I found this article thanks to a helpful email from a Dave Ramsey fan hell-bent on making a great discussion of mortgage debt. I guess you know now why I decided to post a new disclaimer last week.
I figure I should discuss the topic publicly, since the information is incredibly off the mark.
ChristianPF, a personal finance blog with 1,000,000 times more reach than me, posted an article that says:
“Starting to pay off principal at any point during the term of the mortgage loan will help save you money, but start early on to make the most difference – the first half of the payments go toward interest. After the halfway point, the majority of your monthly payment goes to the principal.”
This makes zero practical sense. I say practical sense, because it is true if your only goal is to save money on a mortgage.
It is true is that the first few years of a mortgage payment are mostly interest because the first few years of payments will pay off the tail end of your mortgage debt. A mortgage is an amortizing loan.
To say that paying more than the minimum payment on your mortgage earlier and not later nets a bigger positive return is true in much the same way that a 5% return compounded for 20 years creates a bigger return than a 5% return compounded for 10 years.
Of course, in looking at this in absolute terms, a 5% return for 10 years provides more interest than a 5% return for 20 years. Five percent APY compounded monthly for 10 years works out to be 64.70%. The same return, compounded for 20 years, works out to be 171.26%.
If the finance world accepted similar thinking, the yield curve wouldn’t offer higher yields to longer term debt. Instead, longer dates would have lower rates. A 4% rate compounded for 30 years is far more than 100% compounded for one year. You should know that this isn’t how the yield curve works. It works in an opposite fashion, with longer terms naturally having higher rates of interest.
The article also makes some other faulty generalizations about paying off a mortgage that ignore the benefits of capital structure—namely, the tax benefits of debt. The article continues by saying:
Another argument against is that the extra money could be put into investments – but you’d have to make at least the same percentage return as your interest just to break even. Right now, that means playing the stock market or putting money into less-risky savings vehicles, such as CDs, which are barely paying 2% in some places. But don’t forget, these investments are taxable. Your mortgage interest can be used to reduce your tax burden.
Most anyone can find faults here:
- The tax benefits of debt allow you to generate lower rates on your borrowed cash than you would receive in paying back your mortgage early. You do not need to make the same percentage return.
- Comparing 30 year mortgages to 5-year retail CDs isn’t a very fair comparison. More importantly, homes are not a risk-free investment, and neither is mortgage debt. Bankruptcy/lending laws protect your retirement, but not the whole of your home.
- The mention of mortgage interest is contradictory. The author is saying that mortgage interest reduces your tax burden, but investment income increases your tax burden. Simple mathematics tells us that reducing a 15%+ tax burden (income) and increasing a 15% tax burden (investment income) by neglecting mortgage prepayments and investing the available cash is a net positive for our net worth. This is bad math right out of the Dave Ramsey playbook. See page 187 of Total Money Makeover where he says CPAs can’t do math.
I can make this really simple. Effectively, what Dave Ramsey and the author are saying is that a grocery store should stop buying 24-packs of Coca-Cola since they rack up a $4.00 charge from the distributor for each case. That sounds fine and dandy, until you realize they receive $5.00 in revenue for each sale. If we focus on the $4.00 loss, this sounds like a pretty miserable deal. If we look at both sides of the transaction, we see that the grocery store makes $1. Dave Ramsey wants to capitalize on this way of thinking with his new book Entreleadership!
I’ll try my hardest to stick with the one point I want to hit: paying more on your mortgage early will net you a higher return in the context of paying off a mortgage, but not in the context of improving your net worth, which is the only real objective. If growing our wealth isn’t an objective, then I’m fine with assuming that the only perennially-available investment opportunity is our own debt. There is no shortage of financial commentators who have, directly or indirectly, come to similar conclusions.
Cynical and simple as it might be, this point is very important: prepayments will always earn you the interest rate you pay on the loan for the length of the loan term remaining. Making X% for 20 years is only better than making X% for 10 years if there are no opportunities to make X% in any other investment vehicle.