What Does it Mean to be Debt Free?

I had a great conversation last week with a client.  We’ll call her “Jill”.  Jill was in her early 50’s and had just gotten divorced from her husband of 20+ years.  She had gotten about $400,000 in the divorce and kept her retirement account (another ~$250,000).  I knew her financial counselor and he had already advised me that her return on the retirement account that he had managed for her over the past 20 years had been 7.2% during that time period.  She had a great job and shared with me that she intended to work for at least 10-15 more years.  She was buying a house for $400,000 and asked for my advice on what made the most sense from a financing perspective.  Her main goal was to be debt free, so she had planned on paying cash for the house.  I told her that I loved the idea of being debt free, so I asked her what that meant to her.  As expected, she told me that to be debt free, “I don’t owe anyone any money.”  While I didn’t disagree with her, I asked her another question.  I asked her “If you have the ability to pay off any debt you may have, but choose to have debt anyway, are you any less debt free?”

She was well versed financially and I could see the wheels spinning in her mind – I could tell that she had never really thought about it from that perspective.  I showed her that she could put $80,000 down on the house (20% to avoid MI) and get a 15 year loan at 3% with a $2,209 monthly payment.  Even though she didn’t really want a mortgage payment, this payment fit well within her budget.  If she paid the loan for the full 15 years, her total payments would be $398,000 (so she paid back the principal + $78,000 in interest).  I showed her that she could invest the other $320,000 at 3.5% (which was less than half of what her average return had been – I wanted to be ultra conservative), and that investment would grow to over $536,000 by the end of 15 years.  At 7%, it would be $883,000.  And even at 2%, it would be over $430,000 (so the additional $110,000 is still way more than the interest paid over that time).

I also showed her that it is more than just the return.  If she paid cash, she would have liquidated pretty much all of her liquid savings.  Sure, she would have no mortgage.  But she would still have taxes, insurance and all of her other bills as well – with no solid safety net.  What happens if she lost her job or had a medical set back – or really any emergency that required immediate cash?  I asked her “which is the better place to be in – no debt and no money, or debt but plenty of cash to live on if things go bad?”  She was already convinced, just from the investment opportunity, that getting a mortgage was the more financially astute thing to do.  But when I reminded her of the importance of being liquid, it was an easy decision.  And the reality is that she will still have the ability to pay the loan off any time she wants to if her monthly budget changes and she no longer wants to make a mortgage payment.

When I hear people talk about the great feeling they will have when they go to bed knowing their mortgage is paid off, I understand and empathize with that feeling.  But in my opinion, it is much better to go to sleep knowing that there is money invested safely, earning a return, and ready/able to pay the mortgage off whenever I choose.