Why Paying Off Debt Can Cost Your Financial Freedom
I want to start this by saying, I used to be a Dave Ramsey Endorsed Local Provider and Financial Peace University Coordinator. Why is this relevant? Because that system is what the majority of the people I grew up with follow for their finances. America focuses intently on paying off debt and becoming debt free. But I want to share with you why this mindset and financial behavior can actually be the thing that prevents you from becoming financially free.
I’m going to share a few real case studies of mine with you so that you can see why “debt free” isn’t an end goal and also to teach you how to properly pay off your debt.
#1: “Big Hat No Cash Flow”.
This particular client was meeting with me about 4 years ago. He had land, he had commercial real estate, and he had a few different properties in addition to his business. He was making about $2 million per year with the business, but he still had less than $250k in investments when I met him. At the time, I was still a Dave Ramsey ELP and so I was congratulating him and setting him up with those “12% growth stock mutual funds”. But still, he had less than $250k in investments and he had almost no cash flow from these assets he owned. The cash flow was so poor that he was actually considering selling them to just put the money in mutual funds. You may ask, what does poor cash flow have to do with paying off debt? Well, he used to have debt, but he paid it all off. He was so interested in being debt free that he overlooked that he could own $250k outright in investments OR he could leverage that $250k to own $1 million in investments, earn the same or better cash flow, and also get the benefits of debt paydown and interest write offs if he used it for real estate. But he was so against debt that it cost him this opportunity.
#2: House Poor.
I have had several clients who fall into the category. I recall a few of them who had paid off their house. Again, at the time, I was a Dave Ramsey guy so I wanted to do their “debt free scream” and make a big deal about it. But they were still stressed about money, still relatively paycheck to paycheck, and they had almost nothing in assets outside the house and no income from those assets. Later, I learned that after inflation, a residential home earns only a 0.10% annualized rate of return over the last 100 years. When these people factor in taxes, insurance, interest, PMI, maintenance, improvements, and the cost of their time maintaining the property they are actually losing money every single year. Why did they want to pay off the debt? Because they felt that paying a mortgage was losing money. So instead they paid off a $300,000 home and not only lost the interest deductions at the time, but also lost the opportunity for that $300k to earn them more than the measly 4% that they saved by paying off the house early.
#3 Baby Step 2 Circuit.
If you’re not familiar, Baby Step 2 is when people pay off all of their credit card debt, student loans, medical debt, car loans, and any other consumer debt. I did it. It felt good at the time because I could see my debts getting paid down. I encouraged hundreds of clients to do the same. Here is the issue: debt is a symptom of having no money. So when someone gets into debt it is because they aren’t earning enough income, otherwise they’d have money in savings to cover the expense or leftover cash flow to cover it. Because they don’t have either of those things, they must use debt. See, it is an income problem. So look what happens when someone who has an income problem pays off all their debt. They are debt free, with still no money in the bank and an incident comes up and they go back into debt. Why? Because they didn’t fix the real problem. I have seen several people succumb to this vicious cycle for YEARS. They still yearn for the day they will be debt free but when you talk to them they are always working on paying off their debt. People doing this don’t stand a chance at building wealth. They will be well into the 40’s and 50’s still struggling to pay off their debt with less than $50,000 saved and no real investments.
Personal rate of return.
When someone buys an asset, it is added to their balance sheet. If it provides an income, that income is added to their cash flow statement. If a person were to divide their annual passive income by the amount of assets they own, they would be able to calculate their personal rate of return. Let’s say they are earning $6,000 per year and have $100,000 in assets. $6k divided by $100k would be 6%, meaning that their personal rate of return is 6%. By not using debt, the personal rate of return will never be more than 6-8%. Why? Because there is no leverage. By using leverage, a 6% rate of return can become an easy 12% rate of return simply because there is more money produced on less assets. When investing in anything, you need to consider what it will do to your personal rate of return. Paying off consumer debt is an investment. You pay the debt off early and save the interest. That’s a rate of return just like an investment. It also frees up monthly income which could be looked at as a yield. The problem is that the investment of paying off your debt early has no reflection on your personal rate of return. It is a wasted effort in the wealth building arena.
How should you handle debt?
Pay the minimums and let the interest grow. Why? It’s deferred. Like your 401k, you don’t have access to the whole balance right now, with debt you don’t have to pay the whole balance right now. Pay as little as possible and save money. Use the savings to invest in your ability to increase income. When your income spikes up to a higher level, use that excess income to pay off your smallest debt. This will free up some cash flow. Save that cash flow. Invest it back into your ability to increase income. Get another spike in income and use that spike to pay off the next smallest debt to free up the cash flow. Repeat that cycle until you’re debt free.
A few tips:
NEVER pay off a vehicle early
NEVER pay off a home early
Paying off credit cards is like saving money in a sense. You can still use the full dollar amount you paid off in available lines of credit. My point? You don’t have to never use credit cards again. Once they’re paid off, just make sure you don’t charge more than you can pay off in a one month period.
In summary, I believe paying off debt is a main reason people never become wealthy. Interest doesn’t cost money. Debt doesn’t cost money. Credit cards don’t cost money. Not making money costs you money. If you would like to get on a plan to build wealth rather than be debt free, click here.
Own Your Potential,
Jerry Fetta
Grant Cardone Certified Coach
Jerry Fetta helps his clients build wealth so that they can eradicate poverty in their own lives and own their potential.
He believes scarcity and abundance cannot co-exist and that the way to end poverty is to help you build wealth.
You were not created to spend 40+ hours per week serving the 40-year-to-life sentence trading your precious time for money just to live in mediocrity.
However, the truth is that time and money must be exchanged. It just doesn’t need to be you making the exchange.
Jerry helps his clients create wealth that exchanges time and money on their behalf. The only way to do this is to make more money, keep it, and then multiply it.
He has helped clients double their income, save $100,000 tax-free, and secure 8-12% fixed annual returns on their assets.
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