Aspiration, Strategy

The Difference Between Being Debt Free and Financially Free

By Matt Picheny

A lot of people either learn or assume that paying off all your debts is the same as financial freedom. But just because someone isn’t banging on your door and asking for money, that doesn’t mean you’ve made it. Maybe you’ve just made it through today but without a plan for income tomorrow. Being financially free means being set up for life, and that’s a completely different matter.

I always remind people that the aim should be to increase their assets and reduce their liabilities. This means having your money work for you, so you never need to trade your time for cash. And guess what: carrying some debt is a route to achieving that.

Assets And Liabilities

I cover both these important terms (and a lot more) in the Backstage Guide to Real Estate.

An asset is a thing of value. Think of it as ownership of something that makes you money. It’s an income generator, meaning that money flows in for you.

A liability is a thing you owe money for. Think of it as ownership of anything that costs you money. Instead of generating income, liabilities lead to money flowing away from you.

And here’s the key thing to remember: having debt for assets is good but using debt for liabilities is not.

Newsflash: Not All Debt Is Bad

There’s no doubt that debt is bad if you have no plan to pay it back or no intention to. That makes you either incompetent or unethical. And there are many forms of debt, such as credit cards and personal loans, that can leave you in financial ruin.

But there is such a thing as good debt. This allows you to increase your returns over time and can even be good for your credit rating, so long as you don’t overextend yourself.

Keeping your money in your hands as long as possible means you can use it to work for you, instead of letting someone else use it to work for them.

Yes, holding on to your money can mean you pay more over the entire term of a loan, such as a mortgage. But actually, so what?

The bottom line is that if your money earns you more than the extra you pay over the term of the loan, you end up financially better off. And besides, you still pay off your debts in the end. But the difference is more money in your pocket that can allow you to live a better life NOW.

Without this insight, your chances of living the life of your dreams – while you’re still young enough to enjoy it – may be limited.

I’m not encouraging anyone to be irresponsible with their money and take out loans they could never afford to pay back. I’m saying that the smart thing to do is to realize that debt in itself isn’t a bad thing. If you can manage it, you can use this to your advantage.

Starting The Mindset Shift

Many of us are taught that it’s not good to owe money to anyone.

You hear people say that they can’t sleep at night because they just have to pay back the money they owe someone.

This attitude extends to many people’s thinking about how money works in general. If owing money is seen as a bad, wrong, or even a shameful state to be in, it’s no surprise that many will want to avoid getting into this situation.

Shunning all debt can drastically impact your standard of living. You can never owe anyone anything, live within your means, and sleep sound at night. But without using good types of debt, like a mortgage, you’re going to be sleeping in a small bed, in a small house, in a small world. This is a harsh example but, honestly, this sort of thinking can really limit what you’re able to do with your life.

It’s natural to want to pay off debts, and you might even be tempted to pay them off quicker than the terms of any repayment agreement. But that’s usually not in your best interests.

What is in your interests is shifting the way you see debts and liabilities. They’re not bad. In fact, their opportunities for you to do smarter things with the money you have, things that generate more money for you now and in the future.

You could pay off the mortgage on your home and have no debt, yet still have to work a 9-to-5 job to pay for everything else in your life.

What if you had the freedom to live without working all day? What if you could live the life you want, without being constrained by money? This is what is meant by the term “Financial Freedom.” Would you mind carrying some good, responsible debt to achieve this?

As I wrote in Why You Should Not Pay Off Your Mortgage, “Mortgage debt can be your best friend.” You can read that article for a deeper discussion on good debt, bad debt, and mortgage strategy.

Positive Carry And Inflation

Getting your money to work smarter for you in the long term is summed up in the idea of “positive carry”.

Positive carry is when you make a profit by taking advantage of the difference between the cost of a loan and the return you could get by investing the money elsewhere. For example, if you pay 5% interest on a loan but you profit 8% on those same dollars being invested elsewhere, you have a positive carry of 3%.

Also, don’t forget inflation. As prices go up over time, a dollar will purchase less. So, borrowing money today and paying that same amount back later on, when the dollar’s value is less, can be a smart strategy.

Both of these factors have a greater effect the longer the term of your loan. So while you might think that, for example, a 15-year mortgage is better than a 30-year one because the absolute amount you have to pay back is less, the reality is that with positive carry and inflation, the longer mortgage can result in more money in your pocket.

Stretching Out Payments Example

Here’s an example that shows the power of not paying what you owe straight away and instead, stretching out your payments. You’re still paying back every cent of what’s due, but you make more money in the process.

For this exercise, we will assume the value of each property appreciates, or goes up in value, by 3% each year (which is lower than the 4% to 6% U.S. national average). Let’s say you have $200K to invest in real estate.

Scenario 1: You buy one, $200,000 property all-cash (no debt).

After five years, at 3% compounding interest, the value is now $231,855. Your profit is $31,855, which is a 16% return.

Scenario 2: You buy four, $200,000 properties with a 25% down payment ($50,000) on each property. You get a mortgage for the remaining costs of the properties, so it is still the same initial out-of-pocket investment ($200,000) as Scenario 1.

You have now purchased $800,000 of real estate but you owe the bank $600,000. After five years, at 3% compounding interest, the value is now $927,419. After you pay the bank back the $600,000 for the mortgage, you are left with $327,419.

Your profit is $127,419, which is a 64% return. This doesn’t include any positive cash flow from renting the properties or the amount of mortgage paid down over five years of monthly payments, so your actual profit would be even more.

Both Scenarios 1 and 2 involve putting the same money in, to begin with, but Scenario 2 earns you 4 times (over $90,000) more than Scenario 1.

On top of this, keep in mind that depreciation can work in your favor too. You get to use the full amount of depreciation when determining your taxes even if the majority of the money involved actually came from a bank loan.

Debt Free Is Not Financially Free

Simply being free from debt is not the same as financial freedom. Paying off all your debts sounds good but it’s not the path to true wealth. For most of my life, I thought it was. I thought that once I had my debts paid off, I would be set. But this just isn’t true, it’s a common misconception and something I’d like you to understand.

You can have responsible debt, and instead of paying it off, use that capital to invest in assets that generate passive income for you. Once you have enough income to cover your debt payments, plus the lifestyle you want, that is when you achieve true financial freedom. That is when you can set yourself up for the kind of life you want — and you can write your own story.


The information provided on this website is not advice and does not purport to be a substitute for professional adviceYou should seek out the services of professionals who are experts in the fields of investment, legal, and accounting concerning your specific situation. The author disclaims any responsibility or any liability, loss, or risk, personal or otherwise, which is incurred as a consequence, directly or indirectly, of the use and application of any contents of this website.