When people talk about their plans to achieve financial independence, eliminating debt is inevitably one of the items on their to-do list. It makes complete sense when you think about it. Being financially independent means that you can cover your expenses without having to rely on income from working. Annihilating your debt is one way to reduce your expenses and move closer to financial independence.
Dave Ramsey, a well-respected personal finance author, even provides several different approaches to paying down debt so you can choose the one that works best for you. In most cases, I absolutely agree that eliminating debt is great! However, with so much negativity surrounding the topic, it’s important to point out that debt can be a powerful tool.
Benefits of Debt
Too often, debt is viewed as poison in the world of personal finance. However, people seem to forget just how useful it can be when used responsibly. Think how difficult it would be to purchase a house if debt didn’t exist. If you think saving up a 20% down payment is a struggle, imagine trying to save enough cash to purchase a house outright! For many, that would be a nearly impossible task.
Without some form of auto financing, some of us might be stuck riding a bicycle to work every day. If student loans weren’t an option, many people wouldn’t have the opportunity to attend college, drastically reducing their earning potential and making employability more difficult.
How We Use Debt
Personally, I’m a big proponent of debt. When used appropriately, leverage can be a powerful tool. Debt has played a role in allowing Nicole (my wife) and me to afford our first investment property. It has provided flexibility to help me start my moving company. We even use debt in the form of margin in our investment account to leverage our existing capital and create opportunities for additional returns.
WARNING: Using margin increases the amount of risk you assume. DO NOT use margin if you do not fully understand all the risks.
Even though Nicole and I are striving for financial independence, becoming debt-free isn’t near the top of our to-do list. In many cases, we have decided to take on debt for investment/business opportunities. When doing so, our goal is to generate a return large enough to cover the interest payments and to provide additional income in the process.
For example, we recently completed a cash-out refinance on our investment property. We refinanced the property at a rate of 4.125%. As the name implies, the refinancing process provided us with some cash, which was determined by the equity that we had previously accumulated in the property. Since we feel confident that we can achieve an average annual investment return in excess of 4.125%, we don’t put any additional money toward the mortgage principal. Sure, if we did, it would guarantee that we would pay less in interest over the term of the mortgage. Instead, we believe we can use the money elsewhere to receive a greater return.
We practice the same technique with the mortgage on our primary residence. Since our private mortgage insurance (PMI) has been removed, we haven’t made any additional payments to reduce the principal amount of the loan. Again, we invest the money elsewhere with the intent of earning a return greater than our mortgage interest rate.
Avoid the Pitfalls
Let me be clear, there are certainly less than optimal and irresponsible uses of debt. Using a credit card to purchase a pair of expensive designer shoes you cannot easily pay off is most likely a poor judgement call. That balance will sit on your credit card statement and accumulate interest month after month. When accounting for interest, those soles will end up costing you a piece of your soul.
Additionally, it’s probably not ideal to take out a second mortgage on your home in order to afford an extravagant tropical vacation. Even though that poolside service might be luxurious, the debt that comes with the vacation will follow you long after your suntan has faded.
Don’t Be Afraid
The point I’m trying to get across here, is that you shouldn’t be afraid of debt. Most people aren’t born debt-laden. In many of the horror stories you’ll hear, poor judgement led to financial ruin, not the debt itself. Deciding whether to take on debt should be calculated. Ask yourself some of the following questions before taking out a loan. It could save you from making a commitment you’ll later regret.
Will the monthly payments that come with this debt impact my ability to reach the goals I have set? If yes, am I okay with that?
Can I realistically afford to make the monthly payments with my current income level? If not, seriously reconsider your decision.
Is this debt for investment/business purposes? If yes, will it ultimately improve my financial picture?
When our society paints debt in such a negative light, it can be hard to see the positives. If you have any questions or if you would like me to further explain my rationale, please leave a comment below or send me an email.
Your thoughts are worth more than a penny.