Money Mastery Coaching

What Loans Should I Pay Off First? Strategies for Smart Debt Repayment

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What is up, everyone? It’s Wade Reed, founder of Money Mastery Coaching, coming at you with another whiteboard discussion about debt, specifically which debt to pay off first. This is perhaps the most common question I get when I start working with a client about their financial circumstances, getting their financial house in order. Do I save first? Do I pay off debt first? And if I do pay off debts, which ones do I do first?

Alright, let’s talk about which debts come first. I would suggest to you that the most important question when considering which debt to pay off first is this: Which loan frees up the most cash flow the fastest? In other words, the fewest dollars that I have to pay to get the loan paid off in order to free up the most cash flow.

Whiteboard screenshot showing what loans to pay off first

Common Methods of Repayment

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So, there’s several methods for approaching this. There’s the method where we take the lowest balance and just put it first. In this case, those would be the credit cards. They have equal balances of $5,000 each, and then we’d have the car loan, personal loan, and then we would have the student loan, and then we would have the mortgage. There’s a big psychological win when we do that. I have no problem with that method for the most part.

Then there’s the mathematical approach where we look at the interest rate and we see that we have a 5% interest rate on a mortgage, 8% on a car, 15% on a personal loan, 8% on a student loan, 20% credit card, and 25% credit card. So mathematical logic would say, let’s pay off the credit card number 2 with the 25% interest rate first, lowest balance and highest interest rate. That would make a lot of sense.

Money Mastery: Cash Flow Index

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I’m going to suggest something that goes against those two, and that is that we look at what the cash flow is that gets freed up when we make that decision. So you’ll notice I have a column on the far right that says CFI. That stands for Cash Flow Index. This is a measure of efficiency, how efficient is the loan payment that I’m making compared to the balance that I have taken on the loan that I have taken on.

Notice a high number on a mortgage and a low number on the personal loan at 29. So let’s highlight those. We’ve got a high 186, and we have a low 29. 29 means inefficient. A low number means inefficient. It’s not serving you very well from a cash flow perspective.

The Impact of Timeframes

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Let’s compare these two, car and personal loan. Notice the terms are 5 years versus 3 years. This is the first indicator of whether or not you have a lower payment. A longer time frame to repay means lower payment. A lower timeframe, like 3 years, means a higher payment.

Now, this can be a problem because if you force yourself into a short repayment period, then you have no flexibility. You are required by the promissory note with the lender to make that minimum payment every single month. There’s no flexibility here, and that’s why I like to look at how we get the fastest cash flow freed up.

The Debt Snowball

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A low cash flow index number means we get more cash per dollar invested in paying off that loan than any other loan. So a car loan versus a personal loan frees up $346 versus $202. That’s easy to see. Well, what’s the implication of that? $346.65 minus $202.76, $143 a month. I mean, that’s decent. Oftentimes on a monthly basis, it doesn’t feel like as much as it could. Sometimes people go, “Well, I’m only freeing up so much. What’s the big deal?” Well, let’s multiply it out by 12 months to get the annual. So we’ve got $1,700. Now that seems a little more meaningful, right? That’s a decent trip somewhere.

What about if we can do that consistently for 10 years? Now we’ve got $17,000 back in our pocket. We have to think about the long game here. What is the value of that cash flow that gets freed up faster growing in our bank account, making it so we can invest in things that we want to invest in: get the trip that we want to take, give generously, whatever our purposes are, the more cash flow we have, the more we can do that quickly.

Finding the Cash Flow Index

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So here’s the minimum requirement when we look at which loan to pay off first. It’s the loan balance over the loan payment. The loan balance divided by the loan payment is how we calculate that cash flow index number, and the lower the number, the faster we pay it off.

Whiteboard explaining cash flow index for what loans to pay off first

What Order to Pay Loans

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So this is the mortgage, $300,000 outstanding, a monthly payment of $1,610.46 is a cash flow index number of 186. That’s the last loan I’m going to pay off in this method. The second last one is going to be the student loan. Many of you are student loan borrowers, and you’re frustrated about the fact that you have student loan payments that have just begun again, and they’re fairly high. They’re around 8% cost to borrow.

And it doesn’t seem like you have much that came with that. But you do have education. You do have a skill set. You do have the ability to get a job that can pay well. So I would suggest that’s the next one that you would want to pay off, but we want to take as long a payment process as we can, so our payment is as low as possible. So I’ve got here 20 years repayment. That’s $418 a month. That’s a really low payment compared to the $50,000 balance. It’s not that far off from the $10,000 personal loan with $346.

So our last loan is the mortgage. Our next one is the personal loan, and then we have the car loan, and then we have the credit cards, and then we have the personal loans. So if we put those in reverse order, the first one to pay off is the personal loan, and then the credit cards, and then the car loan, and then the student loan, and then the mortgage.

What will happen as you pay those off is we still follow the debt snowball, that snowball still works. We just do it faster with more cash flow available. And, in fact, I’m gonna throw a little thought for you here. I want to invite you to think. So let’s think.

Reframing Debt Payments

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What if we stop making extra payments directly to the loans and instead we save that extra payment into a separate savings account. We take that freed up $143 a month by paying off that first loan and save it in a bank account. (Correction: The $143/mo is the additional amount freed up by choosing to pay off the $10,000 Personal loan with a payment of $346.65, which has the lowest CFI of 29 vs the $10,000 car loan with a CFI of 49 and payment of $202.76). At the end of that time, you’ll have $1,726 (Correction: $4,159.80 because you paid off the personal loan with a payment of $346.65 x 12 months = $4,159.80). And then a year later, you’ll double that, and a year later, you’ll double that.

And as you have your emergency fund built up, and then you have extra above that, then in lump sums, I would really encourage you to practice this because it’s safer. Build up your savings. First, build up your savings first, and then pay off your loans in full when you’re ready to, rather than incremental monthly payments over time.

This will allow you to have more cash available should an emergency rise, should a right investment come along, should the giving opportunity you’ve been waiting for come along, or a family member needs some support. You have the ability to do that without having to go back to credit cards or other debt. If we don’t have sufficient savings, then we end up going backward.

So first of all, build up savings. Second of all, make it above 3 months of your living expenses, and once it’s above that, you can use lump sums to pay off these loans quickly. So then hit the credit card, hit the other credit card, free up that $250, or $125 and $125, and then add that to the mix and then do it again, and we create the snowball of savings. And then we’re in the habit of saving.

This is one of the things I see as a problem is, once you pay off loans, oftentimes you typically just spend that money. But if you have the habit of saving all that money first, and then only deliberately paying off in lump sums the next loan, you’ll be able to be in the habit of saving after that last loan is paid off and continue to accelerate your wealth creation and retirement planning.

Hope you like that. We’ll see you on the next one.

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