I’m not against paying off mortgages. I’m not particularly in favor of it either, any more than I have a general opposition to, or support of, latex paint or front wheel drive.
Dave Ramsey is most certainly in favor of paying off your mortgage. Granted, he does consider it a special category of debt, setting it aside to be dealt with in Step 6 rather than in Step 2 with the ordinary stuff. But it’s still debt, and Ramsey takes no prisoners in his fight against that evil scourge.
Arguing against this is a little difficult because there are certainly cases and situations where paying off a mortgage is indeed the best course of action, and it is hard not to fall into the trap of framing the discussion as always vs. never rather than always vs. sometimes.
The main reason why a person might not want to pay off his mortgage, even if he had the cash, is that mortgage money is cheap. Particularly on an after-tax basis, mortgage financing can carry such a low interest rate that it makes sense to invest the money elsewhere instead of paying off the debt.
A big reason why mortgages are so cheap is that mortgage interest on your primary residence is tax deductible, meaning that your payments to the bank are (usually) subsidized by the government. The degree by which it is subsidized, that is, the degree to which mortgage interest reduces your taxes, varies a lot from person to person and in ways that do not always make sense. Such is life in America. But for many people, this subsidy is significant, the equivalent of a fourth or a third off the interest rate.
Ramsey mocks this facet of mortgages and implies that people who believe that the deduction is a worthwhile thing are confused and can’t do math. From Total Money Makeover, discussing a person with a mortgage that has $10,000 in annual interest payments:
This situation is one more opportunity to discover if your CPA can add. If you do not have a $10,000 tax deduction and you are in a 30 percent bracket, you will have to pay $3,000 in taxes on that $10,000. According to the myth, we should send $10,000 in interest to the bank so we don’t have to send $3,000 in taxes to the IRS. Personally, I think I will live debt-free and not make a $10,000 trade for $3,000. However, any of you who want $3,000 of your taxes paid, just e-mail me and I will personally pay $3,000 of your taxes as soon as your check for $10,000 clears into my bank account. I can add. [Page 187]
Ha ha ha. That’s pretty funny. But I think it is fairly obvious that the choice is not between paying the bank $10,000 or not getting a $3,000 tax reduction. The choice is between paying the bank a whole pile of money to discharge the loan or paying them $10,000 a year, $3,000 of which is returned to you by the government. In fact, I think this is obvious to Ramsey too, much as he tries to persuade his readers not to think about it too clearly.
Right after the quote above, Ramsey addresses the reasonable idea, which he calls a “myth”, that a person might be better off not paying off a mortgage at a low interest rate and investing the money in something that paid better. It is here that a thoughtful observer realizes that Ramsey has dug himself a bit of a hole with his own myth-making. Ramsey, you will recall, tells his readers and listeners to expect 12% from their stock market investments. If that were so, why would you pay off a mortgage costing only half that? Well, you probably wouldn’t, but Ramsey is not about to admit that 12% is an unrealistic number meant to build enthusiasm for saving and investing.
Instead, he obfuscates further. He uses as an example borrowing $100,000 at 8%, a pretty high rate for a mortgage, and investing it at 12%. He does concede that you would make $4,000 on the deal. But not so fast, he tells us. You will have to pay taxes on the $12,000 you made from the investment, leaving you with only $9,600, for a profit of just $1,600. Perhaps absent-mindedly, he has forgotten that the $8,000 is tax deductible and, at the 30% marginal rate he uses in the example, costs only $5,600 on an after-tax basis, leaving you with a profit of, let’s see, oh, $4,000.
Then he goes on to use the more legitimate objection to the mortgage-and-invest strategy that the investment side is risky. But he has to tread very lightly, having previously downplayed those risks. So instead of putting it into his usual easily understood vernacular, he says that to take into account the riskiness of investing “we must mathematically factor in a reduction in return if we are sophisticated investors.” [Page 189] And how do we do that? Ramsey doesn’t say. Apparently, it is really hard stuff that you shouldn’t worry yourself about. “Graduate-level financial people are taught mathematical formulas to make risky investments compare apples to apples with safer investments after adjustment for risk.”
Then he sums up that “The bottom line is that after adjusting for taxes and risk you don’t make money on our little formula.” Except that he screws up the tax adjustment and leaves the details of the risk adjustment a mystery.
I’ve actually taken those graduate-level courses, and understand adjusting for risk as well as anybody. And although there is clearly a world of difference between a 12% that is guaranteed and a 12% that is an expected stock market return, if a person really believed that the stock market would return 12% and could get a mortgage at 5%, it would be hard to make any sort of adjustment that would keep that deal from looking profitable in the long run.
Again, I am only arguing that sometimes you should not pay your mortgage off if you have the money, not that you should never pay it off. It’s easy to imagine a plausible scenario in which Ramsey’s little formula is compellingly profitable.
Suppose a person has a $300,000 mortgage, is in the 30% tax bracket, and lives here in Massachusetts. He can refinance into a 30 year fixed at the current average rate of 4.86%. That’s $14,580 a year in interest, $10,206 after taxes. Being risk averse, he could then take the $300,000 he’s not using to pay off the mortgage and loan it to the Commonwealth of Massachusetts in the form of a long-term municipal bond. There’s one for sale today that runs until 2038 and will yield 4.60% tax-free, or $13,800 a year after taxes, for an annual profit of $3,594. Sure, a loan to the Commonwealth is not risk free, but it’s pretty close, and a reasonable person might think the extra $300 a month for 29 years was worth it.
[Read the last post in this series: Step 7.]