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May, 2012

The Counterintuitive Formula for Becoming Debt-Free

By 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.

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