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It’s Called Long-Term For a Reason
By JLP | February 4, 2009
Now that the market is down, I have all sorts of people (mostly Dave Ramsey fans) coming over to AFM and trying to rub my nose in some of my posts about mortgages vs. investing. Take for instance, this comment that was left on this post this morning by someone named LOL (I’m pretty sure that’s a joke):
So it’s almost been two years since this blog entry was made. Ironically March 2007 was the peak for the national average house prices. Since then the average house price has lost 25% (*1) and the S&P 500 is down 40% (*2).
Looks like those loony “ramseyites” aren’t so bad at math after all
BTW, how is that massively arbitraged and up-side down mortgage working for ya?
(*1) census.gov $329,400 down to $246,900 (Dec 08)
(*2) NASDAQ:VFINX 129.62 down to 77.26
I’d be willing to bet that had things been the other way around, this LOL dude wouldn’t have posted this comment. Of course he wouldn’t.
Here’s the deal: TWO YEARS ISN’T LONG-TERM!
Also, let me point out that the house decreased in value by 25%…not exactly “safe.”
My whole point in those posts was that OVER THE LONG-TERM it made sense to take as long as you could to pay back a mortgage loan with a low interest rate and invest any extra money in the stock market, which has a long-term average rate of return of 10% (7% – 8% real return).
I’m still standing by those posts.
Topics: Housing Market, Investing | 18 Comments »
February 4th, 2009 at 2:10 pm
Ramseyites are bred to live day-by-day from their cash envelopes… it doesn’t surprise me that they would consider 2 years long-term.
Keep up the good work. I’m betting that most of your readers have a better view of the long-term.
February 4th, 2009 at 3:25 pm
Sorry, JLP, I didn’t mean to rub your nose in anything. No offense intended. Just a tweak in the comment section about a slight disagreement in our financial priorities.
February 4th, 2009 at 3:37 pm
Sam,
I wasn’t referring to you. I know you would never do such a thing!
I was referring to commenter, LOL.
February 4th, 2009 at 4:28 pm
Seriously? Obviously LOL is the kind of guy/girl that lives for the moment, because he seems to only be looking at the current snapshot. …Which says now is a good time to invest anyway!
February 4th, 2009 at 6:48 pm
Well from what I always learned from good ole dad…nobody has lost anything until they try to sell…so I consider everything null and void unless and until the individual try’s to sell, whether it’s their house or their stocks.
My house could go down to a $1 in value tomorrow and unless I try to sell it doesn’t matter to me. I didn’t really buy my house as an investment. I bought it so I could live in it. There really are a lot of idiots out there…
February 4th, 2009 at 9:07 pm
Yes, that’s the point. Everybody forgets the wisdom of investing at the darkest moment (at least I hope we’ve already reached the darkest moment).
Ramsey talks about how he made it big, lost it all, and made it big again (I admit that I haven’t listened to his show for a few years so maybe he’s quit telling those stories). The only way he ever did it was by taking risks and participating in the business world. Paying off your home and running from the stock market is the opposite of that.
Getting a reasonable mortgage and paying it off on schedule while investing in the stock markets is a nice happy medium I think – not the crazy speculating he used to do and not the stuff he advises now.
February 4th, 2009 at 9:43 pm
@ JLP – You shouldn’t count the fact that real estate fell 25% against the 15-year mortgage supporters. The decrease in the value of the house impacts both sides of your equation and shouldn’t be a factor.
To your larger point…
What you are really comparing in your analysis is the guaranteed return of paying off a mortgage early (6.08% in your earlier post) vs. the non-guaranteed return of the market over 30 years (8.00%). The $96,209 advantage of the 30-year fixed vs. 15-year fixed is purely based on a theoretical return on the investments that, in real life, may NOT come true because the market rate is not guaranteed — whereas the avoidance of interest expense can be known in advance. Of course the market rate may exceed the 8% too and your example would even be better. That’s the risk a person takes.
The whole debate is not about math or anything else — it’s about risk. The key is to understand that some people, based on the their risk tolerance and beliefs, may simply be more comfortable taking the guaranteed return of the 15-year option (paying less interest). To them, the $96,209 POTENTIAL gain from the market is just not worth the risk of hoping to earn that theoretical 8%. On the other hand, others like you or me are more comfortable assuming that risk. Neither position is “right” or “wrong.” That’s one of the goals of a sound financial strategy — to match an individual’s investments with his or her goals and risk tolerance. We’re all unique in that respect and so one answer does not necessarily fit everyone, no matter what the math says.
Keep up the good work!!!
February 4th, 2009 at 11:12 pm
As Steve pointed out, it is all about risk.
The home value falling does not really matter because for most people the value of the home is it’s ability to provide shelter, not return. Gotta live somewhere right?
Investments, however, are solely about return – both rate and principal.
So the true comparison is the guaranteed rate of return on a mortgage paid with after tax dollars vs the rate of return on non-guaranteed investments.
Typically, for most homeowners the tax deduction is muted due to annually increasing standard deduction limits contrasting with annually decreasing interest payments.
Meaning most people are better off taking the standard deduction vs. the mortgage interest deduction anyway. Additionally, as the mortgage is paid down the interest portion which is deductible declines, while the IRS standard deduction threshold increases.
SO…the “tax deductability” of the average homeowner’s interest payment is useless.
Ahhh…but it does take after tax dollars to pay the loan payment each month. So that 6% mortgage payment on average requires 7.5%-8% return on investment to equal out.
Wait….that 7.5%-8% investment will also be taxed at some point. Add another 1.5% to2% needed to compensate for the taxation upon withdrawal compared with the ZERO taxation on home appreciation coupled with the either $250K or 500K capital gains exclusion when selling your primary residence and you get…
Bad advice to arbitrate and invest.
Paying off your home loan typically provides a greater return for the average homeowner over the long term with less risk.
Paying off a risk free guaranteed 6% fixed home loan on average requires a comparable non risk free and non guaranteed 9-10% investment rate of return simply to equal, not better, but only equal it’s performance.
I don’t agree with the “rubbing” that is poor taste. But the end result is the same.
Most of the time,applying additional money toward one’s mortgage balance is a better choice than investing that additional money. Not always, but most of the time for most people.
February 5th, 2009 at 12:03 am
I just got a chuckle scrolling through this post and at one point looking over to see “People are Idiots and I can Prove it!”
Sometimes funny just finds you.
February 5th, 2009 at 1:16 am
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February 5th, 2009 at 9:03 am
I’ll admit to being a bit of a Ramseyite, in that I like his overall approach and his avoidance of debt (it sits well with me) but I certainly wouldn’t say it’s the only approach out there or even that, if you are willing to do the due diligence and study up the financials, that you would be better off one way or another. I will admit that, for myself, I did some math with stock shares I owned and potential future rates of investment vs. paying my mortgage, and I decided that I woukld be better off paying off the entire mortgage and having what used to be my house playment available to invest each month. So that’s what I did. Would it have made more sense to have invested while paying off the mortgage? Hard to say, but what I can say is that, right now, I’m invest three times the amount I used to, because I now roll my former house payment into my investment plan, and can do so very easily.
Not that that was just what felt right for me. I can appreciate the fact that not everyone will feel the same way or have the same game plan as me, and that’s cool. Personally, I feel better knowing that my house (which I do not treat as an asset, I treat it as necessary shelter) is paid for, and having no other debts, it makes investing for the long term a lot easier, because I really can goa long time without feeling a need for that money (and with a 25-30 year time horizon, I feel comfortable making those old house payments as “all in” twice-monthly investments into my investment vehicles of choice (which are low cost index funds).
February 5th, 2009 at 3:16 pm
Regarding Ramseyites: Wasn’t Ramsey suggesting to invest most of the money – with the exception of rather small, IMHO, emergency fund – in the index funds because the market’s average return is over 10%? Of course, not being good in math, he forgot that average return != compound annual return as well as that past performance is no guarantee of future result. How many times have we seen Ramseyites use their average (!) return numbers and then calculate how much your $X investment will be worse in 20 years counting this average return as if it were compound annual return? At any rate, if Ramseyites ask you how your upside down mortgage is working for you, you can ask them how their index funds are doing.
Regarding mortgage. As some posters already mentioned being upside down only matters if you want to sell or take an equity loan. Otherwise, being upside down doesn’t matter much like it doesn’t matter if you like your home and can afford the mortgage.
There are many reasons to pay off the mortgage early -I did – high interest, feeling secure, age (you don’t want mortgage in retirement), etc.
There are also reasons not to pay off mortgage early: planning to move within five years; wishing to keep more money in savings in case of emergency, possibly higher return on investments (after adjustment for taxes) now or in future. Regarding return on investments,Bob and MKL correctly brought up investment risk. However, nobody said that you have to invest in the market.
What everyone seems to disregard is the potential effect of future inflation and possibly future higher interest rates. A lot can happen in 30 years. For example:
-In early 1970s people were taking mortgages at 9%. In late 70s, they could get 18% on a CD; in 1983 I opened my very first 6-month CD for 13%. Also in late 70s one could get a 30 year old government bonds with the rate of 18%.
- In early 2000s, a friend of mine got a mortgage with the interest rate of 4.5%. Just over a year ago HSBC direct was paying 6% promotional rate. At the same time one could find CDs paying 5%.
- Right now the interest rate is low. I didn’t check but it is somewhere between 4 and 5% (tax deductible). Sure the bank savings interest is very low now, but I can get 5% tax free (simple interest – equivalent of interest only loan) on long term AA municipal bonds of my state. There is a degree of risk with municipal bonds but it’s very small with AA and AAA bonds.
Regardless, we don’t know where the interest rates will be within the next 30 years. At the moment deflation is the higher risk than inflation, but I doubt everyone here believes it’s going to last long. How many of you really believe we’ll not have inflation some time within next 30 years? If your interest rate is 7%, maybe it makes sense to refinance? If it is 4.5%, it depends if you believe in deflation or very very low inflation for the duration of your mortgage or if you believe in inflation. If it is the former – you want to pay it off as soon as possible; if it is the latter – you want to drag it.
Or you can play it as you see it: take 30 year fixed, make extra payments when the interest rates are low, and put money in a bank instead when the rates are higher.
There are reasonable arguments on both sides.
February 5th, 2009 at 6:36 pm
JLP: sorry for my little stab at your earlier article, it was a little crude. BTW, I didn’t just swoop in after the fact — I also posted in that thread back in September 2007 and wanted to revisit the subject.
Posts #7 and #8 both hit the nail on the head, you neglected to account for the risk. You should read a little about “Post-Modern Portfolio Theory” for a model that takes into account the down-side risk potentials. I’d be interested in see an article from you on the subject.
Kitty: being upside-down on a mortgage really limits your options; i.e. you can’t move, you can’t sell, etc. Especially if you are forced into the situation (layoff).
Who really cares about the long-term if you destroy your financial life in the short-term? Using the earlier articles numbers, the person with the 15-year note would be ahead of the 30-year guy by about $6,000 now. That’s a lot of money to be losing (in the short-term) for the ‘possibility’ to earn an extra couple hundred a month (long-term).
Back in 2007 I came to the conclusion (luckily) that it is really dumb for me to have a bunch of debt, and also investing in the stock market at the same time. I started DRs plan, and paid off $26k in debt in one year — and have vowed to never invest a single dollar when I have outstanding debt — except for my 15-year mortgage.
I will always keep my finances planned for my ‘worst-case’ scenario: a 40% yearly drop in stocks, and getting layed-off at the same time. If this happens today, worst case, I can liquidate everything, pay off the mortgage and still have a little extra left over.
BTW: I used to be a DR fan, but since he joined FOX, he’s a little to ‘political’ for me now.
February 5th, 2009 at 10:34 pm
@LOL:
“being upside-down on a mortgage really limits your options; i.e. you can’t move, you can’t sell, etc. Especially if you are forced into the situation (layoff).”
Yes, but a little more money in a bank – assuming you saved money you’d otherwise pay in extra payments – will help you to survive a few extra months without a job so maybe you wouldn’t need to move at all. At the same time, with a 15-year old mortgage you’d still have the same monthly payments when you lose a job, but the money are now invested in your home.
“Who really cares about the long-term if you destroy your financial life in the short-term? ”
This is a bit dramatic. We are talking about 15 vs 30 year fixed mortgages, not getting into consumer debt or investing all of your money in the stock market without leaving sufficient amount of money in cash/CDs. Having $6000 less in equity is hardly going to destroy your financial life short-term at least unless you spent all of your savings, gambled it all in the stock market or got into consumer debt. Nothing against the stock market, half of what I have is in stocks, but you shouldn’t invest in the stock market the money you may need if you get laid off (or any money you may need within the next 10 years). I am yet to see anybody who destroyed one’s financial life by simply taking 30 year mortgage vs 15 year mortgage.
I am not saying you shouldn’t repay your mortgage sooner. It would be hypocritical of me as I paid off my mortgage in full when I sold the unit I was renting out with a gain. I am simply saying – it depends. In some cases it makes sense and in some cases it doesn’t depending on your age, your personal preference, your financial situation and the economic conditions.
Looking at my situation as an example, yes, I repaid my mortgage when I sold the one bedroom condo I was renting out. But… When I lived in this condo myself I had a 30 year fixed. I could’ve made extra payments, but I saved the money instead because I felt I may need it. Because I had this money saved, I could afford to upgrade to a townhouse in late 90s without having to sell the condo at a loss. Few people know it, but the condo market was really depressed in the 90s; in some areas the prices dropped by over 50%. So instead of having the money locked up in this one bedroom in form of extra equity, I had it in cash and stocks – enough in cash for over 20% downpayment. As a result I had the flexibility of renting out instead of selling with a loss. Enough money to pay off the mortgage on my current place. If I had a 15-year old on a one bedroom, I mightn’t have had this opportunity.
“Using the earlier articles numbers, the person with the 15-year note would be ahead of the 30-year guy by about $6,000 now. That’s a lot of money to be losing (in the short-term) for the ‘possibility’ to earn an extra couple hundred a month (long-term).”
Again, you are losing it in form of equity in a home – only helpful if you sell. Unless you sell, this money don’t help you short term.
BTW – since I’ve always been smart enough not to get into consumer debt, I’ve never cared about Dave Ramsey. Mind you, I made my share of stupid choices – including not selling everything last year – but at least I avoided getting into debt.
February 6th, 2009 at 5:05 pm
Kitty:
You don’t get into consumer debt?
Don’t you use credit cards? I remember our debate a few weeks ago. Credit cards are consumer debt. Even at zero interest during the “grace period”, but it is still borrowing money and therefore still debt.
Just keeping your toes to the fire:)
February 8th, 2009 at 12:09 pm
Troy – I do use credit cards, and I pay them off at the end of the month. If you want to consider it “debt” fine, I can reword: “I’ve never carried a balance, and I’ve never paid a penny in interest on credit cards”. Satisfied?
Rewording further: I still have a near-seven-digit net worth having come to this country with exactly $127 and don’t need Dave Ramsey’s advice on how to manage my money. Now, if Dave Ramsey had adviced anybody last year to sell stocks as some of my friends did (and stupidly I didn’t listen to them) then I’d listen to his advice.
February 9th, 2009 at 9:38 am
Kitty: One of the biggest criticisms of DR is that he recommends people sell stocks (or stop contributing to 401k) if they are massively in debt — this flies in the face of normal “advice” from financial advisers to never stop buying stocks. So yes, he advises people to sell all the time (in certain cases).
Dave Ramsey’s general advice is that if you can’t get out of consumer debt within 18-24 months using the Debt-snowball or other methods, then you should sell stuff: stocks, cars, etc — whatever you have debt against, sell it to help pay off the debt — and also devise ways to increase your income (second job) so that you pay off your consumer debt in 12 months, up to 18-24 months maximum.
Here is an example (from 2006):
http://nashville.about.com/library/blank/davesays/bldavesays87b.htm
For the 15-year -vs- 30-year, he recommends the 15-year mortgage so people are not buying more house than they can afford. If you are taking on a 30-year mortgage because you can’t afford the payment on the 15-year note, then you should really be purchasing a lower-priced house — not going with the 30-year mortgage.
February 9th, 2009 at 7:32 pm
@LOL On your last point, the intent of the post (at least as I saw it) was not that the author took a 30 year because that was the only way he could afford a house, but because that gave him the lowest REQUIRED payment which frees up cash for other purposes like investing. If you compare a 30 and 15 year mortgage, they’ll end up costing you about the same if you compare the 15 to overpaying the 30 to equal out the payments. Here’s that analysis
The advantage of going the 30 route is that you have the flexibility to put that extra cash towards your mortgage when alternative investments look unattractive and plow as much as possible into them when they’re more favorable (like right now).