I was poking around the CNBC.com website last week when I came across a link to one of Dave's articles. Here is the link if you want to go there yourself. The website asks the financial question, "Is the 30 year mortgage really a bad option?" and then answers it by quoting Dave Ramsey. Here is what Dave had to say, "[T]he 30 year mortgage robs your future. […] It simply enabled borrowers to buy more house than they could afford by spreading the payments out over a longer term. On top of that, those homeowners paid tens—even hundreds of thousands of dollars more in interest." The article then goes on to describe Dave's teachings on the matter of the 30 year mortgage. It says, "Instead of a 30 year mortgage, Dave recommends getting a 15 year mortgage with 'at least a 10% down payment and monthly payments that are no more than 25% of your take-home pay.' Following this advice is a great first step to ensure you build wealth quickly and avoid paying a mortgage into your retirement." The article also makes an argument that I hear all the time from those who oppose 30 year mortgages when it says, " Paying off your mortgage completely will free up income later for other investments and allow you to live more comfortably in your older age." Let's consider this argument for a moment, shall we?
It is true that the longer the term of the mortgage the higher the total amount of interest that will be paid but, so what? Interest paid is just another opportunity cost of owning the mortgage and unlike other costs associated with home ownership, it is tax deductible. There is a better way to look at a long term mortgage. Consider these facts about a hypothetical $200k home with a $1000/mo 30 year fixed rate mortgage:
- The home does not know and does not care how much of it you own prior to realizing capital gains. In other words, you can own the home with 1% down or 99% down and the rate of capital appreciation on the home will be exactly the same.
- Your rate of return on the home is determined by how much you put down on it. If the home appreciates at 5%/year and you bought it for cash, your rate of return on investment is 5%/year. On the other hand, if you put down just $10,000 your rate of return on investment is 100%/year. That is a very strong argument for putting the minimum amount down.
- Unless your tax adjusted rate of interest on the mortgage is higher than your expected rate of total return in an alternative investment, you should put your money into the alternative investment. If your interest rate is 5% and your tax bracket (combined state and federal) is 20%, your effective rate of interest on the loan is 4%. If you can invest money into any other investment and realize more than 4%/year, also after tax adjustments, then you should never put a penny more into your mortgage than you are required to do so. Given the fact that any quality stock mutual fund should realize in excess of 10%/year over the length of your loan, why would you ever put an extra penny into the mortgage?
- The belief that you can pay off a mortgage in 15 years and then invest the mortgage payment for the next fifteen years in order to get a higher net worth thirty years from now is a myth for two reasons. First, human nature being what it is, people simply don't do it. Once the mortgage is paid off people find something other than investments to spend that freed up money on. Second, and you can run the numbers as many times as you would like on this one and the results will always come out the same, it is impossible to catch up for the lost 15 years of the mortgage when you were not investing. Compare the mortgage payment of a 15 year loan with a 30 year loan and plan on investing the difference between the two for thirty years versus investing the entire 15 year amount fifteen years later. The 30 year mortgage always wins. Your net worth will always be higher with the 30 year mortgage. There is no substitute for long periods of time when compounding can work for you. Shortening that term with a 15 year mortgage actually decreases your net worth at the end of the thirty year period.
- With a 4% annual rate of inflation the real cost of your 30 year mortgage will be half of what it was at the start in just eighteen years. By the end of the 30 year term you will be paying with dollars worth about 30% of their original value. As long as banks are willing to assume the risk of loss associated with inflation why should you ever try to shorten the term of your loan? That $1000 monthly payment is only a $300 monthly payment by the end of mortgage term. Let the bank suffer all the losses associated with inflation by taking a loan for the maximum possible term.
Why, given the financial realities I have described, do advisers continue to recommend shortening or paying off your mortgage? The answer to that question is found in Dave's comment about how the 30 year mortgage robs your future because it allows a person to buy a more expensive home. Now that is a different issue entirely. Buying a home that is more expensive than you can afford is just plain stupid. Using a 30 year mortgage to get the monthly payment down so you can buy a larger house is dumb. But that is not the fault of the 30 year mortgage. The blame lies entirely with the sinful materialism of the house buyer. I am not responsible for the sinful materialism of others. As a result I will not recommend against a 30 year mortgage just because someone may use it incorrectly. The 30 year mortgage is a great deal for those who use it responsibly.