Garrett B. Gunderson
It's not about your loan interest rates, nor is it about cutting back or even just about saving money on interest. As a financial advocate to chiropractors, I deal with this issue frequently with my doctor clients. Unfortunately, in a zealous effort to get out of debt, too many doctors 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.
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. Even worse, you may miss payments and hurt your credit score, therefore getting charged more for future loans and missing opportunities to lower your interest rates. 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. Wondering where the money will come from? Keep reading.
Raise Your Insurance Deductible
Once you have cash reserves, you can raise your insurance deductible and extend your elimination periods, which decreases your premiums. Increased cash flow can then be used to strategically pay down debt. I recommend using your home, auto and liability insurance only to 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 holistic approach that takes every factor into consideration, rather than looking at your debt in a vacuum.
Restructure Your Debt
Roll your short-term, high-interest, non-deductible loans into long-term, low-interest, tax-deductible loans. 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. 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. This results in increased cash flow. Having a better credit score also gives you more negotiating leverage. For example, you can refinance your existing mortgage. You can tell your credit card companies you're considering canceling and switching. They might make their terms more favorable for you, especially if you have a higher credit score. 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.
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.
For example:
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 loans faster than if you started with the credit card.
[pb]Address the Risk Factor
Again, this formula 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, they may encourage you to go with a 15 year loan. This locks you into a higher payment and increases your home equity. The more equity you have, the greater the incentive for the bank to foreclose. In addition, you would have less money to build your savings when forced to make higher payments.
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 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 fifteen years by getting greater tax deductions and earning interest on your side account with the difference between payments. Also, as stated earlier, this improves your debt-to-income ratio, which helps your credit score.
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 by products (interest and bondage). Before you employ these techniques, ask yourself questions like these:
- Why did I incur each of my debts? 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 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 in outlook and behavior. You must change who you are, then what you do flows from that change. Debt can come from bad relationships, faulty philosophies and slow course corrections in business, such as not firing under performers quickly enough, not executing on purchased programs, etc. If you're struggling with debt, focus on creating value for others and eliminating destructive relationships, expenses and distractions. Never not borrow to consume. Use cash for luxuries and only borrow for productive assets and resources or necessities.
Increase Your Production and Cash Flow
Most debt-reduction systems train people to cut back. This limited thinking leads to eliminating productive expenses like hiring key employees, implementing marketing programs, etc. It often distracts you from your firm's mission and shrinks your vision. Ultimately, the best way to get out of debt is to increase your productivity and cash flow. I recommend that you take the money you're currently paying extra to loans and use it instead to improve something you're certain will increase the productivity of your business. This could include hiring a new employee, executing a new marketing campaign, developing a critical skill, purchasing new technology that would generate new revenues and/or increase retention, etc.
In other words, find ways to provide more value because dollars follow value. 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? What things would you have to start doing that you're not currently doing?
- How can you leverage your vision (to inspire and build a team) versus increasing your personal labor?
- What things could you do in your business that are the highest and best use of your time, and would produce the greatest long-term ripple effect?
Now, with the increased profit in your business, attack the loan with the lowest Cash Flow Index. This will give you more resources and allow your dollars 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 greater peace of mind.
