Before Caesar became the emperor of Rome, he waged a long campaign in the north, conquering many territories for the glory of Rome. He was becoming more and more powerful, and knew that he could take over Rome with the army he commanded. But did he dare overthrow the power of the senate and install himself as emperor? Weighing his options, he stood before the Rubicon river, and thought deeply for a long time. At length, he chose power and everlasting glory, much to his fame—and infamy.
Like would-be financial caesars, those seeking financial independence must face an early choice: invest excess money or pay off debt aggressively? Which choice will yield the best fate? I read an article recently about the calculus for determining how to make that choice. The article concludes by suggesting that any time your interest rate on debt is lower than 7%, you should pay only the minimum and invest the rest because you’ll get a higher expected return on your money in the market.*
So, over a long enough span of time, you will do better financially because you are putting your dollars to the most efficient use. This makes sense from a purely mathematical perspective. And it will certainly please your lenders by giving them 100% of the potential return on their money. But I emphatically disagree with this advice because it does not discount the expected market return based on the increased risk of having debt. And from a financial freedom perspective, it creates a situation in which the required cash flow is much higher than otherwise would be needed. Let’s run through a few examples.
The Risk Calculus Behind Investing or Paying Off Debt
Lenders are very careful about who they lend to, and for larger loans want to see that your debt does not exceed a certain threshold. They set these thresholds because your risk of default increases dramatically when you exceed them. For conventional mortgages, those limits are 28% of income for housing and 36% of income for all other debts (including housing). So, for someone making $100,000 a year, $28,000/year could go toward a mortgage expense, and an additional $8,000/year could go toward other debts, for a total yearly debt payment of $36,000. Lenders consider this an acceptable level of risk. But it’s still risk. As of the end of 2015, the default rate on mortgages was 5.17%—and that’s for a loan that almost always gets paid first. At the peak of the financial crisis, the rate was more than double that at 11.26%.
Defaults happen for a reason. And it’s not the reason that people wake up one day and think, gee, I just won’t pay this loan anymore. It’s usually because they can’t afford to pay a particular debt at that time. They don’t have the cash flow to make it happen. And that’s why lenders cap the amount of debt they want to see in your projected cash flow, because when too much is going toward debt, that limits the borrower’s flexibility to deal with seen and unforeseen expenses and remain consistent on payments.
So, the article I read makes sense if you can count on your income remaining the same or increasing for the foreseeable future. There are very few jobs that qualify for this level of security (tenured professor, senator, federal judge, perhaps). For basically everybody else, we have no idea what the future holds for our jobs. Sure, we’d all like to think we’re not going to get laid off or fired (we’re all above average in the Lake Wobegon of our minds), but the tough reality is that when the economy tanks most people don’t know and shouldn’t pretend like they know what’s going to happen.
And that means planning for the potential that income decreases unexpectedly in the future. This is why I am now treating my personal finances like a business. The goal is to reduce liabilities (e.g., mandatory payments of all types) and increase assets. Liabilities are a bottleneck on your cash flow. Remove them and become a financial ninja.
With lots of cash flow to place where you like, not where you must, you have extreme flexibility depending on the situation. But if you’re locked in to high student loan payments, credit card payments, car payments, or mortgage payments (or all of the above), with very little left over, you are going to have some very serious and devastating decisions to make if the shit hits the fan. Decisions like, if I sell my car now, can I meet the mortgage payment for a couple months? Or, how much do I have to borrow against my 401(k) while I look for a new job? Or, how do I explain to my kid that they can’t take dance class anymore because times are that tough—and also, we’re selling the house?
I don’t ever want to have to have those conversations or make those decisions. So I am working to free up as much cash flow as possible, which means eliminating all my debt. With no debt—not even a mortgage—the vast majority of my income becomes flexible cash flow.
The Freedom Calculus Behind Investing or Paying Off Debt
In addition to dramatically increasing the likelihood of extremely negative consequences, maintaining high levels of debt because you might be able to get more money overall by investing in the market means that it costs you more to become financially independent.
Consider Johnny Borrower, who is socking away $25,000 a year into his 401(k) and HSA accounts. But he also has a 30-year mortgage at $1200/month and student loans which he expects to pay off over the next 20 years, with monthly payments of $800/month. He also finances a new car every five years, which costs him $400/month. He makes $100,000/year, so he is well under the thresholds discussed above in terms of his debt level. But he effectively needs cash flow of at least $2400/month just to service his debts. His other living expenses add another $1000 a month, bringing him up to $3400/month, or $40,800 per year. Not a crazy number. But let’s look at what that does to his financial independence plans. Even at his healthy 25% savings rate, he needs $1,020,000 in savings before he is financially independent, which will take about 24.2 years according to this nifty mustachian calculator.
But consider this: by eliminating the student loan debt, car loans, and mortgage, he now needs only $12,000/year to be financially independent, or about $300,000 in savings. (If you don’t think that’s possible for a single person, go check out Mr. Money Mustache who retired in his 30’s and lives on $24,000/year with a family of 3.) Even if Johnny Borrower continues to only put $25,000 away per year, he will be financially independent in just 9.8 years after paying off the debt. But if he puts the difference between what he was paying in debt into his investments (an extra $2400 per month!) he becomes financially independent in just five years. That my friends is why the debt freedom calculator is so powerful. And not only are those five years going to be quick and stress free because Johnny Borrower has virtually no liabilities, there is also very little risk of a catastrophic change in circumstances occurring as long as he keeps some type of job.
Over a long enough time horizon investing in the market instead of paying off debt may yield the greatest financial position in terms of dollars held. But if the goal is financial independence and not the maximum (and theoretical) possible amount of money after 30–40 years, in my view chucking debt and living the good life on an income stream that is enough sounds way better than servicing debt and biting my nails about whether I get to keep my job for that period of time. But that’s just me.
What would you choose? Let me know in the comments!