Has anybody had success paying of debt with Dave Ramsey's theory?

[phillylawyer]

At least in his book (as I said to Paul above), his advice about paying off mortgages is, to be honest, flat out financially illiterate. I’m not sure if he does it on purpose to make a point or because he is uninformed. Maybe (hopefully?) it is more nuanced on his radio show.

As you said, of course mortgage debt is not “good” debt. Other than a few differences in the legal implications of bankruptcy and how it is treated with certain loan applications (and low income repayment options for student loans), debt is debt is debt. Mortgage debt is no different.

What IS different about mortgage debt is that, because the interest is tax deductible on your federal income tax return in the U.S., assuming you are itemizing on your federal tax return (and not taking the standard deduction), the EFFECTIVE interest rate on your mortgage is actually lower than what is quoted to you. If you have a 3.25% mortgage and are in a 30% marginal tax bracket, your effective interest rate is 2.275%. This is financially equivalent to having non-mortgage (non-deductible) debt with a rate of 2.275%.

What this means is, when deciding whether to pay off your mortgage early or invest the cash in something else, you should treat paying off the mortgage early as investing in an asset with a guaranteed return of 2.275% (or whatever the effective rate of your mortgage is) because they are financially equivalent. If a guaranteed return of 2.275% is the best investment (or at least the best option as part of your investment portfolio) when compared to other investment options (adjusted for risk) then you should. If not, you shouldn’t. Simple. The fact that is called “debt” does not change this analysis.

At 2.275%, for most people, the answer is it is not the best investment option. Would you move substantial money out of an indexed mutual fund to invest in a treasury bond with a yield of 2.275%? If the answer is no, you shouldn’t use that money to pay off your mortgage early, either.

Dave’s one-size fits all advice about paying it off early is, again, financially naive, and wrong in most cases. And, what is especially ridiculous about this advice is in other places in his book he assumes investing in the stock market will give you a fixed return of 12%. That makes it even more ridiculous.

The above analysis assumes you have already maxed out all tax beneficial investment options for the year (i.e., IRA, 401k, 529 plans, etc.). If you have not done so, the financial argument for not paying off your low interest mortgage early is even greater.

As for NFPWife’s particular advice from the accountant, I have no idea if he was right or wr ong about it being bad to pay off student loans and mortgages early. It really depends on (1) what the interest rate on your mortgage and student loans is (2) whether they are variable or fixed (3) what effective marginal tax bracket you are in (4) whether you are itemizing your deductions or not (5) what age you are and (6) what mix of other investments you have is.

If you had a mortgage with an interest rate of 3% or less, then, financially speaking you probably made the “wrong” decision. But, if the lost investment cost was worth it to you for the peace of mind of having paid off your mortgage, then great. I would never tell someone they are an idiot for making such a decision (if the CPA called you an idiot, I would say he is an idiot), as long as they were informed about the decision. If that financial peace is worth the “cost” of getting a lower return, then great. Just be informed about what the cost of getting that peace is, and make your decisions accordingly. I am all about making good informed decisions for them based on sound, literate, financial advice. Did I say the word “informed” yet?

 

[PaulGH]

Paying off a mortgage with an effective interest rate of 2.275% is financially and mathematically equivalent to investing in an asset (or bond) with a guaranteed return of 2.275%.

I disagree. If you compare the risk of investing say $50,000 in a guaranteed bond vs. investing the $50,000 somewhere else, the risk is, at most, that you might lose $50,000 plus some amount of investment return. Now, that’s a pretty big risk, but it is relatively small compared to the risk of not paying off the remaining $50,000 on your mortgage. There the risk is, at most, that you could lose your house, which is probably worth much more than $50,000, not to mention that losing your house would turn your life upside-down at least for a while.

If Dave’s argument is that an investment with a guaranteed rate of return of 2.275% is always better than investing in the stock market, then that logic should apply across the board. You can invest in treasury bonds that have a guaranteed rate of return of 2.275% and, using Dave’s logic, you should NEVER invest in the market and always invest in those, because there is some risk to investing in the market. Everybody knows that advice is silly.

But I think you are addressing a different topic. This conversation was about Dave Ramsey’s advice about not sending $10,000 to the bank in order to avoid sending $3,000 to the government. And as I said, he is not even trying to address all the reasons why you should or should not pay off your mortgage with that particular argument. He is only trying to address one specific fallacy.

And as I pointed out above, investing X dollars is not the same as paying off the remaining X dollar balance on your mortgage, from a perspective of the worst-case scenario risk that is involved in both cases.

Dave (obviously) does not endorse that idea, because he incorrectly treats early repayment of mortgage (because it’s “debt”) differently than investing in low-risk bonds or some other asset with a fixed rate of return.

I don’t think it is incorrect to treat it differently, because a typical person takes on a higher risk by having a mortgage (i.e., the risk that they will not be able to make the payments due to some future financial calamity, and that they will lose their house) than by investing or not investing the same amount of money in any particular asset. Because when you invest in stocks or bonds, only the amount of your investment is at risk. But when you have a mortgage, your entire house is at risk, which not only is probably worth more than the mortgage balance, but also is an integral part of one’s life that would be a major hardship to lose.

But again, all these questions of risk are a departure from the quote that you initially took issue with, which as I understand it, was only arguing against one particular fallacy about mortgage interest and taxes.

 

[phillylawyer]

I disagree. If you compare the risk of investing say $50,000 in a guaranteed bond vs. investing the $50,000 somewhere else, the risk is, at most, that you might lose $50,000 plus some amount of investment return. Now, that’s a pretty big risk, but it is relatively small compared to the risk of not paying off the remaining $50,000 on your mortgage. There the risk is, at most, that you could lose your house, which is probably worth much more than $50,000, not to mention that losing your house would turn your life upside-down at least for a while.

Paul, I understand what you are saying, and it is a fair point to consider. I have thought about this and run some numbers on several occasions on this very point. But, in the situations we are talking (someone has, say, 50% equity in the house and is deciding whether to use the extra money to pay down the mortgage or invest elsewhere), I actually don’t think it is correct, when you consider the totality of your financial circumstances, to say that you are putting more at risk by (a) investing in stocks instead of guaranteed bonds as opposed to (b) investing in stocks instead of paying off your mortgage early. I think, financially speaking, the risk is the same. Maybe you could provide a concrete example (in a situation where Ramsey would recommend paying down the mortgage early) with financial numbers where that is not the case, because I have not been able to come up with one. In Dave’s program, as you point out, he only recommends paying down the mortgage once you have savings, retirement assets, savings for kids college, etc. So, we are not talking a situation where someone is living pay check to pay check and may be foreclosed on their house next month because they miss a mortgage payment. We are in Dave’s “wealth” accumulation stage.

By way of example, Mark Zuckerberg, when he bought his house for $8M, put 20% down and financed the rest (at some ridiculous rate of 1% or something). Do you really think, by not paying for his house in cash, Zuckerberg really is putting the entire value of his property at risk? Of course not. He knows it makes more sense to invest in other assets (facebook stock? I dunno) then invest in an asset paying a 1% return (even less when factoring in the tax deduction). I actually have a lot of wealthy, sophisticated clients that maintain mortgages of $1M (which is the mortgage deduction cap) for that very reason.

But I think you are addressing a different topic. This conversation was about Dave Ramsey’s advice about not sending $10,000 to the bank in order to avoid sending $3,000 to the government. And as I said, he is not even trying to address all the reasons why you should or should not pay off your mortgage with that particular argument. He is only trying to address one specific fallacy.

I have never heard anyone say that paying interest on a mortgage “earns you money” because of the tax deduction. The only argument is ever that the cost of the loan is reduced because of the tax deduction; therefore it makes financial sense to invest in other assets instead of paying down your mortgage. If Dave, in his book, is really just responding to the argument that the tax deduction is always less than the cost of the interest, then he is only responding to a straw man argument (which is pretty boring if you ask me).

If you read the rest of that chapter of his book (which is summarized nicely in the blog I linked to), it is clear that he is REALLY focusing on pay down your mortgage vs. invest elsewhere discussion.

Thanks for the thoughtful discussion, Paul! I have appreciated the dialogue and learned from your insightful comments! I would much rather pay to take a financial seminar from you than from Dave Ramsey.

 

[NFPWife]

The above analysis assumes you have already maxed out all tax beneficial investment options for the year (i.e., IRA, 401k, 529 plans, etc.). If you have not done so, the financial argument for not paying off your low interest mortgage early is even greater.

As for NFPWife’s particular advice from the accountant, I have no idea if he was right or wr ong about it being bad to pay off student loans and mortgages early. It really depends on (1) what the interest rate on your mortgage and student loans is (2) whether they are variable or fixed (3) what effective marginal tax bracket you are in (4) whether you are itemizing your deductions or not (5) what age you are and (6) what mix of other investments you have is.

If you had a mortgage with an interest rate of 3% or less, then, financially speaking you probably made the “wrong” decision. But, if the lost investment cost was worth it to you for the peace of mind of having paid off your mortgage, then great. I would never tell someone they are an idiot for making such a decision (if the CPA called you an idiot, I would say he is an idiot), as long as they were informed about the decision. If that financial peace is worth the “cost” of getting a lower return, then great. Just be informed about what the cost of getting that peace is, and make your decisions accordingly. I am all about making good informed decisions for them based on sound, literate, financial advice. Did I say the word “informed” yet?

To our situation, he knew nothing about our details. It was a comment he made at the gym when we were talking about something. He’d made an assumption that we had a mortgage and I stopped him to correct it. He was gobsmacked. After I said we didn’t have a mortgage, he assumed we rented. He couldn’t believe anyone at our ages (late 20s/ early 30s) would have a paid for house. He really believed the “You should keep mortgage debt for the deduction” fallacy.

To our specifics, we didn’t have enough deductions for us to go beyond the standard deduction and we were maxed out on retirement savings. It made sense for us to pay it off. Again, this was before I’d ever heard DR, because we maxed retirement, 403Bs and Roths, before accelerating the house. We also bought less house than we could afford so it wasn’t that difficult to knock out. Same with the student loans. Even with my undergrad loans and the house, the interest didn’t make a real difference in the tax return.

While I never offer details about our lifestyle to random pp,l, when someone makes an assumption, like that we have a mortgage or car payment, and I correct it they’re often so shocked that they’ll say things like “that’s stupid.” My response is, “It’s working for us.”

 

[phillylawyer]

To our situation, he knew nothing about our details. It was a comment he made at the gym when we were talking about something. He’d made an assumption that we had a mortgage and I stopped him to correct it. He was gobsmacked. After I said we didn’t have a mortgage, he assumed we rented. He couldn’t believe anyone at our ages (late 20s/ early 30s) would have a paid for house. He really believed the “You should keep mortgage debt for the deduction” fallacy.

To our specifics, we didn’t have enough deductions for us to go beyond the standard deduction and we were maxed out on retirement savings. It made sense for us to pay it off. Again, this was before I’d ever heard DR, because we maxed retirement, 403Bs and Roths, before accelerating the house. We also bought less house than we could afford so it wasn’t that difficult to knock out. Same with the student loans. Even with my undergrad loans and the house, the interest didn’t make a real difference in the tax return.

While I never offer details about our lifestyle to random pp,l, when someone makes an assumption, like that we have a mortgage or car payment, and I correct it they’re often so shocked that they’ll say things like “that’s stupid.” My response is, “It’s working for us.”

Yeah. Sounds like in your situation it may have been a good financial decision. As you said, you thought it through and it works for you.

I also am amazed at how people are so quick to throw around unsolicited advice in an absolute manner. Sounds like the CPA was way out of line. Maybe it makes feel superior to make comments like that? I dunno…

Also, if the CPA really believes that you should “always keep the mortgage for the deduction line” instead of “analyze the cost of the mortgage based on the effective rate by factoring in the deduction,” please don’t ever use that CPA. Aside from the fact that he sounds rude, he just sounds like a bad CPA.

 

[PaulGH]

I have never heard anyone say that paying interest on a mortgage “earns you money” because of the tax deduction. The only argument is ever that the cost of the loan is reduced because of the tax deduction; therefore it makes financial sense to invest in other assets instead of paying down your mortgage. If Dave, in his book, is really just responding to the argument that the tax deduction is always less than the cost of the interest, then he is only responding to a straw man argument (which is pretty boring if you ask me).

Well, I have known people to say that you get back as much money in taxes as you pay in mortgage interest – for example, that if you paid $10,000 in mortgage interest in 2014, then you would save $10,000 on your taxes when you file in early 2015. I have always understood Dave Ramsey to be addressing that fallacy, which in my personal experience is not an uncommon fallacy.

However, as you pointed out, you are basing your conclusions on what he says in his book, while I am basing mine on what he has said many times to callers on his radio show. It is possible that what he says in one venue is slightly different than what he says in another venue. And we also have had very different experiences as to whether this fallacy actually exists or not, which may color the way that we both interpret his comments.

 

[phillylawyer]

To our situation, he knew nothing about our details. It was a comment he made at the gym when we were talking about something. He’d made an assumption that we had a mortgage and I stopped him to correct it. He was gobsmacked. After I said we didn’t have a mortgage, he assumed we rented. He couldn’t believe anyone at our ages (late 20s/ early 30s) would have a paid for house. He really believed the “You should keep mortgage debt for the deduction” fallacy.

To our specifics, we didn’t have enough deductions for us to go beyond the standard deduction and we were maxed out on retirement savings. It made sense for us to pay it off. Again, this was before I’d ever heard DR, because we maxed retirement, 403Bs and Roths, before accelerating the house. We also bought less house than we could afford so it wasn’t that difficult to knock out. Same with the student loans. Even with my undergrad loans and the house, the interest didn’t make a real difference in the tax return.

While I never offer details about our lifestyle to random pp,l, when someone makes an assumption, like that we have a mortgage or car payment, and I correct it they’re often so shocked that they’ll say things like “that’s stupid.” My response is, “It’s working for us.”

Sounds like you are an awesome friend and great at giving people good financial advice. What part of the country are you in? Maybe you should start a financial planning business (if you haven’t already).

 

[phillylawyer]

Well, I have known people to say that you get back as much money in taxes as you pay in mortgage interest – for example, that if you paid $10,000 in mortgage interest in 2014, then you would save $10,000 on your taxes when you file in early 2015. I have always understood Dave Ramsey to be addressing that fallacy, which in my personal experience is not an uncommon fallacy.

However, as you pointed out, you are basing your conclusions on what he says in his book, while I am basing mine on what he has said many times to callers on his radio show. It is possible that what he says in one venue is slightly different than what he says in another venue. And we also have had very different experiences as to whether this fallacy actually exists or not, which may color the way that we both interpret his comments.

Interesting. I haven’t heard that before. That isn’t (all) he is responding to in his book. But, to the extent that is his point on his radio show or other formats, that is definitely an important myth to dispel.

I have heard a lot of people get confused (and really upset) when I tell them that the new mortgage they got this year and all the interest and real estate taxes they were paying didn’t reduce their federal income tax bill at all, because they were still better off using the standard deduction instead of the itemized deduction. I think a lot of people don’t realize that you have to itemize to take advantage of the mortgage interest deduction or real estate deduction (if they even know what itemizing vs. the standard deduction means). That is one that I have seen people get confused about a lot.

So, especially considering Dave Ramsey’s target audience, I think a better point would be that, a lot of you who are in financial trouble and have mortgages, aren’t even getting much (if any tax benefit) because you aren’t itemizing or your itemized deductions barely exceed the standard deduction.

But, you are right that our different experiences about people’s confusion may color our view of Dave’s comments. Good point.

 

[Xantippe]

Well, I have known people to say that you get back as much money in taxes as you pay in mortgage interest – for example, that if you paid $10,000 in mortgage interest in 2014, then you would save $10,000 on your taxes when you file in early 2015. I have always understood Dave Ramsey to be addressing that fallacy, which in my personal experience is not an uncommon fallacy.

However, as you pointed out, you are basing your conclusions on what he says in his book, while I am basing mine on what he has said many times to callers on his radio show. It is possible that what he says in one venue is slightly different than what he says in another venue. And we also have had very different experiences as to whether this fallacy actually exists or not, which may color the way that we both interpret his comments.

Yes–a lot of people talk up the mortgage deduction that aren’t even eligible for the mortgage deduction, which is weird. It’s a realtor talking point that doesn’t really matter much to the average person in lower cost areas of the country.

"Designed to boost homeownership, the mortgage interest deduction is one of the most popular provisions of the tax code. But Internal Revenue Service data show that only a quarter of tax filers claim it.

“The use of the deduction varies widely from region to region, ranging from a high of 37% of taxpayers in Maryland to a low of 15% in North Dakota and West Virginia, according to a USA TODAY analysis of IRS data.”

usatoday.com/story/news/politics/2012/12/04/fiscal-cliff-mortgage-deduction/1737611/

We bought our house a year ago and have about 25% equity in it. With kids’ college coming quickly, it’s going to take a while before we really tear into the mortgage, but there’s a lot of satisfaction in watching the mortgage balance go down. And since we live in an inexpensive part of the country, our equity in our home will always be a relatively small piece of our financial picture. Even with 25% equity and with a not-very-aggressive retirement savings program, we still have 2X as much in retirement as we do home equity, and as time goes by, even as we pay off the house completely, our home equity will hopefully be a smaller and smaller chunk of our financial pie.

Somebody doing the DR plan will have no debt, 3-6 months in emergency savings, aggressive retirement savings and aggressive college savings before they start doing extra on the house. Barring a major disaster that would wipe anybody out under any financial plan, you can’t really screw that up.

And yes, I think the Zuckerberg thing was a little dumb–celebrity houses are often weird, very taste-specific and date rapidly, and the celebrity owners often wind up selling them at a substantial loss. Who really wants to pay top dollar for Zsa Zsa Gabor’s house?

I chose Zsa Zsa’s name at random, but here’s a typical celeb house story:

"After more than two years on the open market, Zsa Zsa Gabor and her weird husband Frederic Prinz von Anhalt have finally sold their long-time house in Bel Air. And now the new owners are probably 'bout to introduce it to the wrecking ball. Von Anhalt started chattering in January 2011 that they were planning to sell the house for $28 million and that they already had scads of Chinese and Russian buyers dying to buy it. Flash-forward to June 2011 when it hit the MLS asking $15 million. The house was built in 1955 and sits on more than acre; it has six bedrooms, seven bathrooms, a wetbar, and an “exquisite dining room that has entertained guests such as Queen Elizabeth, US Presidents, CEO’s, dignitaries and celebrities.” Gabor has owned since the 1970s.

“For the past two years, it’s jumped on and off the market, occasionally undergoing a pricechopping or priceupping, entering into escrow, or appearing in a film (Oscar-winner Argo). Now listing brokerage Rodeo Realty Beverly Hills tells us the house sold last week for $11 million, to an LA-based real estate holding firm, and that the property will probably be redeveloped.”

Typical.

la.curbed.com/archives/2013/05/zsa_zsa_gabors_house_finally_sells_will_probably_be_torn_down_1.php

 

[phillylawyer]

Yes–a lot of people talk up the mortgage deduction that aren’t even eligible for the mortgage deduction, which is weird. It’s a realtor talking point that doesn’t really matter much to the average person in lower cost areas of the country.

"Designed to boost homeownership, the mortgage interest deduction is one of the most popular provisions of the tax code. But Internal Revenue Service data show that only a quarter of tax filers claim it.

As I mentioned above to Paul, that is a fair comment, and I do hear that confusion a lot. I don’t usually see people thinking that their tax deduction cancels out the cost of the interest (in other words, assuming the mortgage interest deduction is really a credit). But, I do see a lot of people who assume that everyone benefits from a mortgage interest deduction, when only those that itemize (15% to 35%, depending on the part of the country, as you said) actually do. This variation does partly have to do with cost of living in the area, but it also largely has to do with what the income tax rate of the state you live in is. Because state income taxes are itemized, if you live in a state like NY (with high income taxes), you are much more likely to benefit from the mortgage interest deduction than in a state like TX, with no state income tax.

And yes, I think the Zuckerberg thing was a little dumb–celebrity houses are often weird, very taste-specific and date rapidly, and the celebrity owners often wind up selling them at a substantial loss. Who really wants to pay top dollar for Zsa Zsa Gabor’s house?

Funny story about Zsa Zsa. Whether Zuckerberg’s design decision or not is a whole different question from whether his decision to get a mortgage made financial sense. I can’t tell you whether he will end up losing a ton of money on that house he got (he probably will, but, with Silicon Valley’s exploding housing market, who knows?). But, I can assure you that when he bought the house, his sophisticated financial advisers told him to get a mortgage with a 1% interest rate instead of paying it all in cash (which he obviously could have done). To not take that mortgage would have been, frankly, dumb and just throwing money away.

 

[PaulGH]

Paul, I understand what you are saying, and it is a fair point to consider. I have thought about this and run some numbers on several occasions on this very point. But, in the situations we are talking (someone has, say, 50% equity in the house and is deciding whether to use the extra money to pay down the mortgage or invest elsewhere), I actually don’t think it is correct, when you consider the totality of your financial circumstances, to say that you are putting more at risk by (a) investing in stocks instead of guaranteed bonds as opposed to (b) investing in stocks instead of paying off your mortgage early. I think, financially speaking, the risk is the same. Maybe you could provide a concrete example (in a situation where Ramsey would recommend paying down the mortgage early) with financial numbers where that is not the case, because I have not been able to come up with one. In Dave’s program, as you point out, he only recommends paying down the mortgage once you have savings, retirement assets, savings for kids college, etc. So, we are not talking a situation where someone is living pay check to pay check and may be foreclosed on their house next month because they miss a mortgage payment. We are in Dave’s “wealth” accumulation stage.

Before getting into specifics, I think it is worth noting that different people are comfortable with different levels of risk, and that there is nothing wrong with that. For example, a financial advisor might recommend an investment mix of 80% stocks and 20% bonds for a young person’s retirement savings. But that person, after looking at lots of past performance data for different investment mixes, may decide that the risk is more than they are comfortable with. So that person might decide to invest instead in 50% stocks and 50% bonds, or whatever. And that is not necessarily wrong, if that is what makes the person comfortable and will keep him from panicking and withdrawing money in a market crash.

By the same principle, I think that if knowing that the risk of foreclosure is absolutely zero is important to a person, and helps him sleep better at night, then we should not discount that.

However, I do think that concrete examples could be provided where the risk is not the same between the two options. But first, you mentioned that the person probably has retirement and college savings. Well yes, but we really should think of these savings as untouchable for any purpose other than retirement or college – otherwise there is always a temptation to use them as an emergency fund, or worse yet, to take money out and spend it on non-emergencies.

(to be continued)

 

[PaulGH]

(continued from above)

Now, here is an example as you requested:

Ted and Alice own a home that is worth $100,000, and they owe $50,000 on their mortgage. They have just recently started saving for retirement and college, though they are putting 15% of income into retirement savings, and somewhat less each month for college. They now have $15,000 saved for retirement, and $5,000 saved for college. They also have a $20,000 emergency fund, and two paid-off cars. Ted makes $80,000 per year, and Alice is a stay-at-home mom. After all expenses are paid each month (including the mortgage and saving for retirement & college), they typically have about $500 left over. They are trying to decide whether to invest an additional $500 per month in the stock market, or to put $500 per month on their mortgage, which will help them pay off their mortgage considerably faster. (If I really wanted to get fancy, I could look up an amortization schedule on their mortgage, to see how much faster they would pay it off, but I don’t want to take the time to do that now.)

So let’s suppose that they invest the money, instead of paying down the mortgage. Then suppose that the stock market plummets like it did around 2008-2009, and at the same time Ted loses his job. And maybe at the same time they also panic, and pull their money out of the stock market right when it is very low.

In this situation, Ted and Alice could certainly use their emergency savings to pay their mortgage and their other living expenses for several months, and they could take their (greatly reduced) investment money and use that as an additional source of emergency money. But beyond that, if Ted or Alice still hasn’t found a job (maybe because the entire economy is in bad shape, as it was around 2008-2009), what are their options? They could take money out of retirement and college savings, but they don’t have much there yet, and what they did have is now worth a lot less than before. They will also pay a penalty for taking it out early, and they will be undercutting the small progress they had started to make on retirement and college savings.

It is starting to look as if their mortgage, as well as some other bills, may not get paid. So now in addition to everything else – the job loss, the burning through all their emergency savings, maybe even cashing out their investments when the market was low, etc. – they also face the prospect of losing their home, at a time when they can’t afford to rent or to buy another house.

On the other hand, if they had managed to pay off their house before this calamity hit, then at least they would know that they could stay in their house, and that that would be one major point of stability in an otherwise very bad situation. (And the fact that they no longer have a monthly mortgage payment will help their emergency savings and any other money like unemployment benefits to go farther as well.) And the biggest risk they would have faced by paying off the mortgage early is that maybe they won’t accummulate as much wealth over those few years.

To me, it is clear in this comparison that at least if we compare worst-case scenarios, the risk is much greater in Ted and Alice not paying off their mortgage. And you might say, well why consider the worst-case scenario, since that is unlikely to happen? But it’s also unlikely that my house will burn down, and I still have homeowner’s insurance. It’s also unlikely that I will die before age 50, but I still have life insurance. And I look at paying off the mortgage as foreclosure insurance. Yes, there is a cost to this insurance, just as with any other insurance. But to me, the cost is worth the reduction in risk (at least within certain parameters – e.g, I wouldn’t try to pay extra on my mortgage if I had no emergency savings).

 

[Xantippe]

Before getting into specifics, I think it is worth noting that different people are comfortable with different levels of risk, and that there is nothing wrong with that. For example, a financial advisor might recommend an investment mix of 80% stocks and 20% bonds for a young person’s retirement savings. But that person, after looking at lots of past performance data for different investment mixes, may decide that the risk is more than they are comfortable with. So that person might decide to invest instead in 50% stocks and 50% bonds, or whatever. And that is not necessarily wrong, if that is what makes the person comfortable and will keep him from panicking and withdrawing money in a market crash.

By the same principle, I think that if knowing that the risk of foreclosure is absolutely zero is important to a person, and helps him sleep better at night, then we should not discount that.

However, I do think that concrete examples could be provided where the risk is not the same between the two options. But first, you mentioned that the person probably has retirement and college savings. Well yes, but we really should think of these savings as untouchable for any purpose other than retirement or college – otherwise there is always a temptation to use them as an emergency fund, or worse yet, to take money out and spend it on non-emergencies.

(to be continued)

Yes. There’s a lot of harm done by people who fund retirement but have no emergency funds and then repeatedly raid their retirement funds whenever they hit a bump. And then they wonder why it never amounts to much…

What DR encourages people to do is to contribute a large (but limited) amount to retirement and then to treat it as sacred until retirement: the emergency fund is for emergencies and retirement savings are for retirement.

 

[PaulGH]

I have heard a lot of people get confused (and really upset) when I tell them that the new mortgage they got this year and all the interest and real estate taxes they were paying didn’t reduce their federal income tax bill at all, because they were still better off using the standard deduction instead of the itemized deduction. I think a lot of people don’t realize that you have to itemize to take advantage of the mortgage interest deduction or real estate deduction (if they even know what itemizing vs. the standard deduction means). That is one that I have seen people get confused about a lot.

Indeed. The standard deduction fallacy is a much more common fallacy than the other one, in my experience. It seems like very few people understand that itemized deductions only help you to the extent that the total of itemized deductions exceeds the standard deduction, which for many people means that itemized deductions (like mortgage interest) actually save you little or nothing on your taxes. When I have tried to explain this to people, I have often been met with blank stares. So I am right with you on this point.

 

[phillylawyer]

(continued from above)

Now, here is an example as you requested:

Ted and Alice own a home that is worth $100,000, and they owe $50,000 on their mortgage. They have just recently started saving for retirement and college, though they are putting 15% of income into retirement savings, and somewhat less each month for college. They now have $15,000 saved for retirement, and $5,000 saved for college. They also have a $20,000 emergency fund, and two paid-off cars. Ted makes $80,000 per year, and Alice is a stay-at-home mom. After all expenses are paid each month (including the mortgage and saving for retirement & college), they typically have about $500 left over. They are trying to decide whether to invest an additional $500 per month in the stock market, or to put $500 per month on their mortgage, which will help them pay off their mortgage considerably faster. (If I really wanted to get fancy, I could look up an amortization schedule on their mortgage, to see how much faster they would pay it off, but I don’t want to take the time to do that now.)

So let’s suppose that they invest the money, instead of paying down the mortgage. Then suppose that the stock market plummets like it did around 2008-2009, and at the same time Ted loses his job. And maybe at the same time they also panic, and pull their money out of the stock market right when it is very low.

In this situation, Ted and Alice could certainly use their emergency savings to pay their mortgage and their other living expenses for several months, and they could take their (greatly reduced) investment money and use that as an additional source of emergency money. But beyond that, if Ted or Alice still hasn’t found a job (maybe because the entire economy is in bad shape, as it was around 2008-2009), what are their options? They could take money out of retirement and college savings, but they don’t have much there yet, and what they did have is now worth a lot less than before. They will also pay a penalty for taking it out early, and they will be undercutting the small progress they had started to make on retirement and college savings.

It is starting to look as if their mortgage, as well as some other bills, may not get paid. So now in addition to everything else – the job loss, the burning through all their emergency savings, the bad decision on cashing out their investment when the market was low, etc. – they also face the prospect of losing their home, at a time when they can’t afford to rent or to buy another house.

On the other hand, if they had managed to pay off their house before this calamity hit, then at least they would know that they could stay in their house, and that that would be one major point of stability in an otherwise very bad situation. (And the fact that they no longer have a monthly mortgage payment will help their emergency savings and any other money like unemployment benefits to go farther as well.) And the biggest risk they would have faced by paying off the mortgage early is that maybe they won’t accummulate as much wealth over those few years.

To me, it is clear in this comparison at least if we compare worst-case scenarios, the risk is much greater in Ted and Alice not paying off their mortgage. And you might say, well why consider the worst-case scenario, since that is unlikely to happen? But it’s also unlikely that my house will burn down, and I still have homeowner’s insurance. It’s also unlikely that I will die before age 50, but I still have life insurance. And I look at paying off the mortgage as foreclosure insurance. Yes, there is a cost to this insurance, just as with any other insurance. But to me, the cost is worth the reduction in risk.

Thanks for the numbers and example. You say “it seems to me” that the risk of investing in the stock market is higher in this case than in the parallel case with stocks vs. bonds. But, in in order to do that analysis, you would actually have to run the numbers with the guy losing his job in one situation vs. another. While the intuitive answer seems to be that the financial risk is higher in the mortgage situation, when you actually run the numbers through I don’t think it’s true. Of course you would be better off by paying off your mortgage early (or investing in low risk bonds) than in the stock market, when the maket tanks. But, the real question is whether the risk calculus changes whether the alternative is paying off mortgage early or low risk bonds.
I will try to run the numbers to compare, but I am heading out to take my wife out on a date, so that will have to wait.

 

[PaulGH]

Thanks for the numbers and example. You say “it seems to me” that the risk of investing in the stock market is higher in this case than in the parallel case with stocks vs. bonds. But, in in order to do that analysis, you would actually have to run the numbers with the guy losing his job in one situation vs. another. While the intuitive answer seems to be that the financial risk is higher in the mortgage situation, when you actually run the numbers through I don’t think it’s true. Of course you would be better off by paying off your mortgage early (or investing in low risk bonds) than in the stock market, when the maket tanks. But, the real question is whether the risk calculus changes whether the alternative is paying off mortgage early or low risk bonds.
I will try to run the numbers to compare, but I am heading out to take my wife out on a date, so that will have to wait.

I don’t think that investing in low-risk bonds vs. paying off the mortgage is the right comparison, because really in that case we are talking about very little difference, even without considering risk. On the one hand, you stand to make a small percentage from the bonds, and on the other hand, you stand to save a small percentage on the mortgage. The amount of difference hardly seems worth worrying about, even before considering risk.

The advice that I always hear, and that I disagree with, is that people should keep their mortgage and instead invest any extra money in stocks, or in a mix of stocks and bonds.

Also, perhaps you and I are talking about two different kinds of risk analysis here, though I’m not sure. For example, I suspect that a certain kind of mathematical analysis, if followed diligently, would lead to the conclusion that a person is better off cancelling their homeowner’s insurance and investing the money they saved. Because after all, the insurance company is making a profit on your policy, so mathematically speaking, the average person is losing money on the deal.

But I think that sometimes it can be worth paying for insurance against really bad events, even if the really bad event is very unlikely. As Dave Ramsey says, 100% of foreclosures happen on houses with mortgages. So if you don’t have a mortgage, you can’t get foreclosed on. To me, that peace of mind is worth the opportunity cost of some investments not made, that might have gained me several percentage points better return than paying off my mortgage. On the other hand, someone else might prefer to take on the extra risk in order to get the extra return, and that’s fine with me as long as they understand that that is what they are doing.

 

[PaulGH]

Thanks for the thoughtful discussion, Paul! I have appreciated the dialogue and learned from your insightful comments! I would much rather pay to take a financial seminar from you than from Dave Ramsey.

Thank you too, and I apologize for taking up so much of your time with my long-winded posts. I have learned some things from your posts as well, even though we don’t agree on everything. And I’m not sure if preferring me as a financial teacher over Dave Ramsey is much of a compliment, given your low opinion of his advice, but I’ll take it as one anyway, so thanks!

I know you said in another post that you are headed out to dinner. If you want to post more later in response to my latest posts, I promise to read it. But I will also try to let you have the last word, as I need to get some other things done today and over the weekend. Take care.

 

[phillylawyer]

Also, perhaps you and I are talking about two different kinds of risk analysis here, though I’m not sure.

You are right. We are talking about two different things here. No. I am not suggesting that you should not get homeowners insurance, and using a type of analysis to show that it is not necessary (besides, it is legally required).

The comparison I was looking at is not whether to pay off your mortgage or invest in low-yield bonds. Instead, what I was saying is, the decision whether to invest in stocks vs. paying off your mortgage early is the same financial analysis (assuming the same situation) as whether to invest in stocks for low-yield bonds. The reason I was making this point was in response to Dave’s simplistic notion that it is always better (at least once you get to a particular stage of his fixed plan) to pay down your mortgage than invest in stocks.

Assuming the same scenario (including the same net worth), I briefly ran the numbers from the scenario you provided (which was helpful, thanks), which showed that the amount of INCREASED risk by investing in stocks over bonds was the same as the amount of increased rick by investing in stocks over paying off your mortgage early.

This can be shown from two angles. First, assuming that the bond is guaranteed, then the increased risk to capital by investing $50k in stocks is the same whether the alternative is bonds or early payment of mortgage - $50k. This is pretty obvious and not what you were driving out, I think.

The second question, though, which is what I think you were driving at, is by investing in stocks instead of paying off your mortgage early, you have an increased risk of also having your house foreclosed on. Your implication is, then, if the choice is between investing in stocks vs. investing in bonds, choosing stocks in this scenario does not also increase the risk of losing your home, as it does in the first scenario.

However, assuming you have the same net worth and assuming everything else remains the same (including owning a home with a particular value), by investing in stocks instead of bonds, if the value of the stocks plummet, you have the SAME increased risk of losing your house, as in the stock vs. paying off the mortgage early scenario, ASSUMING (which is a key assumption) your net worth remains the same.

How does this work? The key is - your net worth remains the same. In order for your net worth to be the same, in the mortgage vs. stock scenario, you have, for example a $50k mortgage on your house ($100k house) and $70k in liquid assets. In the stock vs. bonds example, you have $0 mortgage on your $100k house, and $20k in liquid assets (so that scenarios really are identical in net worth).

In the mortgage vs. stock example, if the stock value crashes and you lose your job, you will have to use the liquid assets to pay your living expenses and your mortgage, until they run out, in which case you will be foreclosed on. In the stock vs. bond example, you will only have to use the cash to pay your living expenses (since you have no mortgage). But, since you have a smaller amount of cash, you will eventually have to sell your house to pay your bills. And, based on any given amount of living expenses, the increased risk of having to sell your house in either scenario #1 or scenario #2 is the same (by investing in stocks). I have a spreadsheet that I have done on this a couple of times, but I don’t want to make this post even longer, by throwing in lots of numbers.

Anyway, the point of all this is threefold -

1. When deciding whether to invest in stocks or paying off your mortgage early, from a purely mathematical perspective, that decision is exactly identical to deciding whether to invest in stocks or guaranteed bonds (ASSUMING the same net worth and you own real property). In other words, contra Mr. Ramsey, if you have a net worth of $100k, and a $200k property, the decision whether to invest in stocks or pay off your mortgage early (because you are worried about risk and having to sell your house) is identical to whether to invest in stocks or bonds (because of risk of losing your house). Because a mortgage is tied to real property, it makes intuitive sense that there is more risk of losing a house in not paying off a mortgage. But, because you would need to access the equity in the house to pay other living expenses in the stock vs. debt situation, the risk analysis is actually identical.
2. I am not saying you shouldn’t pay off your mortgage instead of investing in stocks. Based on your risk tolerance and your current net worth/liquid assets, that decision very well may make sense. I am just pointing out that, if in a particular situation you should (or wish to based on your risk tolerance) pay off your mortgage instead of investing in stocks, you should make the same decision to invest in low risk assets instead of stocks as well.
3. My real beef with this is not that people would choose to pay down their mortgage instead of investing in stocks. I definitely can understand the benefit (both financial and psychological) of having a mortgage paid off. I am not at all criticizing people who make that choice (as a CPA told a previous poster). Instead, this goes back to my complaint that Dave’s advice (a) is one-size fits all / says that there is one right answer for every situation and (b) is (sometimes) financially illiterate. If Dave is going to get up on his high horse and tell CPA’s that “they can’t add” and are financial idiots, he better not be making basic financial mistakes himself.

 

[phillylawyer]

Thank you too, and I apologize for taking up so much of your time with my long-winded posts. I have learned some things from your posts as well, even though we don’t agree on everything. And I’m not sure if preferring me as a financial teacher over Dave Ramsey is much of a compliment, given your low opinion of his advice, but I’ll take it as one anyway, so thanks!

I know you said in another post that you are headed out to dinner. If you want to post more later in response to my latest posts, I promise to read it. But I will also try to let you have the last word, as I need to get some other things done today and over the weekend. Take care.

No need to apologize. I definitely enjoyed and learned from you posts. If anyone was long winder on this thread, it was certainly me.

Preferring you to Dave is a compliment. As I mentioned, I do like some aspects of what Dave does, and I know he has encouraged a number of my friends to get their financial house in order so to speak. And, since most people on this thread are talking positively about Ramsey, any points of discussion will center around aspects of his presentation I don’t like.

That being said, while I do appreciate some aspects of his program and getting people to think about money and debt, his approach does drive me a little nuts sometimes. I think he can accomplish the same benefit to people without some of the negative aspects of his advice that I have mentioned. But, doing so would require not talking in quite such absolute terms in a couple of areas, and, that may hurt his book sales and business. Perhaps I am being too cynical regarding his motivations.

 

[PaulGH]

I was going to let you have the last word, because I don’t have time to make this discussion much longer. But I really want to mention just a few comments and questions:

The comparison I was looking at is not whether to pay off your mortgage or invest in low-yield bonds. Instead, what I was saying is, the decision whether to invest in stocks vs. paying off your mortgage early is the same financial analysis (assuming the same situation) as whether to invest in stocks for low-yield bonds. The reason I was making this point was in response to Dave’s simplistic notion that it is always better (at least once you get to a particular stage of his fixed plan) to pay down your mortgage than invest in stocks.

OK, I see what you meant now about comparing to low-risk bonds. Where I am not entirely following you is this: If I invest $50,000 in low-risk bonds or in stocks, I am putting at most $50,000 at risk. But if I have a $50,000 mortgage balance on a $100,000 home, then I am putting an asset worth $100,000 at risk. So don’t we have a mismatch in risk here, between the “pay off mortgage” scenario and any investing scenario (whether bonds or stocks)?

Furthermore, the risk of losing the home where you live, where you have made memories with your family, where you have watched your children grow up, which may be the only home your children have ever known, is an intangible good that cannot easily be quantified in a numerical risk analysis. But I think that we do have to take this intangible value of a family’s home into account somehow, and I don’t think that a purely mathematical model is likely to do so.

1. When deciding whether to invest in stocks or paying off your mortgage early, from a purely mathematical perspective, that decision is exactly identical to deciding whether to invest in stocks or guaranteed bonds (ASSUMING the same net worth and you own real property). In other words, contra Mr. Ramsey, if you have a net worth of $100k, and a $200k property, the decision whether to invest in stocks or pay off your mortgage early (because you are worried about risk and having to sell your house) is identical to whether to invest in stocks or bonds (because of risk of losing your house). Because a mortgage is tied to real property, it makes intuitive sense that there is more risk of losing a house in not paying off a mortgage. But, because you would need to access the equity in the house to pay other living expenses in the stock vs. debt situation, the risk analysis is actually identical.

Are you taking into account that in the scenario where you invested in stocks instead of paying off your mortgage, it is possible that the value of your stocks could have decreased dramatically, so that if you have to sell them to pay living expenses (including your mortgage), then you could have a lot less money than you initially invested? (It is also possible that the value of your house could dramatically decrease, but I think that this is less important, because this fact comes into play only if the person or family is going to sell the house.)

You have a good point that in a financial hardship, it could conceivably become necessary for a family to sell their home. However, I am not convinced that this is quite so cut-and-dried. For one thing, in times of hardship, families can cut many expenses. But a mortgage is one expense that is difficult to cut. So without a mortgage, it may be easier for a family to cut their expenses to a manageable level (e.g., to a level that can be paid mostly from unemployment benefits), than it would be with a mortgage – especially if the mortgage is a large percentage of the family’s monthly expenses.

Also, I just don’t hear much about families with a paid-for house that are forced to sell because of a job loss or other financial hardship. Maybe this is because few people have a paid-for house. Or maybe it’s because those who do have one tend also to have substantial emergency savings. But I think it might also be because these families find it easier to figure out some way to keep their house in the event of financial hardship, precisely because they don’t have a mortgage.