The terms “debt-free” and “financial freedom” might seem synonymous at first. However, they have very different meanings in the financial world. In this article, we’ll discuss how the two terms are different, which might be better for you to focus on, and how to become debt-free.
Debt-free vs. financial freedom: how they’re different
Debt-free means that you don’t owe any money to a lender. You are the king of your destiny, beholden to no one. Financial freedom, on the other hand, refers to having passive income to cover your necessary living expenses. You don’t have to work a job you hate or think twice about affording an unexpected car repair. In other words, it’s having your loans paid vs. being financially set and in control of your money.
Which should I focus on?
Here are a few scenarios to help you decide whether being debt-free or having financial freedom is more important.
When it makes sense to pay off your debt
It probably makes sense to use your money to pay off debt instead of invest if your debt is high-interest, e.g. credit card debt. A 17% credit card interest rate will cost you more than you’d make back on an investment with a 5% return. It also makes sense to focus on your debt if you’re trying to boost your credit score. A credit utilization ratio is a comparison of the total amount of credit you have available to the amount that you’re using. Most lenders like to see this number below 30%. Paying off debt can lower your ratio and raise your credit score.
When it makes sense to invest
You may want to invest instead of paying off debt if you think you’ll be able to earn more on your investments than your debts are costing you in interest. For example, if your return on investment is 6% and the interest rate you’re paying on your debt is 4%, it likely makes more sense to invest your money.
Debt-free and financial freedom: the best of both worlds
It doesn’t have to be a one-or-the-other decision. You can do both. For example, you could put a portion of your income toward your debt, another portion into investing, and another portion into savings. That way, you’ll pay off your debt, investing to achieve financial freedom, and save for your future or emergencies all at once.
How to become debt-free
If you’ve decided that you’re going to put some or all of your extra cash toward becoming debt-free, here are 3 techniques that can help you kiss that debt goodbye:
1. Debt snowball method
The debt snowball method is when you continue paying the minimum amount on your loans but put more money toward the smallest balance. When that’s paid off, you’ll put extra cash toward the next smallest balance. The debt snowball method can be very encouraging as you’ll see your debts completely eliminated, one by one.
2. Debt avalanche method
The debt avalanche method also involves you paying the minimum amount on your loans but more money will instead go toward the debt with the highest interest rate. When that’s paid off, you’ll focus on the second-highest interest rate. The debt avalanche method is best for saving money overall.
3. Balance transfers
Balance transfers involve taking out a new credit card to pay off existing debt. Your new card will ideally have a better interest rate, which can save you money, in addition to simplifying your bill-paying each month. Balance transfer cards often come with introductory 0% APR periods. It’s best to pay your balance in full during this period to avoid accruing interest on your debt.
Being debt-free and having financial freedom are both important parts of being financially healthy. While your financial needs may dictate which one is more important to you right now, it doesn’t have to mean just selecting one or the other as your permanent financial goal. Who says you can’t have it all?