The case for household debt freedom

A couple times a week, I’ll get an email from a reader asking some variation on this question:

If I can refinance my house at 3.5% why would I ever want to pay it off early if I can earn 7% over the long term in the stock market? Debt freedom seems like a bad goal when credit is so cheap.

Even if credit is available at 0%, I argue that debt freedom is never a bad idea.

In order to explain that idea, let’s roll back the clock to 2005. In 2005, Sarah and I were swimming in consumer debt.

We had one car loan at 7% on which we had to pay $200 a month.
We had another car loan at 6% on which we had to pay $250 a month.
We had a credit card at 20% on which we had to pay $100 a month.
We had two other credit cards (around 20% each) on which we had to pay about $80 a month each.
We had two lines of consumer debt (around 20% each) on which we had to pay about $30 a month each. 

These payments added up to about $770 a month. Add on our rent of about $600 per month, our auto insurance, our commuting costs, our food, and our utilities, and our budget was on the verge of exploding.

The problem in this situation wasn’t the interest rates on those debts. The problem was the sheer amount of debt and our monthly commitment to repayment. Almost $800 per month went toward debt repayment.

If you add a house payment on top of that, it’s easy to see that amount getting into the thousands of dollars a month.

The thing is, even $1,000 a month in take-home pay has a drastic impact on one’s life situation. $1,000 in take-home pay adds up to $12,000 a year in take-home pay. Add federal income tax and state income tax on top of that and you’re easily looking at a salary impact of $20,000 a year.

A person making $40,000 a year with that debt load has the same lifestyle as someone making $20,000 a year that’s debt free.

A person that has the freedom to take a $20,000 a year job without financial suicide has a lot more peace of mind and personal security than a person who has to make $40,000 minimum to keep their head above water.

A person who can live on $20,000 a year can take enormous career risks. They can leap into a new career path without worry. They can shrug if they’re downsized and go apply for a job at Home Depot the next day.

A person who needs $40,000 to pay the bills can’t take such risks. They’re often locked into their job, and if they’re downsized, it’s a desperate situation.

Debt freedom isn’t just freedom from debt. It’s freedom from worry.

But what about the situation where you can take on debt at a low rate and invest it to theoretically earn a better rate, such as in the stock market example above?

First of all, there’s no investment that has a guaranteed return that beats the current interest rates on debt. In order to shoot for a better return, you have to take on some risk, particularly in the short term. If you buy stocks now, you could easily see a 20% loss over the next year, even if you would get that nice 7% annual return over a long period of time.

Let’s say you lose your job as a result of that downturn. Suddenly, you have debt around your neck and an investment that has purged money. That’s the risk you take if you decide to take on personal debt for investment purposes.

Second, even if you do invest that money, you’re still locking yourself into a monthly debt payment. You’re signing up to be tied even more tightly to your job than before and to having a narrower range of jobs and career paths you can take on while you hold that debt.

Debt freedom eliminates all of these concerns. It minimizes your monthly expenditures, giving you maximum freedom in your life. You can stick with the high-paying job and start investing a truckload (or enjoying some of the perks of a large gap between income and expenses), or you can take the lower-paying and lower-stress job for other life benefits.

Debt freedom gives you life freedom. It maximizes your personal gap between income and expenses, which goes a long way toward maximizing the variety of life choices and options available to you. That’s why I’m always in favor of freedom from debt.