I rarely repost an entire blog entry from another site, but I am making an exception here.  Seth Godin is perhaps the most brilliant marketer in the world today and his blog is the most read blog on the Internet.

On May 5th, Seth posted the article below that hits home with my personal philosophy on debt.  In fact, in the article, Seth cites another article by Dave Ramsey, so how could it not line up with my philosophy?

Read the article for yourself and, when you are finished, go ahead and subscribe to Seth’s blog.  You will be glad you did!

Consumer debt is not your friend

Here’s a simple MBA lesson: borrow money to buy things that go up in value. Borrow money if it improves your productivity and makes you more money. Leverage multiplies the power of your business because with leverage, every dollar you make in profit is multiplied.

That’s very different from the consumer version of this lesson: borrow money to buy things that go down in value. This is wrongheaded, short-term and irrational.

A few decades ago, mass marketers had a problem: American consumers had bought all they could buy. It was hard to grow because dispensable income was spoken for. The only way to grow was to steal market share, and that’s difficult. Enter consumer debt.

Why fight for a bigger piece of pie when you can make the whole pie bigger, the marketers think. Charge it, they say. Put it on your card. Pay now, why not, it’s like it’s free, because you don’t have to repay it until later. Why buy a Honda for cash when you can buy a Lexus with credit?

One argument is income shifting: you’re going to make a lot of money later, so borrow now so you can have a nicer car, etc. Then, when money is worth less to you, you can pay it back. This idea is actually reasonably new—fifty years or so—and it’s not borne out by what actually happens. Debt creates stress, stress creates behaviors that don’t lead to happiness…

The other argument is that it’s been around so long, it’s like a trusted friend. Debt seems like fun for a long time, until it’s not. And everyone does it. We’ve been sold very hard on acquisition = happiness, and consumer debt is the engine that permits this. Until it doesn’t.

The thing is, debt has become a marketed product in and of itself. It’s not a free service or a convenience, it’s a massive industry. And that industry works with all the other players in the system to grow, because (at least for now) when they grow, other marketers benefit as well. As soon as you get into serious consumer debt, you work for them, not for you.

It’s simple: when the utility of what you want (however you measure it) is less than the cost of the debt, don’t buy it.

Go read Dave Ramsey’s post: The truth about debt.

Dave has spent his career teaching people a lesson that many marketers are afraid of: debt is expensive, it compounds, it punishes you. Stuff now is rarely better than stuff later, because stuff now costs you forever if you go into debt to purchase it. He’s persistent and persuasive.

It takes discipline to forego pleasure now to avoid a lifetime of pain and fees. Many people, especially when confronted with a blizzard of debt marketing, can’t resist.

Resist. Smart people work at keeping their monthly consumer debt burden to zero. Borrow only for things that go up in value. Easy to say, hard to do. Worth it.

When Dave Ramsey teaches about investing, he always bases his mutual fund returns on the average rate of return of the entire stock market since inception.  Over its entire history, the stock market as a whole has averaged an annual rate of return of around 11.9%.  Some years have done a lot better and others have done a lot worse, but on average the return has been 11.9%.  Dave rounds that to 12% for discussion purposes.

Many of Dave’s critics counter with the argument that you cannot get a 12% rate of return in mutual funds.  However, in my Roth IRA alone I have 4 mutual funds that have averaged over 12% since their inception.    If you visit Morningstar, you will see that there are plenty of mutual funds that have had a long-term rate of return greater than 12%. 

The key is to pick mutual funds that have a long-term track record.  The mutual fund should have been open for at least 10 years and averaged at least 12% over that time.  Also, as an investor, you must have a long-term mentality when investing in mutual funds.  If you cannot leave your money alone in the mutual fund for at least 5 years, then you should not invest.

Below are the four mutual funds in my Roth IRA that meet the criteria above.  They are all part of the American Funds family.  The Fund Lifetime Rates of Return are all as of March 31, 2010.

A disclaimer is in order here…  By no means am I advising you to invest in these funds.  If you are interested in them, then you should review their prospectus carefully and decide for yourself if they are right for you.  My point here is not to recommend a specific fund or fund family.  My point is to dispel the myth that a 12% rate of return is not possible, because that is simply not true.

Fundamental Investors (growth-and-income fund)
Class A shares
Fund Number       10
Ticker/Quotron Symbol     ANCFX
Newspaper Abbreviation     FdInvA
CUSIP Number     360802 10 2 
Fund Inception  August 1, 1978
Fund Lifetime Rate of Return:  12.52%

The Growth Fund of America® (growth fund)
Class A shares
Fund Number       05
Ticker/Quotron Symbol     AGTHX
Newspaper Abbreviation     GwthA
CUSIP Number     399874 10 6 
Fund Inception  December 1, 1973
Fund Lifetime Rate of Return:  13.79%

The Investment Company of America®  (growth-and-income fund)
Class A shares
Fund Number       04
Ticker/Quotron Symbol     AIVSX
Newspaper Abbreviation     ICAA
CUSIP Number     461308 10 8 
Fund Inception  January 1, 1934
Fund Lifetime Rate of Return:  12.18%

New Perspective Fund® (growth fund)
Class A shares
Fund Number       07
Ticker/Quotron Symbol     ANWPX
Newspaper Abbreviation     N PerA
CUSIP Number     648018 10 9 
Fund Inception  March 13, 1973
Fund Lifetime Rate of Return:  12.65%

Baby Step 6 of Dave Ramsey’s Plan is to pay off your home mortgage early and be completely DEBT FREE. 

Similar to Baby Step 2, where you pay off all of your debts except for your home, you should use focused intensity and throw a good portion of your discretionary income (above your 15% retirement contribution and kid’s college funds) toward extra principal payments on your mortgage and knock it out as quickly as possible.  The more intense you become and the more that you are willing to sacrifice, the faster you will pay off your home.  As Dave says, when you own your home free and clear, if you take off your shoes and walk through the back yard, the grass will feel different under your feet.

There are some so-called experts out there who will tell you that it is not wise to pay off your home early.  They usually use one of two arguments to back their false cliams:

Argument #1:  Because mortgage rates are at an all-time low right now (4-5%), they say that you should keep your mortgage and invest your discretionary income in things that could earn you a higher rate of return like mutual funds and stocks.

Rebuttal #1:  They may be correct in their assertion that your could earn a higher rate of return in mutual funds and stocks, but they forgot to factor two things into their equation:  Risk and Taxes.

Risk comes when you still have a mortgage and your company downsizes.  Think about it…  If your company lays you off tomorrow and you have a paid-for house and no payments of any kind in the world, your stress levels would be completely different from someone who would immediately be worried about losing the home where their family sleeps at night.

Also, you will owe capital gains taxes if you invest in mutual funds or stocks and make a profit.  Capital gains taxes are around 15% for most people.

After factoring risk and taxes into the equation, your rate of return on that investment will come closer to the 4-5% that you would earn by not having a mortgage. 

Finally, if you are still not convinced that paying off your mortgage is a good idea, then ask yourself this question:  If you had a completely paid-for home, would you borrow money against it to invest in a mutual fund or the stock market?  If the answer to this question is “No”, then you should pay off your mortgage as quickly as possible and never look back!

Argument #2:  It is not wise to pay off your mortgage early because you will lose the tax deduction.

Rebuttal #2:  I have written a complete article about this argument.  Basically, with a tax deduction, for every dollar that you pay in interest to the bank, you save 25 cents on your taxes (this may be higher or lower depending upon your tax bracket) in the form of a tax deduction.  Trading whole dollars for quarters is unwise.  If you really want a tax deduction, then give the amount that you would be paying in interest to your local church or qualifying charity and you will earn the exact same tax deduction without having to stay in debt to do so.

My wife and I are set to start Baby Step 6 this year.  We are very excited about owning our home free and clear.  We can’t wait to walk through the back yard and see how different the grass will feel under our feet when it belongs to us and not the bank!

Baby Step 5 of Dave Ramsey’s Plan is to set aside some money for your child’s college education.  After Baby Step 4 is underway (saving 15% for retirement), you should set aside some money to help send your child to college.

If you have 5 years or longer until your child will be starting college, then you should invest the money in a good mutual fund inside of an ESA (Educational Savings Account) or 529 plan.  This will be after-tax money that is invested, but much like a Roth IRA, the money will grow tax free if it is used for your child’s college education.

The #1 goal is to not take out a student loan in order to send your child to college! The last thing that your child needs is to graduate from college with $100,000 in student loan debt hanging over his or her head.  This means that the choice of college is very important.  Unless your child receives an academic or athletic scholarship, then a state college should be the destination of choice.  Private schools are too expensive and, except in rare circumstances, employers really are not interested in where your child went to college.  Employers are interested in whether or not your child learned something while they were in college.

As your child approaches college age, he or she can assist with paying for college in a number of ways:

One way is by working full-time during the summer and a few hours per week during the school year.  Many people worked while attending school and you are not a child abuser if you insist that your child be one of them.

Another way is by maintaining a high grade point average and doing well on standardized tests like the SAT and ACT.  Be sure that your child enrolls in prep courses for the standardized tests that he or she plans to take.  Often, a high score on the standardized tests will open the door to scholarships that otherwise would not have been available.

If your child is a junior or senior in high school, a fantastic part-time job is for them to go online and use some of the search engines or purchase one of the computer programs that are available for finding scholarships.  Then, have your child to apply for each and every scholarship that they find.  This will include things like writing essays or submitting art portfolios (depending upon the type of scholarship sought), so it will keep the child very busy.  Dave Ramsey often recounts the story of a listener who purchased one of the computer programs that help find scholarships.  This listener applied for 1,000 scholarships and was turned down for all but 30 of them.  Those 30 scholarships netted her $38,000.  That is not bad for a part-time job!

If you have tried the methods above and you still don’t have enough money to send your child to college, then your child can do what millions of college graduates did…  Your child can work his or her way through college.  It will not kill them!

The most important thing to remember about funding your child’s college education is that you may find yourself in a financial position where you are not able to help your child pay for college.  Either your child is too close to college age or you are in really bad financial shape and you will not have made it to Baby Step 5 in time to help.  If this is the case, you are not a child abuser, so do not feel guilty!  You have kept a roof over your child’s head, clothing on his or her body, and food on the table.  Helping pay for college is at the bottom of the list until you get your own finances in order.  That’s why it is the 5th Baby Step behind paying off all debt except the mortgage, saving a 3 to 6 months of expenses for an emergency fund, and investing 15% of your income into retirement savings.

If, like my wife and me, you do not currently have any children, then you should skip this Baby Step.  Do not set aside college savings for children that you plan to have in the future.

The ABC News program Nightline aired a segment on Dave Ramsey last night.  Be sure to check it out by clicking the video above.

Baby Step 4 of Dave Ramsey’s Plan is to invest 15% of your household income into Roth IRAs and pre-tax retirement plans.  At this point, because you have your Emergency Fund in place and are out of debt except for your home mortgage, you should easily be able to put away 15% for retirement.  Do not, however, put more than 15% into retirement at this Baby Step because there are still other Baby Steps to tackle first.

Dave recommends that you invest in 4 categories of mutual funds within your retirement plans:

Growth (Large Cap)
Growth and Income (Mid Cap)
Aggressive Growth (Small Cap)
International

Dave does not recommend that you ever invest in single stocks, bonds, commodities, CDs, or permanent life insurance, either inside of or outside of your retirement plans.

Because of different income levels or job benefits, not everyone has available all of the different types of retirement plans.  For example, if your income is too high, then you do not qualify to invest in a Roth IRA.  Likewise, your company may not offer a pre-tax retirement plan like a 401(k) or 403(b).  However, if you have both types of retirement plans available to you, then Dave recommends that you invest in them in this order:

Pre-Tax Retirement Plan With Company Match: If your company matches any portion of your savings into a pre-tax retirement plan, then you should invest enough to get all of the match that they offer.  Most companies match between 3-6% of employee contributions.

Roth IRA: Currently, the limits for Roth IRA contributions are $5,000 for an individual or $10,000 for a married couple who files a joint tax return.  Invest into your Roth until either you reach 15% of your income, or until you max it out, whichever comes first.

Pre-Tax Retirement Plan Without Company Match: If you have invested enough in your pre-tax retirement plan to get all of the match that your company offers and then you have maxed out your Roth IRA for the year and you still haven’t reached 15% of your household income, then you should go back and top off your retirement savings in your pre-tax retirement plan until you reach a total of 15% of your income.

As an example of how to determine the order of priority for your retirement investing, assume that your situation matches the profile below:

Household Income:  $100,000
Retirement Contribution for Baby Step 4:  $15,000 ($100,000 x 15%)
Company Offers Pre-Tax Retirement Plan with 3% Match
Married Filing Jointly

You should invest $3,000 ($100,000 x 3%) into the Pre-Tax Retirement Plan in order to take advantage of the company match.  That leaves $12,000 to be invested.

Next, open two Roth IRA accounts (one for each spouse) and max them out for the year by investing $5,000 in each one for a total of $10,000.  That leaves $2,000 to be invested.

Finally, return to your Pre-Tax Retirement Plan and invest the remaining $2,000.

When my wife and I arrived at Baby Step 4 in Spring 2009, we scheduled an appointment with one of Dave Ramsey’s ELP’s (Endorsed Local Providers) for Investing.  There was no charge to meet with them and there was no pressure to buy anything.  They explained all of our options with the heart of a teacher, and worked with us to select mutual funds with low expense ratios and long track records of great returns.  We opened our two Roth IRAs that day and have been very pleased with the results.

My company matches 6% of our 401(k) contributions, so we already had 6% going into that.  After maxing out the Roth IRAs, we added another 2% to my 401(k) to reach our 15% goal.

Investing for retirement can be a very complicated matter because of all of the choices out there.  Be sure to visit daveramsey.com for more information about Dave’s Investing Philosophy.

Some Financial Advisers recommend that their clients not pay off their mortgage early because the mortgage interest creates a tax deduction.  This is bad advice and the example below that Dave Ramsey uses illustrates why:

Let’s suppose that you have a $200,000 mortgage with a 5% interest rate.
This means that you would pay roughly $10,000 in interest this year ($200,000 x .05).

Now, lets suppose that your income is $50,000 per year and that put you in a 25% tax bracket. 

With the mortgage above, you would be able to take a tax deduction of $10,000, so instead of paying taxes on $50,000, you would pay taxes on $40,000. 

In a 25% tax bracket, taxes on $10,000 would be $2,500 ($10,000 x .25).  So, having a mortgage saved you $2,500 on taxes.  That’s good news, right?  Not really.  In order to save that $2,500 in taxes, you paid $10,000 in interest to the bank that holds your mortgage. 

You swapped $10,000 for $2,500.  That is a bad idea!

If you really want the $2,500 tax deduction, then give $10,000 to your church or a qualified charity.  The tax deduction is exactly the same as if you had a mortgage, but you did not have to stay in debt and risk your home in order to get it!

Personally, I would stay away from any Financial Adviser who recommends that I keep a mortgage for the tax deduction.

Baby Step 3(b) is an official part of Dave Ramsey’s Plan, but it is never included in Dave’s list of Baby Steps.  If you listen to the Dave Ramsey Show, people call in all the time who are working the plan and they ask questions like, “When is it OK to purchase another car?” or “Our washing machine is on it’s last legs, when can I purchase another one?” or “When can we take a vacation?”

Dave always says that these things are part of Baby Step 3(b).  Translated, this means that when you are debt free except for your home mortgage (Baby Step 2) and have 3-6 months of expenses set aside as a fully-funded Emergency Fund (Baby Step 3), you are then ready to replace those things that you have let slide during the first 3 Baby Steps.  This can also include a few small luxury items like a reasonable vacation or a new HDTV, but the items that you purchase in this step should mostly be necessities and the list should be small.

Be warned, however, that this can be a very dangerous Baby Step!  When you get here, it usually means that you have sacrificed for 2 or 3 years to get your finances in order.  Perhaps you are driving a beater car or haven’t been on a real vacation during that time.  It would be very easy to go on a spending spree with your newly freed-up income, but you really need to make some tough decisions about exactly what you need to do at this step and what can wait until other Baby Steps have been completed. 

The way to do this is to sit down with your spouce and write out a list of your Baby Step 3(b) goals that you both agree upon and, then, when those goals have been met, move on to Baby Step 4.

After our fully-funded Emergency Fund was in place in late 2008, my wife and I saved up and replaced both of our vehicles in early 2009.  She was driving a 2000 Nissan Frontier and needed a smaller, 4-wheel drive vehicle for her work.  I was driving a 1998 Pontiac Grand Prix with 240,000 miles on it.  We saved up and paid cash for new (to us) cars.  She got a 2002 Subaru Outback Legacy wagon and I got a 2008 Pontiac Grand Prix.  It was a lot of fun saving up and being able to write a check to purchase vehicles.  They really do drive a lot better when they aren’t towing around a payment book!

Baby Step 3 of Dave Ramsey’s Plan is to raise your Starter Emergency Fund until it contains 3-6 months of expenses.  Now that you are debt free except for your home mortgage (if you have one), take all of the payments that you were making toward credit cards, student loans, and car payments and throw it into your Emergency Fund until you get 3-6 months worth of expenses saved up.  According to Dave Ramsey, 3-6 months of expenses represent between $10,000 and $15,000 for most households. 

Unlike the $1,000 that you saved for Baby Step 1, you will not want to keep this in cash.  Instead, you should keep your Emergency Fund in something like a Money Market account that has check writing and/or check card privileges or a basic savings account.  The key is to have quick and easy access to the money with no penalties for withdrawal.  Therefore, you would not use a CD (Certificate of Deposit) for your Emergency Fund because there are penalties for early withdrawal.

Remember, also, that you should not be concerned with the interest rate of your Emergency Fund account.  The Emergency Fund is not an investment.  It is insurance against life’s unexpected events that could not be budgeted for in advance.

After you have completed your Emergency Fund, DO NOT TOUCH IT…  except if you have an unexpected event that leaves you with no other options.  A new HDTV IS NOT an emergency!  Neither are automobile repairs.  If you follow Dave’s budget forms, then you would realize that Auto Repairs is a standing category and you should save for them all along in a separate slush fund.

In our situation, my wife was comfortable with $10,000 in the Emergency Fund.  I wanted $20,000.  We compromised and settled on $15,000.  It is in a Money Market account with a large national bank and, currently, earns about 1.5% interest.  Again, interest rate does not matter here, but I wanted to let you know what to expect.

If you are a follower of Dave Ramsey’s plan and you have gotten through Baby Step 3, take a deep breath and pat yourself on the back.  You are debt free except for your mortgage and you have $10,000-$15,000 in the bank.  Life is pretty good on the planet when you first get yourself in this position.  Realize that you are now way ahead of most of your neighbors, friends, co-workers, and family members financially.  Congratulations!