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