Can You Be Cash Flow Positive Before Paying Off Debt Paying Down Debt

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Paying Down Debt

The school of hard knocks probably taught you one of the four decision-making approaches used to pay or pay off debt. Armed with this knowledge, you are ready to fiscally steer your household or business down a path that will only be wrong about 75% of the time.

Debt can be good. It builds credit, enables expansion, fills gaps and funds education. Conversely, too much debt can plague a family budget or a business. Once you’ve decided to reduce your debt, this quick guide will help you figure out how best to achieve your goal.

Very simply put, if you want to reduce debt, you must first be able to pay all the minimum payments on each debt and other monthly expenses. After that, additional funds must be available for “debt reduction” to be applied to one of the debts in order to eliminate it. Additional funds can be in large amounts or in smaller amounts over time. The amount of money is less important than the process. A bigger pot will help you reach your debt reduction goals faster; however, a smaller pot if used correctly will still get you going in the right direction.

This begs the question: If you have multiple debts (say…a home mortgage, a car loan, and a credit card), which one will you pay off first? There are four decision-making approaches to help you determine what to pay first: the interest rate approach, the breakeven approach, the cash flow approach, and the risk reduction approach.

The interest approach:

The demagogues of modern mythology most likely taught you the first of the four approaches through magazines and trade journals or on radio and television. Pay off the debt with the highest interest rate. So if the mortgage has an APR of 7.4%, while the car loan is 6.0% and the credit card is 5.5%, you decide to pay the debt reduction funds into the loan with the highest interest rate – the mortgage.

The rationale behind this approach is sound, and the math is simple. It’s not wrong; it is only incomplete as it represents only one tool in your toolkit to use when your goal is to reduce the total interest you pay. And as much as a hammer is a wonderful tool, it doesn’t help much if you remove a screw or cut a board in half.

A balanced approach:

The beauty of debt reduction is the snowball effect that allows future debt reduction payments to be much larger than the initial payments. When you pay off the first debt, all else being equal, you can now add the monthly payment you were making on that debt to your original debt reduction payment, and you can now apply both to the second debt. The balance approach therefore guides you to pay off the debt with the smallest remaining loan amount when your goal is to reduce the number of debts. So if your mortgage balance is $258,000, your car loan is $3,500, and your credit card balance is $8,000 – pay off the car loan first. This will allow you to combine the payment you were making on your car loan and the additional debt reduction payment towards your next debt – either a mortgage or a credit card.

Cash flow approach:

The only constant thing in life is “change”. Just as you need to be flexible in life, you should strive to be more flexible in your finances. The cash flow approach teaches you to reduce your loan, which will reduce your monthly cash flow; which means the amount you have to pay each month as the sum of all your minimum payments. Mortgages and car loans are often installment loans, so even if you pay well over the minimum this month, you’ll still owe the same minimum payment next month. In contrast, credit cards, lines of credit and interest-only loans adjust their monthly payment amounts based on the balance due. So if the minimum monthly mortgage payment is $2,100, the car loan is $650, and the credit card is $200 – pay the credit card first.

As your credit card balance is paid off, the minimum payment amount will drop, which will drain less money out of your finances. This allows for maximum flexibility if things take a turn for the worse, opportunities arise or plans change.

A risk mitigation approach:

Lenders categorize debt based on risk exposure, and so should you. While your plan may be to completely eliminate all debt, plans change. At some point in the future, you may find yourself in front of a lender again looking for a new loan, perhaps to refinance your loan at a better interest rate. Chances are, this will happen before your perfect debt elimination plan is fully realized. Prepare for this possibility by paying off high-risk debts first to reduce your overall cumulative risk so that lenders are more likely to approve you for that future loan.

Lenders first categorize debt as “secured” and “unsecured.” Secured debt is backed by assets that the lender can seize or foreclose if you stop living up to your end of the bargain. This can be complicated, as lenders further categorize secured debt based on the value of the collateral, how the collateral typically increases/decreases, and the ability to resell it. Therefore, a well-maintained building is better insurance than undeveloped land, and both are better than a vehicle, which is better than a boat. The better the collateral, the lower the risk associated with the debt. As you might suspect, unsecured debt is unsecured. It has nothing to back it up except your word that you will pay off the debt. Unsecured debt is therefore the riskiest debt.

Following the example above, using a risk reduction approach, pay off the credit card first, then the car loan, and then the mortgage.

The best approach for you:

As you can see, each approach can lead to a different answer as to which debt to reduce first. Unfortunately, just like there is no magic wand, there is no best approach. All four approaches are very useful and can provide the “right answer”. In the end, you are the one who has to decide on a prudent financial management solution to achieve your goals. Review the analysis using each tool. Submit results for your specific situation. Balance what you find out with your personal strengths and weaknesses as you weigh possible future scenarios. Then decide! No decision you make to reduce debt will be wrong, it will just reduce your total interest payments, reduce the number of debts, add more flexibility to your finances or prepare you to find a new loan. Whatever the decision, make it today.

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