Why being debt-free isn’t your best shot at financial freedom

Dave Ramsey has a well-known blueprint for financial success. He calls it “Baby Steps.”

It’s a seven-step program—by the end of which, you should have paid off all your debt, even your mortgage.

Granted, a debt-free life is quite a financial feat and part of many best-seller “playbooks.”

But while laudable, is it really the most lucrative move in the grand scheme of things? And does being out of debt really give you the best shot at financial freedom?

Recent data points to a rather different conclusion.

New money vs. old money

Do you need debt to get rich? Turns out that depends on when you were born.

A 2023 paper found that, on average, wealthy people employ very little debt relative to their net worth. They also found that the richest people typically start their lives well off. They termed this the Old Money group.

However, the authors discovered a clear distinction between the Old Money group and the New Money group (those that were independently wealthy).

The New Money group, it turns out, did indeed use leverage significantly early on.

In fact, during their early years, the New Money group, on average, possessed a debt-to-asset ratio of 1.6. That means they held $1.60 in debt for every dollar of assets they owned.

In other words, they were far from living a debt-free lifestyle.

Most financial gurus would be shocked by this number. For them, anything over 0.5 is alarming. But some of the wealthiest individuals maintained a ratio over three times as high.

When is debt good?

Justifying the use of debt falls into two main buckets:

When it makes financial sense: In many cases, people incur debt in pursuit of an investment.

Imagine you take out a $10,000 loan with a 3% interest rate. You do this because you’re confident you can earn 7% by investing the proceeds. If you’re right, the debt will help you earn a return on an investment you otherwise couldn’t make.

The great thing about this bucket—it’s all math. If you can earn more on the loaned cash than the interest you owe, it’s likely a wise financial decision.

Of course, nothing is guaranteed. In reality, no investment is a sure bet. It’s possible the investment tanks. In that case, you lose on the investment and still owe interest on the loan: a lose-lose situation.

When it unlocks value: Even when debt isn’t a great option (i.e., interest rates are relatively high), it may be the only option.

For example, most people could never afford a house without taking on debt (mortgage). Is it worth forgoing the dream of homeownership to avoid debt? That depends on what you value.

Most would have to save for decades to accumulate enough money to buy a house in cash. Not only that, it’s impossible to estimate how much the house will appreciate.

And that’s to say nothing of the fact that you’ll have to delay enjoying your own home for years. Debt-free living comes at a cost, just not always a monetary one.

Scenarios where debt can be useful

• Education: Debt can help you attain higher education. This education can lead to a better-paying job. But will the additional pay you earn from this degree outweigh the added cost of obtaining the student loan to pay for it?
• Improved credit: Taking out a loan and diligently paying it off can help you build a healthy credit history.
• Starting a business: Businesses often require substantial capital. Starting a restaurant, for example, would be impossible for most people without a loan.
• Buying a house: The average person will require a mortgage to purchase a house.
• Investing: Again, using leverage to invest can help improve your return. Of course, the opposite is also true.
• Emergencies: Sometimes, unexpected costs will require you to borrow money, like paying for an urgent, life-saving medical procedure.

The power of leverage

Do you ever wonder how some of the wealthiest people multiply small investments into massive returns? Often, it’s by using leverage.

But be warned, leverage is risky. It can magnify profits and losses.

The following example will break down how leverage can be used to earn a higher return. Some of the best traders on Wall Street employ it as part of their primary strategy. It allows for outsized bets relative to their invested capital.

Imagine you have $10,000 in cash to invest. You identify a promising stock that you expect will return 10% over the next 12 months.

Investing without leverage

If you invest your $10,000 for one year and your prediction pans out, you’ll generate a $1,000 return (10% of $10,000). At the end of the year, you’ll walk away with $11,000.

Investing with leverage

Now imagine the next year you decide to use leverage to boost your return. You take out a loan for $40,000 with a 5% interest rate.

After one year, you owe $2,000 in interest on the loan (5% of $40,000). At the same time, you earned $4,000 (10% of $40,000) on the amount you invested.

Remember, this is over and above the $1,000 you also earned the previous year on the initial amount you already had in cash. Therefore you returned $5,000 ($4,000 + $1,000) on the investment.

Accounting for the loan, your total net profit from the entire transaction is $3,000 ($5,000 investment return less $2,000 paid in interest).

Playing with fire

When the market’s rising and business is booming, leverage looks phenomenal. When your trades turn south or sales soften, however, a huge debt obligation can be devastating.

Whatever you do, proceed with caution and consult a financial advisor. Remember, leverage magnifies both wins and losses.