After three years, the Federal Reserve has finally begun hiking rates to help stem rising inflation. With the latest 7.9% inflation print, inflation is now at a 40-year high.

The Federal Reserve has telegraphed it will hike the Fed Funds rate 6-7 times over the next 12 months. Therefore, we could easily see 1% – 1.75% higher Fed Funds rates in the near future.

The Fed is behind the curve when it comes to hiking rates. And that’s understandable. The Fed would rather be a little too slow in hiking rates than a little too fast in order to help our economy survive a pandemic.

Put another way, which would you rather have, higher inflation and a stronger labor market, or lower inflation and a weaker labor market? The former is usually preferred. In an ideal world, the Fed would love to have 2%-2.5% inflation and 3.5% – 4% unemployment levels.

But the reality is, the upcoming Fed rate hikes will have a negligible impact on your finances, especially if you have been a regular Financial Samurai reader. Fed rate hikes won’t make borrowing costs that much greater. Therefore, for those of you who like to take out credit card debt, auto loans, student loans, and mortgage rates, I wouldn’t worry too much.

Let’s break down how Fed rate hikes will affect borrowing costs for each category.

Do you want to destroy debt quicker? You’re in luck because I have the best way to destroy debt quicker and boost your wealth faster.

If you haven’t noticed, we live in a consumerism society where we are bombarded by advertisements that compel us to spend on things we don’t need. Some things are definitely worth spending up on. But for everything else, save your money.

Like many people, I have debt. Although my debt is tied to property, which tends to appreciate over time, it’s still debt that I plan on getting rid of by 2027. I don’t have any revolving credit card debt because their interest rates are absurdly high.

Earlier this year, I got rid of $815,000 of debt by selling a rental house for roughly 30X annual gross rent. I don’t miss the rental income because I don’t miss the $3,400 monthly mortgage, the $23,000 in annual property tax, the $3,000 in annual maintenance, the $2,000 in annual insurance, and pain in the ass tenants.

Despite the large pay down, I still have about $1,000,000 in debt spread between my primary residence and my vacation rental in Lake Tahoe. Simple math states that if I can pay down $100,000 a year, I will be debt free in 10 years.

Here’s an easy strategy for how I plan to get there relatively painlessly that I recommend you follow as well.

The decision to pay down debt or invest is a personal one. It depends on a lot of factors such as risk tolerance, your number of income streams, liquidity needs, family expenses, job security, investing acumen, retirement age, inflation forecasts, and bullishness about your future in general.

I’ve had hundreds of people ask me whether to pay down debt or invest over the years. As a result, I came up with the Financial Samurai Debt And Investment Ratio, or FS DAIR for short back in 2014. Despite interest rates plunging since then, the FS DAIR framework still holds up strong.

The FS DAIR formula for deciding whether to pay down debt or invest is as follows:

Debt interest rate X 10 = percent of cash flow after living expenses allocated towards debt pay down

In other words, if you have a mortgage with an interest rate of 3%, utilize 30% of your monthly cash flow after living expenses each paycheck to pay down debt. Invest the remaining 70% of your cash flow based on your investment preferences.

If you concurrently pay down debt and invest, it’s very hard to lose in the long run. Ultimately, it’s best to be debt-free when you retiree or no longer have the desire to work.

As the CFO of our own finances, it’s up to us to figure out the most efficient use of capital. With FS DAIR, you will approach paying down debt or investing in a rational manner.  

The best way to measure your financial security is by calculating your debt-to-cash ratio. Having a lot of debt lowers your financial security. Whereas having a lot of cash increases your financial security.

The lower your debt-to-cash ratio, the strong your financial security and vice versa. Using debt to buy a house that is appreciating in value is great. But using debt to buy a house when it is depreciating could cause problems if you don’t have enough cash on hand.

Your Debt-To-Cash Ratio

One of the reasons why I want to rebuild my cash reserves back over $100,000 is because of financial risk. With two rental mortgages to pay and no steady job, having less than $100,000 feels irresponsible. Further, I’ve got two young kids to take care of.

Theoretically, I could lose all my tenants and therefore have to shoulder both mortgage payments on my own. In such a scenario, because of property taxes, an HOA fee, maintenance, and mortgage payments, $100,000 would be exhausted in 12 months.

Going off a gut feeling to determine how much cash to have is OK. But it would be nice to formalize a debt-to-cash ratio to see at what level debt is too much.

Because of excessive debt, way too many people got their heads blown off during the last financial crisis. 

Today, we once again see plenty of people borrowing from their home equity to buy things they don’t need. It’s so funny how quickly we forget about the risk of having too much debt!

Although the economy is recovering from the pandemic, reaching herd immunity is nowhere near certain.