Why Dave’s Mortgage Analysis is Flawed 

 

I love Dave Ramsey. When Dave’s organization asked me to be a reviewer of Dave’s new college program, I readily accepted. And, if you read my Now What Do I Do? post (April 6^th), you know how strongly I believe that our culture of reckless spending funded by irresponsible debt badly needs to be repaired. Living within our means is CRITICAL for personal, family, and national financial solvency (look at what has happened to Greece after years of government spending like drunken spring breakers – and this is the direction we have been heading recently) Few people carry this message as well as Dave Ramsey. This is why I signed on board with Dave as a reviewer and why I have my personal finance students watch his videos. So far, the feedback has been enormously positive.

 

HOWEVER, Dave’s assertion that accountants and financial advisors are missing something (actually Dave puts this much more harshly) is highly misleading and his analysis of mortgages is seriously flawed. This is puzzling because Dave does a tremendous job of demonstrating the opportunity cost of smoking, the opportunity cost of drinking that expensive latte from Starbucks every day, and the opportunity cost of Whole Life Insurance. He also does a great job of explaining the time value of money and compound interest. BUT HE IGNORES BOTH OPPORTUNITY COST AND THE TIME VALUE OF MONEY in his mortgage videos.

 

These are enormous errors in any financial analysis. We must always consider the most valuable alternative in any decision making process and no student should ever leave a finance class without understanding that cash flows need to be in the same time period in order to add and subtract them. Taking all these things into consideration, it would be easy to determine that it is Dave who can't add, but that wouldn't be any more accurate than Dave's denigration of CPAs and financial advisors. I can only conclude that Dave just doesn’t want to complicate things (he is trying to be a good dad). While his intentions may be honorable, the fact is that he just isn't telling you the whole story. What he is keeping from you is the concept of financial leverage. Certainly, financial leverage can be risky even in the hands of the most sophisticated investors, but with so many financial professionals (including Warren Buffett who is one of the richest men in the world) advocating 30-year mortgages (as well as the professional journals, see excerpts from these journals in my April 30^th post: Why Putting Everything in Your Mortgage is Risky), I want you to understand why this is the case.   

 

Here are the numbers Dave uses in his videos:

• Mortgage: $225,000 at 6% 

• Monthly Payment for 15-Year Mortgage is $1,898.68. Multiply by 180 months for a total of 341,762.02 

• Monthly Payment for 30-Year Mortgage is $1,348.99. Multiply by 360 months for a total of 485,635.93 

The difference between the 30 and 15 year mortgages is 485,635.93 – 341,762.02 = 143,873.91. This is how much a 15-year mortgage will save you according to Dave Ramsey.

 

There are two problems here: 1) these cash flows take place over time and therefore do not have the same value. This means that we cannot simply multiply the amount of the payments by the number of payments as Dave did above (remember, money has a time value, a dollar today is worth more than a dollar tomorrow because we can invest the dollar today and have more than a dollar tomorrow), and 2) we must consider the alternative use of the difference in payments. The 15-year mortgage payment is $1,898.68 and the 30-year payment is $1,348.99 with the difference being $549.69. 

 

A CRITICAL POINT IS THAT THIS $549.69 DIFFERENCE HAS ALTERNATIVE USES AND THESE USES MUST BE CONSIDERED WHEN ANALYZING MORTGAGE CHOICES. 

 

Given what we know about the historical returns in the financial markets, the 30-year mortgage may be a very good option BUT IT ALL DEPENDS ON WHAT YOU ACTUALLY DO WITH THE $549.69. If you opt for the 30-year mortgage and just spend the extra $549 on who knows what, then you would have been better off with a 15-year mortgage as Dave asserts. However, suppose you are very disciplined and invest, rather than spend, that $549. Then what? We will look at three possible scenarios. All numbers are after tax.

 

Scenario #1: The investment return is equal to the mortgage rate

 

Okay, you want to pay your house off in 15 years but you opt for the 30-year mortgage and are going to invest the difference in payments at 6% for 15 years. You are then going to take your accumulated investment proceeds and pay off the mortgage. Here are the numbers:

• In 15 years, your monthly investment of $549.69 will total $159,860

• In 15 years, your monthly payment of $1,348.99 will leave you with a balance on your mortgage of $159,860 

In this case, you are completely indifferent between a 15-year and 30-year mortgage because you have exactly enough in your investment account to pay off the entire balance. Thus, there is no benefit or savings by getting the 15-year mortgage over the 30-year. (For simplicity we are assuming that the rates are the same on a 15 and a 30 year mortgage. In practice, rates on 15-year mortgages are a little lower and this difference in mortgage rates would be included in your calculation of the difference in payments) 

 

This result should not be surprising. You are borrowing and investing at the same rate so we would expect it to be a wash. 

 

Scenario #2: The investment return is greater than the mortgage rate 

 

This is where you can really do quite well by having a 30-year mortgage (and why so many financial professionals recommend this). As noted previously, a 30-year mortgage will have a lower monthly payment than a 15-year mortgage and if you invest that difference each month in a stock index mutual fund over that 15-year period, you can be well ahead of the game. Using Dave’s numbers of 12% (which he uses in his video on investing) for the long-term return (maybe a little optimistic, frankly), we have: 

• In 15 years, your investment will total $274,614

• As before, your mortgage balance after 15 years is $159,860

After paying off your mortgage, you will have $114,754 left over. In this case, a 15-year mortgage would not have saved you anything. Rather, it would have cost you a bundle. You would have missed the opportunity to earn an extra $114K . 

 

Scenario #3: The investment return is less than the mortgage rate 

 

This time things didn’t work out as planned and the investment only returned 3%: 

• In 15 years, your investment will total $124,764 and the mortgage balance (it doesn’t change) is $159,860.

• Since your investment returns are less than the mortgage rate, you won’t have enough to pay off the entire mortgage and will still owe $35,096. 

So what should you do? 

 

It all comes down to how risk averse you are, how self-disciplined you are, and how much you understand investing. For those who are not very knowledgeable about investing and/or not very self-disciplined, I would seriously consider the 15-year mortgage as Dave advocates. On the other hand, if history is any indicator of the future (and it may or may not be), investment returns are likely to be higher than mortgage rates over the long term and financial leverage can be a great way to increase your wealth. As always, there are costs and benefits (and risks) with any road we take.

 

MM

 

 

The Crucial Importance of Profit

We often hear 'profit' spoken like it is a dirty word. The fact is, however, that without these nasty little profits, we would not have anywhere near the innovation, entrepreneurship, productivity, and standard of living we enjoy today. Why would anyone do all the work and take the risks of inventing and innovating unless they believe it will make them better off? 

Let me explain it this way. Suppose you have been saving your money to buy a new mountain bike, priced at $1,000. Just as you are ready to lay your money down, a stranger comes up to you and asks you to lend him that $1,000 so he can buy a mountain bike instead. He promises to pay you back in one year. You will probably wonder why you should you forego the enjoyment of a full year of mountain biking just so this other guy (a perfect stranger) can ride? Most likely you will not make this loan because you are not getting anything in return. 

BUT if you are compensated for giving up all that bike riding, now that is a different story. If the borrower offers to pay you $1,500 next year (instead of just returning your $1,000), you may be very happy to make this loan. It depends on whether or not the $500 interest adequately compensates you for the lost enjoyment. If $1,500 isn’t enough, then maybe $2,000 or $10,000 will do the trick. The point is that you will need to be made better off (make a profit) to be willing to defer consumption into the future.

The same thing applies when we purchase shares of company ownership in the stock market (or lend our money in the bond market, buy CDs, or deposit money in a savings account at the bank). If companies don't make profits that can be shared with their investors, we will not purchase their stocks and these firms will not have the funds needed to make investments in new technology and new products and our standard of living will be static. 

So profits are desirable. Without the profit motive we wouldn't have automobiles, iphones, computers or air-conditioning. The pursuit of profits is what unleashes the forces of innovation. It is what allocates scarce resources to their highest valued use. It is what determines if we have too many hair dressers, lawyers, truck drivers, or not enough engineers.

Please see the Paul Solman video below (about 7 minutes)

What is Profit?

MM

 

Who are you who are so wise in the ways of science?

 

So logically, if she weighs the same as a duck, she's made of wood, and therefore ... 
 

Critical thinking is all the rage in higher education these days -- and for good reason. It is critical to think critically J. But what exactly is critical thinking? Well, sometimes it is best to begin with what something is NOT. This is one of my favorite examples of NON critical thinking:

http://www.youtube.com/watch?v=zrzMhU_4m-g

A Parable of Equality and Efficiency

(Challenges in Getting Socialism to Work)

The following ‘parable’ explains why there tends to be a tradeoff between equality and efficiency, why socialism has difficulty working very well, and why socialism requires limits on personal freedom to have a reasonable chance of working at all. 

Let’s suppose that you and some of your best friends decide to move out to Kansas and become farmers. After being farmers for a while it is clear that some of you have a real talent for making things grow while others are not as skilled. Also, some of you are more industrious than others. While you are out fertilizing and watering, some of your friends take time off to watch Jerry and Maury on TV. As a result of these differences in talent and work ethic, differences emerge in how much wheat is grown on each farm, resulting in differences in standards of living. Adding together the output of wheat from each farm, your community total is 1000 bushels. 

Not liking the unequal distribution and being best friends and all, you decide to put the wheat in a community silo and split the revenues equally. With this kind of arrangement, however, there is no longer a direct relationship between effort and income. This means that the most industrious and productive farmers will be receiving less and the least productive farmers will be getting more. The unintended consequence is that effort and innovation are now being penalized while lack thereof is being rewarded. Seeing no reason to work quite as hard as before, now even the most productive farmers decide to watch a little Maury instead of knocking themselves out in the fields. The less productive farmers add Oprah to their viewing pleasure. Changing the system has changed behavior and the standard of living falls to 800 bushels.   

You are all glad about everybody being equal, but sad that the economic pie is now smaller. You achieved maximum efficiency when everybody had property rights over their production. You had maximum equality when everything was shared and distributed evenly. (Grading in school would be another example. Do students work harder when they have property rights over their own scores or would they be better motivated under a communal system where everybody’s scores are added together and averaged? With the link between effort and grades weakened, most students would study less under a communal system of grading)    

 

Now, another problem emerges. Some of the best farmers are unhappy about their reduced living standards and want to leave the commune and move to Iowa where they can once again enjoy all the fruits of their labor. If the best farmers move to Iowa, this would leave only the least productive farmers in Kansas and community output would fall even further. To avoid a crisis, a law is passed prohibiting anyone from leaving Kansas. Later a wall is built and armed guards patrol the area to make sure nobody slips through. Output now falls to 700 bushels as resources are diverted away from farming to build and patrol the wall.

With the best farmers prevented from leaving, output remains at 700 bushels, but you are all looking a bit peaked from too little nutrition and want to get production back to 1000. In other words, you want both efficiency AND equality. To accomplish this, it is decided that officials will be appointed to watch and make sure everybody is doing their fair share. If it is determined that somebody is slacking off, or trying to convince others to rise up and go back to the old system of property rights, they will be sent to a labor camp in Minnesota where they can be educated/trained/rehabilitated.  If they prove themselves in Minnesota, they may be given a chance to return to Kansas.

Adding officials to make sure everybody is doing their share increases output to 900 bushels (Output cannot return to 1000 because people were permanently transferred away from farming to become guards and officials) and many are unhappy about being watched and living in fear and spend considerable time and effort trying to figure out a way to escape (time and effort that could have been used for production and innovation)

The above scenario illustrates why communal systems tend to have low standards of living, why citizens of the Soviet Union were rarely (if ever) allowed to leave the country, why the infamous Berlin Wall was built, and why so many have died trying to swim, boat, or surf their way from Havana to Miami.  

With all that said, I personally believe that socialism is a great idea. On the surface, what's not to like? “From each according to his ability, to each according to his need”.  A true utopia with everybody working together, helping each other, and being equal. Oh, if only it were possible! Unfortunately, probably not in this life or on this planet as this is an idea that is extremely difficult to implement because it requires near perfect people to succeed. It requires people who are willing to be innovative and industrious even when they know that their allotment will be less than they personally produce. (In the grading example, this would mean continuing to study for an ‘A’ knowing that a grade of ‘C’ is all that will be awarded) It means that those who are less productive will still try their best (i.e. no free riders) even though it won't have much impact on how much they receive. In the absence of people who are purely motivated by the welfare of others, the only alternative is to use fear and force (e.g. The Soviet Union, East Germany, China, Cuba, North Korea) which history has demonstrated doesn't work well at all.     

The Pilgrims tried communal living in the 1600s but productivity was so low that they nearly starved. In desperation, Governor William Bradford implemented a system of private property rights. Once these powerful incentives were in place, the result was such an astonishing increase in output that they actually had enough corn left over to export.

It all comes down to how much you value freedom and how much you value equality. How much personal freedom are you willing to sacrifice to gain more equality? What is the right mix? At what point are the tradeoffs no longer acceptable? (The Soviet Union slaughtered 61 Million of its own citizens in its extreme quest for equality)

All economic systems have serious flaws, but market based systems have produced the highest standards of living (and freedom) for everyone involved -- but at the cost of less equality.

I highly recommend these Paul Solman videos (about 10 minutes each):  

Private Property (and Pilgrims, Too)

Capitalism vs Socialism

MM