Day 8: Home Sweet Home

This post is part of a series on Dave Ramsey’s Financial Peace University (FPU). The following is my impression of small pieces of the class. For more, I highly recommend taking the class for yourself.

Having covered Baby Steps 4 and 5 simultaneously in his lesson on investing, Dave Ramsey moves on to his bread and butter: real estate and paying off the mortgage early (Baby Step 6). This is where he both made his fortune and stumbled and fell into bankruptcy in his personal life many years ago, so he has plenty of wisdom to share on this topic. As a former real estate agent, Ramsey shares many “tips and tricks” for those purchasing or selling real estate that I won’t go into here – most of it is information you can find online, like making sure you get a home inspection and appraisal.

The One Exception

Ramsey, as anti-debt as he is, is willing to accept buying houses with a mortgage, provided you get a 15 year loan and pay it off early. I think he recognizes that it would take too much time for people to save up and pay cash for a house. They would end up losing decades’ worth of rent while they wait, in essence making two payments each month the whole time (one to the landlord, one to the savings account). He is quick to say that paying cash is by far the better option, but a mortgage can be acceptable. To show why a 15 year mortgage is best, he gives an example of a $225,000 house with a 6% mortgage interest rate. The picture below shows the huge difference between the two types of mortgages.

Mortgage Comparison

Pretty significant. The 15 year mortgage ends up costing about $140,000 less, even though the monthly payment differs by only $550! Based on this, its about 30% cheaper! “Saving interest” is the number one reason people give for paying off debts early. Rightfully so, you do save a lot of interest. The same thing is shown by this graph:

Change in mortgage balance at the end of each year.

Because the 15 year mortgage has a higher payment, the balance of the loan falls much more quickly, ending up at zero after year 15, while the 30 year mortgage still has a balance over $150,000.

Taking a Step Back

A good economist views every situation in terms of opportunity cost. If the 15 year mortgage costs an extra $550 per month, the economist asks: What could that $550 do for you elsewhere? If it could buy you a new iPad, then your 15 year mortgage may be saving you interest, but its costing you an iPad every month (or anything else you could do with the $550). So thinking in terms of “saving interest” is a tunnel-vision view of your finances. You’re not looking at the whole picture.

Let’s say you took that extra $550/month and invested it (since you don’t need a new iPad every month) at Ramsey’s 12% annual return (which is not realistic). Thirty years of investing the extra $550/month results in a final balance of almost $2 million! Meanwhile, the 15 year mortgage guy paid off his house in 15 years and then started throwing the entire amount of his payment into investments for the next 15 years. He ends up with just under $1 million.

When investing the difference in the monthly payment between the two mortgages, the 30 year starts investing right away, while the 15 year only invests after paying off the house.

When investing the difference in the monthly payment between the two mortgages, the 30 year starts investing right away, while the 15 year only invests after paying off the house.

The Expensive 15 Year Mortgage

As I mentioned above, the person with a 15 year mortgage saves about $140,000 in interest over the life of the loan. However, at the end of 30 years, that person also has $1,000,000 less in their investments. How can that be? Since the interest on the mortgage is 6% and the assumed return of the market is 12% (according to Ramsey), you’re saving money at 6%, but losing it at 12% by not investing as much as you could for as long as you can. So in the end, you actually end up with more money if you go with the 30 year mortgage option, which seems counter intuitive. The key is investing the difference between the two payments. If you don’t do that, then the whole thing falls apart.

When viewed holistically, the 15 year mortgage in this example actually costs $800,000 more!

When viewed holistically, the 15 year mortgage in this example actually costs $800,000 more!

Protecting Yourself

Ramsey also mentions in his lesson that “100% of foreclosures happen on houses with mortgages.” If you don’t pay off your mortgage quickly, you run the risk of losing your income and therefore your house. While this is true, it is, again, not the whole story. Since the 30 year mortgage is accruing money through investments, you would always have more cash on hand than the one with a 15 year mortgage, meaning you could pay the monthly payments for quite some time before going into default. In this way, the 30 year mortgage is surprisingly safer than the 15 because it doesn’t deplete your cash as much as you try to make the monthly payments.

See For Yourself

Don’t believe me? I understand. It doesn’t seem to make sense on the surface and doesn’t “feel” right. It’s counter intuitive, but true. Click the link below to open the excel spreadsheet I used. Play around with the numbers. Change the mortgage amount, rate, and investment rate and see how it affects the graphs. I tried all kinds of (realistic) numbers and the 30 year mortgage option always comes out on top.

Mortgage Comparison

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One thought on “Day 8: Home Sweet Home

  1. Pingback: Day 9: Finishing Strong | Numbers And Sense

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