Four Steps to Financial Freedom
Let’s talk about money and how it works…
Over the next few pages, you will be reading about a simple, yet powerful model that could change your financial future dramatically. We call it “The Four-Step Cash Flow Priority Model.” It was originally brought to our attention by Jim McQuaig from Nations Home Funding in Reston, Virginia. The goal of this model is two-fold:
- To educate you about money and how it works.
- To provide a road map from which to make an informed decision about your mortgage structure.
The model itself is a very conservative, common-sense approach to managing cash flow priorities. We believe that by taking time to agree on basic financial principles, we can better advise you on mortgage types and structures that at first may seem counterintuitive or even risky. We have the opportunity to show you that we care about you and your financial future, and that our focus isn’t solely on the transaction.
It’s important to add context to this discussion so that you have an idea of where we’re going. Remember, this is a process that most have never gone through. Most clients expect us to focus completely on the mortgage, along with all the “normal” topics of discussion such as rates, fees and programs.
As we’ve observed the mortgage industry over the years, it concerns us that most loan officers tend to be order takers. You call up a lender/loan officer and the first thing they typically do is ask you what you want. You of course ask for ‘the lowest rate’ because that’s the only value you think they can offer you. The loan officer proceeds to quote you a rate and maybe fax a good faith estimate. You could go through this process a few times with different lenders. In addition, you may become frustrated with them because they’ve done a pretty good job of confusing you with a bunch of numbers. So you decide to use one lender over another based on a set of criteria that has nothing to do with your long-term financial benefit. Most clients confirm a similar scenario.
We differ from that approach. We believe the mortgage you ultimately choose is a big decision. We believe you deserve more than just a couple of minutes on the phone and a sheet full of numbers you may not understand. That’s why we insist on making an appointment in our office. We want to give this decision the time and attention it deserves.
We have found that the best way to compare mortgages is to first talk about money in general and how it works. The mistake most people make when getting a loan is they tend to take a compartmentalized approach to analyzing the mortgage. They look at the mortgage by itself, independent of their overall financial picture. They tend to view the mortgage as a necessary evil, something to eliminate as soon as possible, instead of looking at it as a dynamic financial tool and using it as an integral part of their long-term financial plan.
We’ve developed a short Four-Step Cash Flow Priority Model that acts as a guide to help prioritize your monthly cash flow. Simply stated, “As dollar bills come into the household budget (paychecks), what is the most effective way to allocate those dollars in order of priority to create the greatest long-term financial benefit for you and your family?”
Step One: Cushion
Create a cash cushion. This means money on-hand and readily accessible for life’s little unbudgeted emergencies. We aren’t talking huge money here. For a family of four, earning $80,000 per year, $3,000 to $5,000 should cover it. If you are self-employed or on commissions the number should be higher to account for an irregular monthly income. The purpose is to allow you to handle emergencies with cash and not fall into the habit of always using credit for these unforeseen circumstances.
The biggest point we want to get across is that personal finance is often based on habits and not on numbers and rates. If a person has good financial habits and they consistently exercise those habits over a long period of time, things will most likely work out for them when it comes to finances. When you consider that approximately half of all marriages end in divorce, and most indicate money as a key factor in their divorce, we can easily see how this kind of advice can impact those we serve.
Step Two: Get Debt Free
The idea here is to eliminate all non-preferred debt. This would be all debt that isn’t a mortgage. For the couple who is buying their first home, and has significant debt relative to their income, this may be a long discussion. The end result will allow us to direct someone on a positive financial track that will pay them dividends for a lifetime.
We go over various ways to pay off your debts. We advise people using the “snowball technique” of debt reduction. A good resource to learn more about this is Financial Peace by Dave Ramsey. It’s good to be knowledgeable in areas like zero percent auto loans, auto leasing vs. buying, student loans, adverse credit issues, etc.
The top two reasons to eliminate these types of debts are to free up your monthly cash flow, and form the habit of saving money and earning interest instead of paying interest. The key to financial independence is for you to have control of where your money goes and then to conserve (save) and not consume that money.
Step Three: Liquidity
Many times we will write down “one year’s salary saved.” We’re talking big bucks here. This isn’t retirement savings, but true liquidity. This is money that you can access at ANY time, for two primary reasons: good and bad. An example of a “good” reason would be to take advantage of business or investment opportunities. Most of the time, when someone is presented with an opportunity, there’s an up-front capital/cash requirement. If you have the money, you at least have the option of taking advantage of the opportunity. An example of a “bad” reason would be a major interruption of income. This would include health issues, job layoffs or any economic factor that’s outside of your control. Currently, the number one cause of home foreclosure is disability.
If you had no debt outside of your home mortgage, and one year’s salary saved in a liquid, safe, diversified place, you would have gone a long way toward reducing or eliminating the financial stress in your life. You would also have choices that most will never have. You’ll be able to make decisions, both major and minor, without having finance as your number one consideration. Where could you work or live if money wasn’t a factor? What would you do with your time? How would your relationship with your spouse change?
Step Four: Pay Off Your House
Here’s where it really begins to get fun. Most people dream of some day having their home paid off. For many, this is a faraway dream and it seems that more and more people are starting to doubt if they’ll ever have a mortgage burning party. Most homeowners would define “having their home paid off” as not having a mortgage. That, of course, is one way to look at it – but wouldn’t it also be true that if they had a $400,000 mortgage and also had $400,000 readily available, they would, from a balance sheet perspective, have their home paid off?
This raises some very interesting questions and opens up some powerful opportunities for you. There are three areas we like to address in this step:
- Down payment
- Principal payments
- Home equity management
In looking at the Four-Step Cash Flow Priority Model, we said that our monthly cash flow should first go to developing a cushion, then to paying off all non-preferred debt, then to liquidity/savings, and finally to paying off the house.
If you haven’t completed steps one through three, does it make sense for you to make a big down payment when buying a home? Does it make sense for you to get a loan that requires principal payments? When refinancing, does it make sense for you to leave equity in the property if you have other debts or lack liquidity?
Paying off your home isn’t always the best option, and we’ll explain that in just a minute…
At this point, we remind our clients what will be the most important concept as we talk about more advanced equity management strategies: You must be committed to conserve and not consume your equity.
The effective management of home equity along with consistent long-term financial discipline can be the key to financial independence, but it can also spell disaster without a plan. The best tool we’ve found to ensure a positive outcome is to assemble a great team, including a mortgage consultant, realtor and financial planner who will assist you in developing, implementing and monitoring a plan.
We’ve now set the stage for an intelligent discussion of the mortgage options available. We’ve also established a very conservative financial model from which to evaluate these options.
Is It Good To Pay My Mortgage As Fast As Possible?
Sometimes, but not always. Let’s go back to where it all started and consider a few key points…
Most of us learned our lessons about money at the dinner table. There were no courses in school, and most of the people we know have learned the same way.
Traditionally, the goal has always been pay off your house. But consider every dollar that leaves your pocket every month.
Here’s some facts about your mortgage as an investment:
(1) You can make more than the minimum required contribution, but not less. If you attempt to pay less, the financial institution can keep all prior contributions and terminate the account.
(2) All dollars in the investment are not liquid. You could never access the money easily if you ever really needed it.
(3) Every contribution results in less safety of the investment, increased tax liability and no rate of return on the money invested.
Here’s a question to consider: How much has your mortgage given back to you? Last time we checked, the bank is investing your money and getting even richer from it. Remember that you earn zero interest on the money that you’ve already paid off.
(4) When all contributions are complete, there is no payoff to you.
Very interesting…
What did we just describe? Home equity in a nutshell.
Almost every financial advisor we’ve met will advise their clients to pay off their home as quickly as possible. But is that really the BEST option?
Try to think of it factually, not emotionally. When you pay down a mortgage, you can’t access your equity easily when you really need it, and your money isn’t multiplying over time. In fact, the bank uses your money to work for them.
A lot of people might argue that their home is going up in value, and they want to invest in their home. But think about this: whether you had 5% of your home paid off, or 50% paid off, would your home go up in value the same regardless? The answer is yes, absolutely. The value of your home goes up the same amount no matter how much equity you have in it. You can even buy a home with zero down, and enjoy all the same benefits.
Most times, having the ABILITY and LIQUIDITY to pay off your house at any time, if you’d like, is a much better option.
Believe it or not, there are some great ways to make money work for you, instead of you working for your money. And as always, knowledge is power.
Email us for a complete list of upcoming FREE seminars at freedom@hipcityspace.com.
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