Don't take on debt and invest the difference

There are a few things Dave Ramsey recommends which don't always make sense on paper, but seem to work really well in real life.

Paying off low interest debt is one of them. In his baby steps, he recommends paying off all debt except for your house, before saving for retirement. Whether those are student loans at 5% or an older auto-loan at 3%, his motto is, "pay it off!"

In the traditional financial world, you'd figure that this is a bad decision. Why use funds to earn 3% on your debt when you could invest that money and get 10% in the stock market? But there are a few problems with this more "sophisticated" strategy. And having done it, I can speak from experience.

The first problem is cash flow. If you have a 3% auto loan, it doesn't sound like you'll be paying very much money each month. The way most people's brains work, they figure, well 3% on a $30,000 car is only, what like $900 a year? That's hardly anything. But you forgot about principal! Sure the interest is only $900 a year, but your payment will be $539 a month! That's $539 that you aren't saving or investing at all. Yeah the interest is only $75 a month, but you're still hemorrhaging money. It's very hard to build wealth with that kind of bleeding.

The underlying problem is that it makes it too easy to live beyond your means. It's easy to convince yourself that you'll get your savings and retirement back on track later. Maybe once you get through [whatever it is you're going through], but right now you need a car! The old one might break any day now. When you look at things in terms of payments, it doesn't seem like as big of a difference, and you're probably a little less likely to shop around or haggle or get rid of unneeded features. If you're paying cash, however, you're going to look at every $200 increment as a significant amount of money. That's smart.

With debt, it's easy to go from a $30,000 car to a $35,000 car because the difference between $539 a month and $628 a month isn't "that big of a deal." I'm not sure exactly why this is, but I see it happen all the time. I routinely see friends and acquaintances come back with a car that's $5000 over budget, on the basis that "it's only another $85 a month, and it's so much nicer, will last longer, is safer for later on when we might have kids...." These are all rationalizations. If you're in the wealth-building phase of your life, a car is not a good investment. Paying more for something "newer, that will last longer" is just not a good decision.

Finally, even if you do have the money to pay cash, but instead opt to invest that money while financing your purchase, you will likely have a hard time making truly long term investments with that money. It's a lot harder to make good decisions when you're close to the edge and risk being underwater on a depreciating asset. Rather than have the proper time horizon and patience with that money, you'll be more tempted by "quick returns" or "can't lose" investments. Thus, you'll be more likely to step foot into "get rich quick schemes," than into a quality investment. Even the best investments will fluctuate, and sometimes quite a bit. There just isn't any escaping this.

Very often when you read books written about great investors, you'll see stories that tested their patience, where they bought a stock at, say $20, thinking it was a good bargain at that price. Only to see the stock drop to $16, and eventually $8 before going back up again. If you've got cash that you can put to work, that could be a buying opportunity, but if you're already leveraged to the gills going into it, you're going to have a bad time. When you have cash, you get to take advantage of great bargains in the stock market. When you don't have cash, you create them for other people.

Let's review what it takes to build wealth. 1) You have to live below your means. 2) You have behave yourself when it comes to your investments. Having debt encourages exactly the opposite of those two golden behaviors.