Evaluating Debt Payoff Strategies
This article is a guest post from Dr. David Graham, MD, CFP, who is a practicing Infectious Disease physician and blogs at FiPhysician.com. He also has a CFP and provides a fee-only financial planning service for Montana physicians.
The Frugal Physician has no financial relationship with FiPhysician. This post is published here for its merits and for the excellent information it provides to TFP readers. When looking at a mountain of debt and just a little extra in cash flow every month, it is very important to know how apply that extra cash to debt to get the most bang for our bucks. Today, Dr. Graham will introduce us to the idea of the Cash Flow Index created by the Wealth Factory and will evaluate whether he would recommend it as a debt payoff strategy. Included also is a good breakdown of the debt snowball versus the debt avalanche versus the debt flood for debt payoff.
Cash Flow Index
A Better Way to Look at Debt Repayment?
Traditionally, Dave Ramsey followers subscribe to the debt snowball where the smallest debts are paid first to free up money and attack increasingly larger debts. This has momentum and psychology behind it.
Alternatively, the debt avalanche pays off the highest interest rate debts first and lower rates subsequently. Mathematically, this makes the most sense and costs the least.
Finally, if you don’t know Dave or math, the default method is to split payment between all debts equally. If you have a windfall or extra money, just pay a little extra on each debt. Let’s call this the debt flood. It’s not a great idea as we will see below.
A method I just learned about is called the Cash Flow Index (CFI)*. The point of CFI is to pay off inefficient debt. Huh… debt can be efficient? I’ll explain later.
Let’s look at a theoretical debt payment scenario for a doctor (let’s call her Dr. Debt) and her husband to see how each of the models work.
The Story of Dr. Debt- A Case Presentation
Dr. Debt earns $260,000 a year and she and her husband continue to live like residents in order to pay off debt. Their fixed costs before debt are about $60,000 a year, but they are not the world’s best budgeters. In reviewing cash flows, about $8,000 goes missing a year.
They are good savers, however, and max contributions to a 401k with a 6% match. They contribute $6000 a year to a backdoor Roth and $6,000 a year to a brokerage account. All investments are in a total stock market index fund with low expense ratios.
Monthly debt service costs are $7,896.
Car loan 5%
Credit Card 19%
Student loan 4%
Figure 1 (list of debts)
Their debts are listed in Figure 1 above from smallest to largest, with associated interest rates. They have a car loan, a credit card, a personal loan, refinanced med school debt, and a home mortgage. Payments and minimum payments are shown. They are paying extra on the credit card.
Different Ways to Pay Off This Debt
The Debt Flood
What if Dr. Debt made no additional payments to her debt? Figure 2 represents that in blue. Their debt will take almost 30 years to pay off. If they add an extra $1,000 a month to their debt, dividing it to apply a little to all accounts (utilizing the Debt Flood- shown in teal), they will get out of debt 56 months sooner. This way they save over $74,000. Wow.
Figure 2- Standard Repayment vs a Debt Flood
The Debt Snowball
Now, let’s try Dave Ramsey’s debt snowball. In the debt snowball, Dr. Debt uses that same extra $1,000 a month to pay her debt from smallest to largest amount, not taking into account interest rates. This saves her family over $217,000, and they get out of debt 19-and-a-half years earlier!
Figure 3: Standard repayment vs Debt Snowball
Dave is on to something! Roll debt snowball!
The Debt Avalanche
If Dr. Debt used the debt avalanche, she would put that $1000 towards the highest interest rate loan first. In this example, the avalanche produces similar results to the debt snowball. Using the debt avalanche, the couple is debt-free 237 months sooner and they save $220,709 when compared to standard repayment. When compared to the debt snowball, they have only $3,391 more in savings and are out of debt 1 month faster.
Cash Flow Index- What is it?
So let’s introduce the cash flow index now- exactly what is it?
Cash flow index is calculated by taking the total debt and dividing by the minimum monthly payment.
Debts with low CFIs are considered inefficient and should be paid of first.
So, looking at the numerator of the CFI calculation: the higher the debt, the higher the CFI will be and the less priority on paying it off. The denominator has an inverse relationship: the larger your minimum payment, the lower the CFI. Low CFIs are considered inefficient and should be paid off.
Put another way, if the minimum payment is high, you will get more cash flow if you prioritize paying it off rather than focusing on APR. Conversely, if the total debt is high, it will take a long time to pay off the loan and get increased cash flow, so the CFI is high, or efficient, and should not be paid off early.
With the CFI, debt repayment begins with the lowest CFI number and proceeds up numerically.
Specifically, a CFI less than 50 is considered critical debt, which is inefficient and should be paid off. Debt with a CFI between 50 and 100 is borderline and may be paid off to free up cash flow, or restructured. Debt with a CFI greater than 100 should not be paid off, as it is efficient debt and will not lead to increased cash flow in the short term.
A goal of debt repayment via CFI is to not pay off your efficient debts—those with CFIs >100. This cash flow can be better used investing in other assets such as businesses (or for the creators of CFI, cash value life insurance).
Applying the CFI to Dr. Debt's Example
If we apply CFI to Dr. Debt’s situation, the personal loan is paid off first as it is least efficient with a 25 CFI. Unfortunately, it is a large loan and takes 20 months to pay off. Next is the car debt (CFI 33), and then after all that is paid off, the 19% APR credit card is handled. See table below.
Balance and Payoff
Balance and Payoff
Balance and Payoff
10,000 @1300/m 7.7m
2616 @6300/m 0.5m
48,026 @2300/m 20.8m
50,000 @2000/m 25m
11,784 @6000/m 2m
300,731 @8896/m 33.8m
301,391 8896/m 33.9m
Months (first 3)
Months (all 5)
Figure 4 (order of payoff and debt balances at the time the debt is paid above the minimum)
Figure 4 lists order of payoff for snowball, avalanche, and CFI. Note the order of the first three payments are all different, and the avalanche pays off the home loans before student loans because the interest rate is slightly higher.
Remaining debt balance is shown at the time the debt is addressed above minimum payments. Also shown is how long the debt takes to pay off given the minimum payment, plus the $1000 extra payment (plus the addition of the next minimum payment as the next debt is addressed).
The number of months it takes to pay off the first three debts and all five debts is shown as well.
For the snowball, 7.7 months are spent paying off the smallest debt, and then that money rolls to the second largest debt for 20.8 months. By that time, the personal loan has already been paid off due to large minimum payments and so debt payment moves on to the student loan and then mortgage.
In the avalanche, 25 months are spent on the first debt, which is the high interest credit card. The personal loan is next followed by the car, mortgage, then student loan.
The CFIs are shown in parentheses under the rank number.
According to CFI, the score of 50 suggests the credit card should be refinanced to a lower interest credit card, and 50 isn’t even the real number. If we reflect back on Figure 1, the actual minimum payment is $250 a month, giving it a CFI of 200, which makes it the most efficient debt on the list. That doesn’t quite make sense to me as that puts you in the freedom zone and suggests you should never pay off that debt. Huh… never pay off a debt compounding at 19%. That is a quick way to the poor house! Obviously, you can’t ignore the interest rate in all situations.
Rate of Return (on Loans)
Another calculation can be done when considering the CFI. The rate of return on a loan is calculated as minimum payment x 12 divided by the loan balance.
Rate of Return
Figure 5 (CFI rank, CFI and Rate of Return)
Figure 5 shows the CFI rank, the CFI, and the rate of return. If you had $100,000, you could pay off the personal debt, which would free up $4000 a month and lead to a rate of return of 48% on your “investment.” That makes sense. Using $10,000 to pay off your car loan would lead to a rate of return of 36% on your money, or $300 a month. For the efficient loans, the rate of return is in the single digits, which means not much cash flow from paying off these debts.
Let’s look at another example.
Debt and Interest Rate
Rate of return
Figure 6 (another example)
Here in Figure 6, you pay off the 0% loan because the rate of return is 120% and it is less efficient. In this example, after a few months you have your car paid off if you throw extra money at it, and it frees up the $1000 monthly payment which will let you snowball the credit card pretty rapidly with your increased cash flow. But, if you delay paying the credit card, you could be stuck with $1000 in interest payments over the course of the year to allow that increase in cash flow. Maybe CFI isn’t a great plan….
Loan Efficiency and Control
The point of CFI: it allows you to better control cash flow. The creators of CFI suggest (after an emergency fund) stockpile your cash and then pay off debts in order of efficiency when you can make lump sum payments. Then go back to saving cash again. This does afford greater security by having liquid assets around if needed.
As to efficiency of loans, if there are large balances or low relative minimum payments, the loan likely has a CFI greater than 100 and is considered efficient. I’m not sure that is the word I would pick, though. Maybe “expensive”: a big-ass loan and would take too long to pay off and not free up the cash flow to make it worth it.
Cash Flow Index models another way to consider debt repayment.
Criticism of Dave Ramsey (aside from suggesting you pay down debt rather than take a match on a 401k) includes ignoring interest rates as you pay the smallest debt first and snowball your way up the hierarchy of debts. Dave says it is about behavior not math. If you could do math, you wouldn’t be in debt in the first place. As evidenced above, there is not much difference between the snowball and avalanche.
CFI ignores interest rates like Dave Ramsey and places a high importance on obtaining cash flow quickly so you can meet investment priorities and have more control of your finances. I fear, given who created this index, that the priorities are cash value life insurance, and the use of this insurance to “bank on yourself.”
Looking at the rate with which we get higher cash flows with CFI in our original example, I’m not impressed. After 20 months, you free up $5300 a month with which to continue to pay debts. Of course, this will vary by loan amount and minimum payment.
In summary, CFI is an interesting idea but there may be a reason few have heard of it and financial planning software doesn’t bother modeling it.
David Graham, MD, is a practicing Infectious Disease physician and blogs at FiPhysician.com. After discovering his passion for personal finance, he started a Registered Investment Advisory to promote his mission of “Financial Literacy for Physicians.” For personal enjoyment, he recently sat for and passed the CFP exam.
I like this post because it shows there are many ways to pay off debt, but some are more efficient than others. Dr. Graham didn’t end up endorsing the CFI method and he showed us why. I really liked the graphics showing how the debt snowball or the debt avalanche can really accelerate debt payoff. Sure, the debt avalanche saves a little more money but I think the psychological satisfaction gained from the debt snowball has a lot of value in that it keeps us motivated to continue on with saving and paying off debt. Just like a diet, the best debt payoff method is one we can stick to for the long months required to become debt free. But, both the debt avalanche and the debt snowball can make us debt free a lot faster than the debt flood.
So stay frugal, TFP tribe!
Until next week,
Standard Disclaimer: Not meant as individualized financial advice. Images from unsplash.com.
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