Last time I introduced Velocity Banking and laid the groundwork. We discussed banks and banking, the good and the bad. Defined the differences between a “loan” and a “line of credit” and why the interest rate doesn’t always tell the whole story. We took a closer look at amortized interest (like your mortgage and car loan) and I showed you that many people get themselves into forty-year mortgages and don’t even realize it. Today I want to dig deeper into Velocity Banking and start to give you examples of how this strategy might work for you. We are going to start with something I’m guessing most of us are intimately familiar with, credit cards.
Velocity Banking – Credit Cards
Credit cards, most of us have them, most of us use them but they have a tendency to get a lot of people in to trouble. Does this make them bad? No, they are a tool and just like any tool, if they are used correctly they can make amazing things happen, used incorrectly and they can be incredibly damaging. Just like the chess example in the last blog, it’s all about knowing the rules and strategies that can make credit cards an incredibly powerful tool.
There is a seemingly endless amount of credit cards out there. So, how do you choose? Secured or unsecured, miles or cashback, plus there is a huge variance of interest rates and fees. I am not a credit card expert so I won’t even pretend to give you advice as to which card to choose. I will give you a bit of advice, be careful on sites like creditcard.com. They are a business and their goal is to make money, not necessarily look out for the people who visit their site. The order in which the credit card offers are displayed on their site is based on the how much money they make on the offer, not whether it is the best card for you. See my blog on credit management for more information on this topic. In the future I will bring an expert on the blog to make some suggestions, but for now let’s just talk about how to make any credit card a Financial Ninja tool that will turbo charge your quest to take control of your finances.
The Interest Rate
Credit card interest rates can look scary, and they are if you don’t know how they work. For my examples, I generally use a hypothetical card with an interest rate of 21%APR for my examples. Unfortunately, this tends to be an average interest rate for many people with which I work. If you’ve made some credit mistakes in the past, even minor ones, you may end up paying interest like this, or more, on your cards at least for now. The truth is, as far as Velocity Banking is concerned, the interest rate doesn’t matter that much. You’ll soon see why.
Let’s break down the interest rate and how it works. On most credit cards the interest rate is an “APR”, which means “annual percentage rate”, it is a simple interest rate calculated on your average daily balance. To calculate the interest you pay, the APR is divided by 360 (the banks use a 360-day year for some reason) and your principal is multiplied by that number each day. The credit card company then adds up all the interest for each day in a month and you are sent a bill every 30 days. This is an important concept to understand because it is where simple interest and amortized interest differ so dramatically. And it is why Velocity Banking is so powerful.
To make these calculations a little bit easier to manage I divide the APR by 12 (twelve months in a year), which gives me a monthly percentage rate. I multiply that monthly percentage rate by the average principal each month to figure out how much interest you will be paying. My version isn’t perfectly accurate but it gets the job done with much easier math and it is usually a conservative estimate meaning that in reality the outcome should be a little better. In my examples, I use an APR of 21%, which when divided by 12 equals 0.175 or 1.75%. For all the examples going forward I will be using 1.8% per month for my calculations (again being conservative), 1.8% interest per month sounds a lot less scary than 21% per years, doesn’t it?
The Smith Family
I want to introduce you to the Smith family, a fictitious family I will be using for all of the Velocity Banking examples to come. Mr. and Mrs. Smith are a pretty typical middle-class family. They bring home about $5000 a month in income after taxes, they have a $300,000 mortgage (6%, 30-year fixed), a couple cars, and a credit card with a $12,000 balance ($15,000 limit). They have expenses of about $1200 a month (utilities, eating out, etc.) and they are putting away about $800 per month split between their 401Ks and savings accounts. They are not hurting financially but they are not getting very far ahead either. What they do have is an open mind, they are ready to start learning, and are willing to put in the work to become Financial Ninjas!
The Smith’s operate financially just like the vast majority of middle-class Americans do, their income goes directly into their checking account every month (except their 401K contributions, they are with-held from their checks) and from the checking account they pay all their bills. If there is anything left over at the end of the month it gets moved to a savings account, we’ll call that their “rainy day fund”. Their mortgage (principal and interest) payment is $1800, their car payment is $600, and their expenses total about $1200 per month. They pay their minimum on their credit card every month, which with their $12,000 balance, comes out to be $600. Their 401K contributions and the money they put in savings on average comes out to be about $800. The Smith’s make it through the month financially but they have little to no cash flow, technically they are cash flow neutral. Most months $5000 comes in and $5000 goes out. This puts the Smiths one catastrophe away from financial ruin.
Cash Flow is King
When most people hear the words “cash flow” it generally makes them think of a business. Anyone who has spent any time in the business world or has ever taken a business class knows that cash flow is king. Cash flow is the lifeblood of a business, in most cases the “bottom line” is what many claim to be most important but its cash flow that keeps the business running day to day. The same can be said for your personal finances, I wish it was said more often. Statics have shown that most bankruptcies could have been avoided if the person or family had just $500 more in cash flow per month. If that doesn’t illustrate the importance of cash flow, I don’t know what does. Unfortunately, most people don’t give cash flow a second thought until it breaks down. Most people go to work, collect their check every two weeks, and settle in to a rhythm of spending money knowing that in two weeks there will be another direct deposit. I didn’t give cash flow much thought until I became self-employed, when you stop getting those consistent paychecks, cash flow becomes very important.
In our example, the Smiths are cash flow neutral, meaning they have just enough cash flow to cover the bills they have. If an emergency arises they could be in big trouble. An all too familiar situation in the US today, millions of people are one emergency away from their financial lives crumbing to the ground. This became painfully apparent during the great recession in 2008 and 2009, many people who thought they were in decent financial shape found themselves in a world of trouble. Velocity Banking can change this dynamic without requiring you to make any more money and without drastically changing your lifestyle. All it requires is a mindset shift and to call upon strategies that go against the status quo. That shouldn’t be difficult for a Financial Ninja.
The Mindset Shift
Humans generally don’t like to change, it can be scary. Most of us are creatures of habit to some extent. Creating new behaviors and habits can be difficult and often takes time. We humans are motivated by both pain and pleasure. For us to change a habit we usually need to be moving away from pain or towards pleasure, ironically, we will move away from pain much sooner than we will move towards pleasure. We are hardwired to stay with what works even if a better option exists, it is an evolutionary trait that I will dig deeper into in the coming months. So, making mindset shifts are not easy. Even if we logically understand that making a change is the best thing for us, it still can a very taxing process. Making the mindset shifts necessary to start using Velocity Banking is pretty minor in the grand scheme but can still be really hard for many people. I have some strategies to make the shift easier, I will explain these strategies in future blogs. For the Smiths, there isn’t a lot of pain for them to move away from, all their bills are paid and they are even putting a little money away. However, that one emergency could be just around the corner that could derail their whole lives, Velocity Banking can help them be prepared for just about anything that might come along.
So, What is The Shift?
Below is a picture that sums up the Smith’s current financial situation:
Their money goes into the checking account every month and then out from the checking account to pay all the bills. Anything left over is moved to the savings account. All of their bills are paid and as long as nothing goes wrong they continue to move at this rhythm. In the green box you can see the Smiths are cash flow neutral, $5000 in $5000 out. Pretty normal, right?
What if we made just a small change:
What if, instead of putting your paycheck in your checking account you made a payment of your full paycheck amount ($5000) to your credit card and then paid all of your monthly bills with the credit card? Sounds crazy, right? This accomplishes several interesting things. First, if you look closely at the two pictures you will notice several subtle differences. There is no longer a $600 credit card payment on the second picture. Why is that? Well, if you make a payment to the credit card of your entire paycheck you have satisfied your minimum payment as far as the credit card company is concerned. This instantly creates an extra $600 of positive cash flow in your life. That $600 can go towards paying down the principal balance on the credit card. Second, you’ll notice that the $800 savings is missing from the second picture. This is where I start to lose friends and make people nervous, what I’m going to suggest is pretty controversial. I’m suggesting putting savings on hold, at least temporally. Velocity Banking is a strategy to rapidly reduce or eliminate debt. The benefits of doing so can vastly out weight the benefits of putting your money in a savings account or a 401K, allow me to prove it.
To Save or Not to Save
This is a touchy subject and I get varied reactions every time I get to this point in the presentation. This is also a major place where the logic of the situation slams right into the mindset that we have all been brought up to believe. We have been taught that saving is good, “a penny saved is a penny earned”. I’m not here to dispute that point, I just want to point out that it isn’t as simple as you might think.
Have you looked at the rates banks are paying or savings accounts today? You are lucky to get .05% APR for a savings account, maybe a little higher at an online bank with no overhead. CDs are not any better, they may pay 1% but your money is tied up for twelve months or more. Today’s inflation rate is 3.2%, so you are actually losing money by storing your money in a savings account or CD. Your 401K isn’t much better. A good mutual fund might return 6% a year which sounds okay except you might not know the whole story. Tony Robbins wrote a book a few years ago called Money, Mastering the Game where he blew the lid off the mutual fund world. He found that even funds that are so called “low fee” can have 1.5% or more in hidden fees, add that to the 3.2% inflation rate and that 6% doesn’t looks so good anymore, does it?
Caveat: I believe that having an emergency fund is a very prudent idea, a few months (or more) of money in an accessible, liquid account somewhere just in case. Any savings beyond that could probably be used more effectively in another way. This is a very personal decision, one which varies a lot based on your level of risk tolerance. When comes to 401K or IRAs there is another variable to consider. If your employer matches your 401K contributions then you may want to keep making those contributions because that is essentially free money. You may not want to give that up. Although the benefits of Velocity Banking may even outweigh that free money. A pretty bold statement, I know!
Velocity Banking will allow you to pay off debts incredibly fast and it will dramatically improve your financial situation, that being said, it is not without its tradeoffs. To fully implement this strategy, you may need to make hard decisions about what your current priorities are, in our example the Smith’s priority is to reduce their debt as fast as possible. This means putting saving on hold for now, later I’ll prove why this is a wise decision. But for now, stick with me and I promise I’ll make it worth it.
Forcing Cash Flow into Your Life
By the Smiths putting their entire paycheck on their credit card and putting saving on hold for now they have forced $1400 of positive cash flow into their lives. They do this by making these relatively simple changes in how they manage their money. Those small changes will have profound effects on their finances in just a few short months. Below is a graph of how this change will affect their credit card balance:
You see two lines; the top line is showing what making $600 minimum payments would do to the credit card balance assuming they didn’t charge anything else during that time. The yellow line shows how Velocity Banking could affect the balance. The process is simple, every month $5000 is paid to the credit card and all the other expenses, $3600, are paid with the credit card. The difference between the $5000 paid in and the $3600 paid out is used to pay down the principal balance on the credit card. No other changes need to be made, the Smith’s lifestyle remains exactly the same. It is not necessary to make any extra money for this strategy to work. And if an emergency comes up, they use the credit card and the pay down process just takes a little longer. In seven months, the balance of the credit card is paid off, the Smiths could go back to their old way of doing things and start putting their money back into their checking account like they’ve always done. Or they can use this strategy to pay off their other bills like their cars or their mortgage, more on that later.
This is usually the point that someone says that they can’t pay their mortgage with their credit card. It is actually possible to pay your mortgage with your credit card, it does take a little bit of work but it is doable. Or you can put your paycheck into your checking account and pay your mortgage from there, then move the rest to your credit card and pay all your other bills. The affect will be the similar, it just may take a little longer.
As we move through the examples I get a lot of questions and some push back on certain things I’m going to suggest. Paying your mortgage with your credit card for example. I like to explain the Velocity Banking strategy using a credit card first because most everyone has one in their pocket and it is something for which they are familiar. The Velocity Banking strategy is more effective, and much less cumbersome, using a line of credit like a HELOC (home equity line of credit) or a PLOC (personal line of credit). However, for some, these tools are not an option when they are starting out. I will cover these tools and several others in future blogs, so stay tuned. Please, just hang with me and know that there are reasonable ways to accomplish all the things I’m going to suggest, including paying your mortgage with a credit card. Try not to get hung up on the minutia and try to focus more on the overall strategy, it just may change your life.
For those who are really good at math, you may have noticed that I have left off the interest that the credit card company will charge each month on the Velocity Banking line. I have done this to keep the numbers simple because I’m trying to make the strategy as simple as possible to understand. But it is a valid point, the Smiths will be charged 1.8% interest on their average balance each month. So, let’s take a look at what that might look like. Because the Smiths are putting their whole paycheck on the credit card the average daily balance is much lower than it would be if they were making minimum payments. In month one they started with a balance of $12,000 and ended with a balance of $10,600 so let’s say they were charged interest on the average of those numbers, $11,300. That means they would be charged approximately $203.40 for the month of January. In February, they would be charged interest on $9,900 which would be around $178.20. March’s interest would be $153, April’s would be $127.80, May’s would be $102.60. There would be no interest in June because June’s paycheck would bring the balance to zero and anything they charge would not accrue interest because of the grace period on anything you charge on a credit card. The total interest they would pay during the seven months it would take to pay off their balance would be $765, give or take a few dollars. By contrast, if they just made their minimum payments for those same seven months, and not charged anything else, they would have made $4200 in payments but only paid $2744 of the principal, $1456 would have gone to interest, almost twice as much interest as with Velocity Banking. They would also still have a balance of $9256 on the card. Imagine how much more money the Smiths could save if they had a card with a lower interest rate?
Do You See the Power Now?
Velocity Banking is an awesome tool. The Smith example gives you a glimpse of just how powerful it can be. From the Smith’s example, I’m sure you can see how Velocity Banking can improve your cash flow position. It allows you to use your credit cards to instantly create more leverage in your financial life. Using their entire paycheck to lower their credit card balance the Smith’s put their money to work 24/7 instead of just paying their credit card bill once a month, they forced the balance down all month which means they got charged significantly less in interest. If the Smith’s continued to make their minimum payments to their credit card, and didn’t charge anything else, it would have taken them 25 payments to pay off that $12,000 balance and they would have ended up paying $2899 in interest.
There is an added side effect to this strategy, your credit score will go through the roof. The credit card companies, like the bank, are in the business of making money, so if you are paying off your credit card you would think they will make less money, so how will that help your credit score? Remember the credit card companies make money not just on the interest you pay but every time that card is swiped, and you are going to be doing a lot of swiping. Plus, you are charging more than ever because everything is getting run through the card. As the strategies get more advanced you may be using that credit card even more. In addition, about 30% of your credit score is based on your “utilization”, anything over 30% utilization hurts your score. At the beginning of the example, the Smith’s had an 80% utilization rate. Once the card is paid off, even if they charge all their bills every month, the highest the utilization rate would go is about 25%. Velocity Banking will allow you to bring that utilization down very quickly.
Ready to Take It to the Next Level?
As you may have guessed, Velocity Banking is good for more than just credit cards. My next blog will show you how to use this same strategy to pay off your mortgage. The Smiths have a $300,000 mortgage at 6%, fixed for 30-years. I’m going to show you how they will pay that off in under 10-years and save several hundred, thousands of dollars in interest, because the Smiths are quickly becoming Financial Ninjas!