeownership helps. After I was laid off in 2001, I was able to take a $30,000 home equity line of credit (HELOC). That helped cover groceries and the mortgage while I was in school. Once I had a new job, I used the HELOC to pay down higher-interest debts. People assume HELOCs are only for home repairs, but banks don’t care much; they just like having your mortgage as security. I consolidated credit card debt and some student loans onto the HELOC at a lower rate. Back then the HELOC interest was tax-deductible — the 2018 tax law may have changed that.
Long term, it’s wise to keep a HELOC open but unused, like an emergency fund. If you’re comfortable with risk, you can use it to make down payments on rental properties. That’s leverage and can be lucrative if you do your homework, but be careful.
I stopped using interest rates alone to pick which loan to pay off first. I use the cash flow index (CFI). Why? A few years back I read Killing Sacred Cows by Garrett B. Gunderson. I recommend it. The book won’t have you follow everything it says, but it will change how you think about money. I follow some of its ideas and ignore others, but one useful tool it offers is the Cash Flow Index.
Here’s how CFI works: divide the loan balance by the monthly payment. Example: a $10,000 car loan with a $400 monthly payment has a CFI of 25. A $100,000 mortgage with a $900 monthly payment has a CFI of 111. The lower the score, the more you should prioritize that debt. So in this example, tackle the car loan before the mortgage — even if the mortgage rate is higher. Why? Because the goal is to free up cash flow fast, not to play rate arbitrage.
I’ve used CFI for most of our debts over the last decade. I compare all our CFIs and put extra payments toward the lowest score first. It frees up cash quickly and creates a snowball effect as each low-CFI debt gets paid off.
Gunderson calls a CFI of 100 or higher an “efficient” loan — one you can ignore for a while. Our mortgage’s CFI is 165. A smarter technical move might be investing extra money instead of paying the mortgage early, but for us the priority is cutting monthly payments before retirement to improve cash flow.
A few simple rules:
– Pay off credit cards first. They’re usually 12%+ and often require almost interest-only minimum payments. Ignore the CFI for credit cards and kill them by interest rate, highest first.
– For non-credit-card debt, use the Cash Flow Index. Lower CFI gets priority.
Early retirement — the dream of relaxing in a hammock — actually takes a lot of work and sacrifice. Companies don’t want to lose top employees. Some in the early-retire community obsess over net worth and even share it publicly as proof of progress. Net worth matters, but it’s not everything. Assets that don’t produce income (cars, houses, jewelry) are hard to live on in retirement. Cash flow — the money moving in and out — is what really matters.
Run your finances with discipline and curiosity. Cut debt while finding ways to increase income and cash flow.
Part of our plan is to save about 18 months of income in taxable index funds near the end of my corporate career. We’ll withdraw that money slowly over about 13 years until I can tap my 401(k) at 60. That bridge funding gives our budget flexibility. We expect to need around $60K a year in retirement to cover expenses and a few luxuries.
Our main cash flow comes from rental real estate. We own four single-family homes that each net about $500 a month. At tax time we take depreciation and maintenance deductions. Because the rentals are near us and we’re willing to do some work, we avoid property management fees. One of the best reasons to get into real estate is the cash flow if you do it right. Single-family rentals are my favorite for passive, low-hassle tenants. Vacation rentals can pay more but require more work.
Look at your budget. Most items are expenses, and many are hard to cut. But recurring bills deserve attention. After months of paying for internet and cell service without thinking, I called to lower our internet bill and switched our phone service to Ting — now two lines cost $40 a month. Small savings add up when your cash flow drops in retirement. Stay vigilant.
I try to focus on cash flow rather than net worth. My plan uses four cash-flow builders: a business (rentals, blogs), part-time work, investment income, and cost avoidance. That focus can change decisions: is it better to pay off the high-interest loan first, or the one that frees the most cash? When rates are close, think about cash flow.
Whatever method you choose to pay off debt, don’t fall into the trap of keeping up with the Kardashians. That kind of spending will keep you on the job hamster wheel for decades longer than you want.