Addressing a Dave Ramsey Fan’s Comment

My old Dave Ramsey posts regarding comparisons between the 15-year and 30-year mortgage still receive comments from time to time. This afternoon I noticed the following comment (on this post) that I want to address:

In the comparison above the amount in savings is only listed for the 30 year mortgage. Where does this number come from? Multiplying $458 times 180 (months) come to $82440. Nonetheless, one really important peice is missing. If I am in the 15 year category, and I just paid off my last payment of $1696. How’s about I save $1696/mo for 15 years and then let’s compare savings accounts. At the end of 15 years of saving $1696 (as I paid off my mortgge after 15 years), my savings account reads a sweet $305,280. Did I miss something?

His comment refers to this graphic:

Mortgage Comparison Snapshot

Let’s look at this reader’s questions, one at a time:

In the comparison above the amount in savings is only listed for the 30 year mortgage. Where does this number come from? Multiplying $458 times 180 (months) come to $82440.

The savings is the difference in payment amounts between the 30-year and 15-year mortgages. I went on the assumption that the person could afford either mortgage and that the payment difference would be saved and invested.

Simply multiplying $458 by 180 ignores the potential investment growth. In the example, I used an 8% growth rate. Granted that rate has turned out to be high given the bad markets we have had recently. But the 8% number is well within reach over the long-term.

The reader then goes on to say…

Nonetheless, one really important peice is missing. If I am in the 15 year category, and I just paid off my last payment of $1696. How’s about I save $1696/mo for 15 years and then let’s compare savings accounts. At the end of 15 years of saving $1696 (as I paid off my mortgge after 15 years), my savings account reads a sweet $305,280. Did I miss something?

Yes, he missed something. If you look at the graphic, you’ll see that I do in fact assume that after the 15-year mortgage is paid off the payment ($1,696) is invested at an 8% rate of return for the next 15 years. That’s why the savings account balance at the end of 30 years is $587.009 rather than the $305,280 that the commenter mentions ($1,696 x 180 months).

Anyway, I won’t go into all the details of that post. You can read it here along with all the very thoughtful comments that followed.

20 thoughts on “Addressing a Dave Ramsey Fan’s Comment”

  1. The question is whether the 8% return is realistic (assuming all numbers are after tax)?

    Another way of looking at it is to ask what rate of after tax return to I need to get to beat the after tax cost of the interest payments on the mortgage?

  2. #1) The assumed growth rate doesn’t matter (as long as it is positive), for the 30-year mortgage guy to come out ahead — as the table is laid out currently.

    That math, as JLP showed, is correct. The only issue I have, is not accounting for all the other things that affect the outcome: risk of layoff, divorce, death of spouse, etc.

    The odds of something financially bad happening in a 30-year time frame is higher than for a shorter-term mortgage. Suppose a layoff happens between the 15 and 30th years — you might have to dump stock (at a low point) to continue making payments.

    Basically, there is a risk in carrying debt — the 30-year is “riskier” than a 15-year mortgage (once the 15-year mortgage is paid off).

    If the 30-year was such a sure thing, then why not opt for a 40-year mortgage, or just an interest-only loan…

  3. I would be reluctant to assume that the “savings” of $458/month realized by the 30 year mortgage would be invested.

    It seems more likely that the 15-year mortgage payment would be met with greater discipline than the $458 savings.

    On the other hand, the same is true for the 15-year mortgage holder saving $1,696/mo after the mortgage is paid.

  4. I guess we could all guesstimate what would provide the better outcome just by looking at the rates you used. 8% inv return is larger than 3% home appreciation, so if savings are started earlier, of course the 30-year scenario will most likely be the winner. However, if inflation were to go wild and investment returns increased (i.e. cd rates rivaling those from the 70s) one would have to assess if the house’s value would increase at that same rate or something different and proceed accordingly. The debt isn’t moving so you could pay it off “easier” presuming wages were increasing, too.

    I’m a big believer in the shortest mortgage you can handle. Like our famous friend in NY who never posts anymore…”hard debt and soft assets.” Paying down debt is a sure-fire return on your money, esp if you’re not itemizing your deductions. But don’t do it at the expense of an adequate emergency fund (Like a year’s worth!)

    Of course there’s nothing wrong w/going w/the longer term and making extra prin pmts when you are able or saving it as the above table suggests. It’s the ultimate in financial flexibility, but you most likely will have a higher int rate. On a large mortgage balance, that interest spread could really hurt.

  5. Maybe I am missing something but I noticed that with the 30 yr note you are paying 140k more to be up 94k in 30 yrs. that is kinda counter-productive if you ask me.

  6. #6) The goal with the 30-year plan is to capture the extra 1.7% return (take out a loan at 6.3% and invest it at 8%).

    But, the is a little extra push you get with the 30-year mortgage, and that is the mortgage-interest tax deduction (if you qualify, and meet the standard deduction limits). Deducting the interest on your taxes, lowers the loan percentage somewhat (front-side of the loan), so the spread is larger, which should garner a little extra gain than just the 1.7%.

    As the commenter in #1 was saying, as long as your realized return on your investments (after taxes, etc) is higher than the interest on the loan, you make money. But, IMHO, it’s a lot of risk for a little gain — to each his own.

  7. JAG,

    Yes, you are missing something…

    The $94,000 is ABOVE what you would have had you gone witht he 15-year mortgage in this example.

    Of course, the scenario has to play out as illustrated. The results could be better or could be worse than the illustration.

  8. BG&JC – risk is actually goes both ways. Yes, the odds of something happening over 30 years period is higher. But the probability is also high that 1) during the first 15 years one’s income will go up sufficiently that mortgage will represent a significantly smaller percentage of one’s income and may even be affordable on one salary 2) assuming one saves the difference in premiums, after 15 years one will have a fair amount in savings/investments to survive the emergency 3) during first 15 years one would accumulate sufficient equity that it’ll be possible to downsize and walk away with money. Even now, most people who bought their properties 15 years ago and who haven’t used it as a piggy bank have large amount of equity.

    First 15 years is actually the riskiest time. This is the time when the fluctuations of real estate market really affect the equity and when one doesn’t earn enough. If the buyers are relatively young, this is also the time when the kids are still living with them, so the expenses are higher. And if your emergency happens during first 15 years, you are much better off if your payments are low and you have more money in liquid savings or investments that can be sold than if you have all your money locked in the house.

    In terms of return, a lot depends on inflation. In a deflationary environment, it’s better to repay the loan as soon as possible. If we hit high inflation – like in the 80s – anybody with low fixed interest loans and cash/investments will do much better than those with money locked in a home. This is of course impossible to predict, but given current interest rates, printed money, and government debt, the probability of a period of inflation within next 30 years is pretty high. This may not happen. But with 30 years interest mortgage, one at least has the flexibility of making extra payments when it makes sense financially and putting money in savings or investments when it doesn’t.

    This is really an investment decision, and as any investment decision it has risks and benefits. So ultimately, it is personal decision with no real right and wrong except for in hindsight.

  9. #9) Are you really saying it is less risky to have debt? I guess in your mind, having a 5-year mortgage is even more risky, and no mortgage at all is “dancing with the devil”.

    “…This is really an investment decision…”

    I’d never treat my house as an investment. You can lose 50% of your stock investments, but you can’t lose 50% of your house — you lose all of it.

    For the people in CA and other states that were extracting home equity to invest in the market: they took that risk upon themselves, and deserve no bailouts.

    As for me, my house is my home, and I plan on having it paid off in 4 more years (9 years, start-to-finish) by the time I’m 37. I guess I’m just a risk-taker.

  10. @BG Who loses all of their home’s value, short of it sliding down a CA hillside? Up to 50% maybe in this market, but not 100%. Even the copper wiring has some value…

    Stocks can be more risky than a home–just look at the darkest days of GM’s swandive, etc.

    Kitty’s point is a good one…either financing path you choose, the 1st 15 year’s risk level affects either term (whether 15- or 30-yr) and certainly has more impact in the earlier years when your earning power is less and you have fewer resources.

    We’re the perfect example: 15 years ago my husband was 31 and we were just about to have our first child. Salary was way less than half of what it is now and we had no significant E-fund (early years of our mortgage.)Fast forward 15 years later: Now we could get thru a year if God forbid, something catastrophic happened that he couldn’t provide (and in the event of disability, we’d have his disability income.)

    So yes, there is less risk in the latter years of a loan for most people as they should have some resources at their disposal.

    And yes, Kitty did not mispeak when stating it was an investing decision. You either invest the money and go long-term on the loan or you choose another path for the funds (pay down debt, further your education, etc.) Whether you’re paying rent or a mortgage, the use of the discretionary funds is indeed an investing decision.

    Finally, if inflation gets to 5%+ percent and one’s mortgage is fixed at 4.75%, then it was less risky to maintain some level of debt b/c you can be earning a better return on your funds than your mortgage rate. You may not sleep better, but the spread is there. Arbitrage.

  11. #11 Stacey) I meant: losing the house in a foreclosure (you can’t just lose 50% your house in a foreclosure, you lose 100% of it). There are plenty of foreclosures going on right now.

    If you and kitty both think that the earlier years of owning a home are the riskiest time-periods, then shouldn’t you be more conservative with excess cash instead of putting it into a non-guaranteed & risky stock investment?

    If we want to approach the subject specifically from an “investment” POV:

    We are comparing two investments:

    1) risk-free (and tax-free) return of 6.3%, for mortgage prepayment

    2) non-guaranteed, hence risky, and taxable (unless in a Roth) return of 8.0% for stock investing

    In my mind, the 1.7% return you are trying to capture with the 30-year scenario just simply is not enough for the risk you are taking (my opinion). If the spread were 5%, then you’d get my attention…

    But it is all about the risk. My mortgage is at 5%, and if CDs were yielding 5.5%, then I’d buy them instead of prepaying the mortgage — but in this case, both investments would be “risk-free” and the yields are comparable, though I’d need to do the math for the tax consequences on the CDs.

  12. I hear you about the foreclosure situation, but that isn’t my reality, so it wasn’t forefront in my mind. Also, for a while I was earning more than my extremely low debt rates…thus the debt! Tho it wasn’t by choice it was b/c we couldn’t sell the dang house! See more detail below:

    The answer to your investing point is this: my husband and I do a combo re: investing. For the past 18 months we have consciously chosen to have a lot in laddered cds (rates had been around 3-4%, now rolled over into 1.9- 2%), our ING savings acct, some EE and I savings bonds, cash value of our NWM life insurance, our retirement 401ks and IRAs, some P&G stock, and a mutual fund. Since we’ve been working 20+ years and my husband has had nice e’er matches, of course the majority of our investments would be in stocks, but I’d say 70% stocks vs 30% cash/CDs/US bonds.

    We’ve been carrying 3 mortgages for the last 2 years: 1st mortg and equity line (used as downpmt on our current house and for its renovations) on our 1st house and our 1st mortgage on our “dream” house. Yup, we thought we’d be able to sell our house right away…23 months later it finally happened this week. If it weren’t for my 2.75% equity rate and 3% ING ARM on the 1st home it could have been much worse carrying the debt load. Looking back, if I hadn’t been so intent on paying off the 1st home’s mortgage w/extra prin pmts and had instead saved more, we might not have had to take the equity line. So…it all depends on what you think is coming down the road. I never thought we’d move from our 1st house so I pursued the paydown w/vigor. And that was ok as we did save a lot on interest in the early years when it was 6%+. Did I beat the market while I had such low debt rates in the last couple years? Well my cds were at a higher rate than my 1st home’s debt rates, but that was just dumb luck. I got the debt at the right time and I got the cds at the right time. Meanwhile the stocks took a beating but have, of course, come back. But the time value is lost…

    Now I’m a little wiser and will still pay a little extra on our 4.75% mortgage, but I like the cash cushion, being able to save for college (yes, all equities) and continue fully funding hubby’s 401k. And I’m starting to sleep better…

  13. #10 – BG: “are you saying it is less risky to have debt”

    No, what I am saying is that it is less risky to have smaller payments and more money in the bank than larger payments and less or no money in the bank. You are not debt-free for the first 15 years with either mortgage, but with one you have higher premiums, hence more risk. This is also the time when you are more vulnerable – you are still young, didn’t have much time to save money and are earning less.

    The remaining 15 years are riskier with 30 year mortgage, but my point was that if you have saved money during the first 15 years and if you got a normal growth of income; you have enough of a cushion to survive an emergency. I.e. the extra risk with 15 year mortgage in the first 15 years is higher than the extra risk in the second 15 years. Why is it so difficult to understand? Do you get raises every year (or every other year)? Are you hoping for the promotions? Do you really think you’ll have less money and less income 15 years from now?

    ‘“…This is really an investment decision…”

    I’d never treat my house as an investment. You can lose 50% of your stock investments, but you can’t lose 50% of your house — you lose all of it.’

    You misunderstood. I don’t consider my home as an investment either. But I am not saying buying or not buying a home is an investment decision, I am talking about taking a loan or not taking a loan or talking a shorter term loan or longer term loan. Saying that choosing the type of mortgage is an investment decision has nothing to do with whether or not your home is an investment. It is an investment decision because you are choosing of what to do with the money to get higher return: invest more of your money into your house by paying it off quicker or invest less money into your house and put the rest elsewhere.

    In terms of taking money from the house and investing it in the market. It is an investment decision even if a stupid one. Any investment decision can be good or bad, less risky or more risky. Buying stocks on margin is also an investment decision though for most people it is likely to be a stupid one. Now, what is stupid or “risk that paid off” is often better visible in hindsight, but it is certainly an extremely risky decision. Putting all of your money into GM bonds would’ve been an extremely stupid decision, but it is still an investment decision. But taking a 30-year vs 15-year mortgage and putting money in, for example, AAA municipal bonds may not be a bad decision. Or buying a rental. Taking a 30-year fixed in, for example, 1970 and just keeping money in a bank waiting for higher interest rates turned out to be a better investment decision that taking a 15-year fixed. In 1980, those who took 15-year mortgages in 1970 still had higher payments and less cash whereas those who took 30-year mortgages and saved extra money in CDs, could simply take the money they saved and buy 13% CDs while paying 9% to the bank (I didn’t check the exact interest rates, so my exact years may be a bit off). If you are taking a 15 year fixed right now and we end up getting 80-style inflation 5 years from now and double digit interest rates on CDs, would you rather have cash or all your money in a house equity?

    Now, if your mortgage is at 5% and CDs are at 2%, it makes sense to prepay. But if in a few years the interest rates change, you can put money in a CD instead. This is what you get with 30-year mortgage: more flexibility. You can pay extra while you have money and interest rates are low – all the way keeping a nice cash cushion to cover payments if something happens. Then if you have some family emergency, at least you have lower payments. But if interest rates change, you have flexibility of putting extra money into a CD instead. Or municipal bonds. BTW – just a few months ago I bought AA and AAA individual munis with yield-to-maturity of 5.5% (tax-free rate of 5% and 5.25% on two different issues; 5.5 YTM is because I bought at a discount).

  14. This is a very interesting comparison, which I did not catch the first time around.

    My short observation would be that with an 8% difference in net worth at the end of 30 years, with assumed 8% investment growth, it’s pretty much a wash.

    My second observation would be that it depends very much what real-world buyers would be doing outside of the play model (6% mortgage and 8% investment income). The lower payments with the 30 year mortgage give greater opportunity to invest … wisely or badly. Of course, Mr 15 Years might have priced his housing to still allow parallel investment … wisely or badly.

    I overpaid my adjustable rate 30 yr loan, essentially making it into a 15. In retrospect I could have kept it at a 30 year pace and bought SP500 starting in the mid-eighties. I’d be ahead no doubt, but of course I didn’t know then what I know now.

  15. Yep it is about risk, and one of the biggest factors to that risk is age. I am over 40, so taking on a 30 year loan and leaving the money in the stock market while I am in my 70s may be too much of a risk, so going with a 15 year would make more sense.

    However, with a 30 year loan, you can choose to pay it off in 15 years and pay the higher payment, but have the lower payment to come back to if there is a sudden loss in income. This isn’t possible with the 15 year loan, where you are locked into the rate.

    So if I was 25 and had a home, I would get the 30 year and invest the rest of the money, as my timeline would be longer and I would not have so much at risk in the market when I am close to retirement.

    Finally, you can lose 100% of your house. If you have a disaster that isn’t covered by your insurance, then you lose everything on your paid-for house. Even if you are insured, there is still the need to rent and cover deductables until your new house is built, which is much easier to do when you have the extra cash you have been putting away. In other words, the safest place to be would not necessarily having the house paid, but having enough liquid assets (cash, stocks, bonds) to cover the rest of the cost of the house.

  16. #15 kitty):

    “Now, if your mortgage is at 5% and CDs are at 2%, it makes sense to prepay. But if in a few years the interest rates change, you can put money in a CD instead. This is what you get with 30-year mortgage: more flexibility.”

    Actually I am prepaying quite a bit on my mortgage — almost double payments a month, since CD yields are nowhere near my mortgage interest. I have a fairly large cash reserve as well, which I recommend everyone to have before any investing or prepaying. My specific goal is to have the house paid off before my first child enters college — and that is driving my decisions at this point. The equity I’m building in my house is never lost, since I can always take out a no-cost HELOC if I needed the money again. Some would argue that you should “invest” for kids college, but instead, I’m freeing up future cashflow to pay for college on the spot… It’s a conservative / low-risk move on my part.

    FYI, I do invest 6% into a matching Roth-401k for retirement.

    If CD’s yields rise above my mortgage interest rate, then instead of prepaying, I’ll buy the CDs instead (that’s a no-brainer) — but not until that happens. I doubt CD rates will go above my mortgage rate in the next 4 years anyhow.

    Once my house if paid off, I’m going to get quite aggressive in my investing, since I still will have a 25-year time horizon until retirement. I feel that I can get aggressive at this time because I’ll have $0 debt. Plus having no debt will give me the _freedom_ to pursue other lines of work (ie; start a business), as an alternate investment than just the stock market.

    That’s my plan anyhow…

  17. One final thing that no one else is bringing up. A standard mortgage is fully amortized. This means that all the interest is pre-calculated and built into the payment. This is different than a simple interest loan (such as an equity loan) where the interest is paid up front. Therefore, the amount of a payment that goes towards interest on a fully amortized loan doesn’t change when you pay extra. Essentially you are paying the back end of the loan off.

    The reason I bring this up is that people have this idea that if they have a 6% mortgage (fully amortized), that they are saving 6% by paying it off early. But you are not. You are saving more like 3-4%, as you are essentially applying the extra money to the final payments.

    Keep this in mind when doing calculations for paying the loan off early and how much interest is really being saved percentage wise.

  18. #19 Steve) Do you have any citations to back that up? I’ve never heard of such a thing. All mortgages that I’ve seen calculate the interest monthly, based on the outstanding principal at those points in time. Secondary mortgages (HELOCs) normally calculate the interest daily.

    Prepaying a mortgage is prepaying the principal, which immediately lowers the interest portion of future payments (and giving you an immediate 6% return for the rest of the life of the loan).

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