THE BLOG
01/22/2015 10:54 am ET Updated Mar 24, 2015

Rocket Scientist Invents New Way to Pay Down Debt

There was a rocket scientist in the audience and he looked skeptical. His father was a client of mine who insisted I was teaching great things about manufacturing wealth, but he felt like his finances were already in order. Finally he agreed to hear me speak at our next event so he could decide for himself.

The result? Rocket scientist, Dale Clarke, came up to me after the event and said he was hooked. He spent the next year of his life rearranging his finances to live wealthier now and in the future.

And soon after, we were working together -- using his talent as a rocket scientist and my knowledge of finance -- to engineer a new way to pay down debt.

We concluded that paying down debt in the most efficient way possible means knowing which loan to pay off first, how fast to pay it off, and when to take a break from paying off loans.

The Number One Rule for Paying Down Debt

The number one rule is to focus on one loan at a time. So instead of paying more than the minimum payment to multiple loans, you only overpay to one loan at a time.

But which loan do you pay more to? The most common advice is to pay down the loan with the highest interest rate. But that completely ignores cash flow.

If you have student loan debt at 8 percent interest with a minimum payment of $50, and a car loan at 2.9 percent with a $400 payment, paying off the car loan and freeing up an extra $400 per month in cash flow will give you more immediate flexibility and opportunity in the future.

And then if you wanted, after you pay off the car, you could even start putting that $400 towards the student loan, which will speed up the time in which you pay it off and help you save on interest in the long run.

That's why we think the Cash Flow Index is the best way to choose which loan to pay off first.

The New Cash Flow Index

To get a Cash Flow Index for each of your loans, divide a loan balance by its minimum payment.

This gives you a number, and the lower the number, the faster I recommend paying off the loan to free up cash flow.

Any number that falls under 50 is in the danger zone and I recommend you pay it off as fast as you can.

A loan with a Cash Flow Index between 50 and 100 is in the caution zone. Here you may want to consider restructuring the loan for a longer term or a lower interest rate.

Finally, a Cash Flow Index greater than 100 is an efficient loan, and paying it off can be low on your priority list.

When to Temporarily Stop Paying Down Debt

One last thing on managing loan repayments: sometimes it is sensible to make just the minimum payment to all of your loans and delay paying any of them down.

We call it the 90-Day Debt Delay.

Why do this? Because just like sometimes it's a good idea to delay retirement contributions, sometimes it's a good idea to put your money to a more productive use than paying down a loan with a 3 to 13 percent interest rate.

For example, you may have a credit card with a 13% interest rate. But your business may also be returning 25 percent for every $1 you put into it.

Why pay down a 13 percent interest loan when it means missing out on earning 25 percent interest?

So understanding your loans and managing your payments for maximum productivity is another way to recover cash flow.

To recap how to pay down debt like a rocket scientist, use the Cash Flow Index to determine which debt to target first and the urgency with which you should pay it off. Then, consider delaying debt payments if there's an opportunity to earn a greater return elsewhere.

PHOTO GALLERY
States With Highest Average Student Debt - TICAS - Class Of 2012