Now that we've talked about the different types of emergency funds and then picking a strategy to get out of debt, let's talk about one of those options - the Free Cash Flow Method. It seems like this one is better for those of you that want to keep a smaller emergency fund, free up more cash on a monthly basis and reduce your overall debt down the road. Most financial experts say while the economy is unstable (hello, 2020!), it is better to focus on saving money while making minimum payments. Have you ever played The Game of Life? If so, you know it's important which paths you take on your road to retirement.
What exactly is the Free Cash Flow Method?
It is a scoring system to determine the efficiency of your loans/debts, which allows you to pay off your most inefficient loans first. This method provides you with the specific order to pay your debts off in the most effective manner. If you are not aggressively tackling your debt as much as we are, this will still allow you to eliminate debt while also freeing up more cash each month. Sounds like a win-win situation to me! The best things about this method are that it's simple to calculate, easy to maintain and, in my opinion, the safest path.
So, how does it work?
Debt Snowball Method using the Cash Flow Index (CFI)
Cash Flow Index = Loan Balance / Minimum Monthly Payment
First, get a list of every debt/loan you have. Yes, all of them! For each debt, take the total balance owed and divide it by its monthly minimum payment. You will get a number for each debt, which is the Cash Flow Index (CFI). The higher the CFI number, the more efficient the debt. Which debt has the lowest number? That is the one you should pay off first. Remember, I said it was simple to calculate!
Once you have your CFI numbers, you want to see where they rank on the scale, which generally says the following:
1-50: Inefficient - attack first!
50-100: Debts to restructure! Try to negotiate interest rates or consolidate the balance
into a more efficient loan if possible.
100+: Cash flow efficient! There's really no need to pay more than the minimum.
These are usually things like your mortgage or student loan. Your cash is
better utilized by saving and investing.
Here are some examples for the visual people like me:
Credit Card Balance: $13,000
Interest Rate: 12%
Monthly Payment: $260
CFI: 50 ($13,000 / $260)
Auto Loan Balance: $6,800
Interest Rate: 3%
Monthly Payment: $460
CFI: 15 ($6,800 / $460)
Credit Card Balance: $5,300
Interest Rate: 18%
Monthly Payment $125
CFI: 42 ($5,300 / $125)
Student Loan: $50,000
Interest Rate: 4%
Monthly Payment: $325
CFI: 154 ($50,000 / $325)
Looking at this example, you can see how the CFI numbers range from 15 to 154. It may seem like the most sensible choice would be to pay off the credit card first since it has the lowest balance and highest interest rate. However, the auto loan is actually the least efficient loan. By tackling the auto loan first, you free up a lot more cash flow to work on other debts. Now, it's making sense! Again, keeping it simple! You aren't focusing on interest rates. It's all about efficiency and freeing up more cash in your budget.
You can further decrease your risk by avoiding small overpayments on the debt. Instead, hold off until you have enough cash (above your predetermined emergency fund) to pay the balance of the loan off in full. How does that help? It allows you to maintain control. You will either have enough cash saved up to pay off the debt or you will have the newly created cash flow from paying off the balance. Either way, it sounds like another win-win to me!
Why I like the Cash Flow Method better than the standard Snowball and Avalanche Methods?
If you remember back in one of my previous blogs, I told you that I started out with the Snowball Method to knock out a few smaller balances first. As planned, we were able to do that and then switched over to the Free Cash Flow Method. It's helped me knowing that I can use one method to reach a certain goal and jump back over to another method to achieve a different goal. Sticking with one method can be exhausting and lead to burnout. The Cash Flow Method lets me take a break from obsessing over interest rates, and it offers less risk. My favorite part of this method is hands-down the increased monthly cash flow! Please believe that it gives me the most motivation to see that extra cash and know that we are getting somewhere.
In summary, getting rid of inefficient debts is the quickest and safest way to reduce your overall debt and simultaneously increase your monthly cash flow. A true win-win that will have you on the right path to becoming debt free in The Game of [real] Life.