Debt-free living is one of those topics that most people feel they have a handle on. Instinctively, we all know it’s better to be debt free than to carry a lot of debt. And yet, time and again we see reports that North Americans are taking on more and more debt. Could it be that there is a fundamental misunderstanding of the impact debt has on our personal finances? Are we underestimating the extent to which debt impairs our ability to realize our financial goals?
The Financial Benefit To Debt-Free Living May Be Larger Than You Think
One of the challenges to maintaining discipline when it comes to consumer debt, is that it can be hard to see the true financial impact that debt has on our long-term financial well-being. Most of us appreciate and understand how compound interest works when it comes to building wealth, but I think there is a real tendency to discount the impact when it comes to interest on our debts.
The impact that debt has on our ability to grow our net worth and reach financial independence is not only large, but is long-lasting, as well. As we’ll see in the illustration to follow, avoiding unnecessary debt is critical to successfully moving forward financially and not becoming bogged down along the way. Let’s look at how debt-free living has a mathematical impact on our ability to meet our financial goals.
Case Study: Growing Net Worth From Two Different Starting Points
Imagine a new investor named Jennifer, who has just landed her first serious job. She has identified that she now has $500 in free cash flow that she can direct to savings every month. Jennifer has decided that her immediate financial goal is to have $50,000 invested and no debt outstanding.
If we look at the chart below, we can see that Jennifer’s goal can be reasonably easy to meet. The first bar on the chart shows that by investing that $500 per month at 5%, in 84 months Jennifer will have met the goal of having $50,000 invested.
But what if Jennifer doesn’t start off on this savings program from a debt-free position? The second bar on the chart shows how much longer it would take to reach her goal if she starts out with $20,000 in credit card debt that she is paying 15% on. Note that instead of reaching her goal in 84 months, it now takes 140 months.
What is significant about this is that Jennifer had to save 40% more to reach her goal ($70,000 instead of just $50,000) but it took 67% more time to get there (140 months instead of 84)! And this is why consumer debt is such an important thing to avoid: it greatly lengthens the amount of time it takes to reach your goals. And it’s significantly more time than would be suggested by just looking at the amount borrowed.
Save First, Spend Later (Or Not At All)
But what if Jennifer really needed the things that the credit card was used to pay for? What would have been the preferable way to go about obtaining those things without impairing her ability to reach her goal?
The third bar on the chart shows what the situation would be if Jennifer first saved the money needed for spending, and then started to invest. Here, we see her goal is reached in just 122 months, 13% less time than is needed if those expenses go on a credit card first.
Think about this: by simply choosing to save first and spend later, Jennifer saved herself 18 full months of $500 payments!
The last bar on the chart shows what would have happened had Jennifer been able to avoid spending the $20,000 at all. In the 140 months it took to pay off $20,000 in credit card debt and accumulate $50,000 in investments, she could have instead directed all $500 per month to investments for the whole period, and would have seen her investment grow to $95,020. That’s a 90% increase in her end net worth over the period. All by simply avoiding excess spending and consumer debt.
Debt-Free Living Works
When thinking about this information, the important thing to keep in mind is that the larger the debts, the higher the interest rate on the debt, and the better the investment returns are, the more exaggerated the difference between the strategies becomes. But the core takeaway is that interest is a great thing when it’s working for you, but as great as that advantage is, it has at least as much negative impact when it’s working against you.
However, when it comes to consumer debt, there can be no doubt that the best way to plan your finances is with a “zero debt” philosophy. You will absolutely have an easier life if you do. It will be much easier to meet your financial goals, you will be better positioned to deal with emergencies, and you will have noticeably greater freedom and less financial stress.