Ramsey’s Step 6: Pay Off the Mortgage

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.]

Dave Ramsey, Gurus, Housing | Frank Curmudgeon | April 22, 2009 2:12 pm

15 Comments

By Rob Bennett, April 22, 2009 @ 2:40 pm

I applaud you for writing this series, Frank.

I have nothing against Dave Ramsey. I don’t know enough about him to have a strong personal take. But lots of people I respect like him a lot. That just makes it that much more important that someone check into what he is saying and let people know the other side of the story. I think you’ve done a good job in the two Ramsey articles of yours that I have read.

The idea that people should have been expecting to get a 12 percent return on their stock investments when we were at the prices we were at until recently makes me sick.

I paid off my mortgage a long time ago and I think it was a good move. But I don’t think it’s a good idea to use phony arguments to make the case. And there are indeed circumstances in which it makes sense not to pay off the mortgage.

It took guts to write this. And I don’t see anything unfair in what you wrote. I think you made a strong and balanced case.

Rob
By dawn, April 22, 2009 @ 2:58 pm

i’m quite sure that when dave ramsey wrote his book, it was pre-recession. So it’s not fair to attack him on expected investment returns with the benefit of 20/20 hindsight.

That being said, i wouldn’t count of 12% returns even in a bull market. I believe Ibbotson long-range average annual returns since 1926 are at about 10%?
By devil, April 22, 2009 @ 3:15 pm

I paid off my mortgage last month. It was the right move for me, as it was fixed at six percent. Also, my husband plans to retire in six years and we don’t want any debt of any kind hanging over us.

Your point is well-taken. Everyone’s situation is different and a one-size-fits-all mentality is too stifling. Each person needs to crunch their own numbers.

I like Dave Ramsey’s simple approach, though. He’s reaching people who get very intimidated by personal finance issues. They need some very, very basic guidelines and he provides them. I can’t think of anyone who would actually be harmed by having a paid-off home, so it’s generally good advice.
By Rob Bennett, April 22, 2009 @ 3:26 pm

I believe Ibbotson long-range average annual returns since 1926 are at about 10%?

The average long-term return is 6.5 percent real. When we are at the sorts of valuation levels that applied from 1995 through the first part of 2008, the likely return is much less than that. At the height of the bubble in 2000, the most likely annualized 10-year return was a negative 1 percent real.

To get to 12 percent, you would need to engage in three bits of “spin”

1) Ignore the effect of valuations. That brings you up to 6.5 percent real, the average long-term return;

2) Ignore inflation. That brings you up to perhaps 10 percent.

3) Use only recent returns (those from the wild bull years) rather than the full historical record as your guide. For example, you might compute the average return only from 1980 forward. That might bring you up to 12 percent.

Ain’t spin wonderful?

Rob
By Mr. ToughMoneyLove, April 22, 2009 @ 3:58 pm

Ramsey is a simplifier (and maybe a simpleton) and skips the steps that you explained. But I think you skipped one (and maybe two) as well. The tax benefit from mortgage interest applies only to the extent that your deductions exceed the standard deduction. To simplify using your example, if I am married and my only deduction in 2009 is the $14,850 mortgage interest, only the last $3450 of it is actually helping me because I can deduct $11,400 without having a mortgage. The other factor to consider in tax planning is that a paid-for house can provide you thousands in phantom income (shelter services) that is tax free. If you are living off investments or other income you can control, your need for income to pay for shelter diminishes, perhaps saving you much more in taxes than the interest deduction provides. That can really help if your Social Security is being taxed or if you are living off withdrawals from non-Roth retirement accounts. As you say, the issue is more complex than most folks believe or understand.
By Rick Francis, April 22, 2009 @ 4:19 pm

I’ve never agreed with Dave Ramsey’s rabid anti-debt philosophy. I thought your bond example was a pretty good argument for not prepaying a low interest rate mortgage.

A 10% compound annual growth rate is a more reasonable average for a 30 year investment but I would do a calculation with an 8% CAGR as a worst case since we don’t really know what the future holds.

-Rick Francis
By Mark Wolfinger, April 22, 2009 @ 8:00 pm

To me, there’s only one good reason for paying off a low-interest mortgage – and that’s the peace of mind it brings to some people.

Those of us who understand how money works recognize the economic foolishness, but when emotions get in the way, logic is set aside.
By LHM, April 23, 2009 @ 3:09 pm

This is one site where the comments are ALMOST as useful as the blog article. Rob Bennet and Frank C on the same page is almost as good as it gets.

I also have paid off my mortage this year. With a mortgage too low to benefit from the tax savings, the 6% risk free ROI seemed the prudent thing to do a few years before retirement. I paid off the last third of the loan with 0% balance transfer money which I will roll over until the offers dry up or I get bored messing with it and then pay it off with the money I saved in the meantime.

I like Mr.ToughMoneyLove’s shelter income concept as well, and now until retirement I can save the amount that was going to the mortgage allowing me to put off tapping into retirement money that has lost significant value hoping it will eventually recover.
By GPR, April 23, 2009 @ 3:41 pm

Of the people buying Ramsey’s book, how many do you suppose can pay off their mortgage? Or the other way round: of those people who have managed to have ~300,000 in movable investments, what percentage still feels the need to buy mainstream financial advice books?
By Frank Curmudgeon, April 23, 2009 @ 4:36 pm

Dawn: Rob Bennett’s estimations of expected returns based on current valuations aside, 12% was never a sober estimate. If Ramsey got caught up in the exuberance of 2003 (when Total Money Makeover was published) then so much the worse for him.

Mr. ToughMoneyLove: I agree that the untaxed imputed rent effect that you speak of is an important reason to own a house rather than rent it, but it doesn’t have much to do with whether or not you have a mortgage. You get to live in the place either way without paying taxes on the rent you are not paying. And sorry if I did not make clear that some people don’t get much of a tax benefit from mortgage interest, often for arbitrary reasons such as the one you give.

LHM: I think the comments are nearly the best part of this blog too. (Although I do wish more people would participate. Don’t be shy, people.) And I’m really happy that Rob Bennett contributes so much. Even though I often disagree with him, I know a fellow iconoclast when I see one.

GPR: Ramsey claims to have 3.5 – 4 million daily listeners, so there must be a few who really are in the position to pay off the mortgage rather than invest. Still, you make a good point. I was surprised how little material there was on his website on mortgages and step 6, relative to what is there on other debt and step 2.
By frugal in Europe, April 27, 2009 @ 10:42 am

“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.”

The thing I do not like about these type of calculations is that they assume that you have the 300,000 sitting around to either pay of the mortgage or invest. That is just not the case for most people.

It would be much more interesting to see a calculation that answers the following question. I pay 10,206 in interest each year and save 30,000 dollar a year for 30 years. Would it make sense for me to first pay of my mortgage and then save 40,206 a year after 10 years; or would it make sense to save 30,000 a year for 30 years and then pay of the mortgage?

In scenario 1 you can save 10,206 dollar more for 20 years (avoided interest payments). In scenario 2 you save a lot of money in the end but then need to subtract the costs (is 300,000 for the house plus 306180 in paid interest).

Of course the results diver given the expected interest you get on your savings. However, I ran these numbers for our household (mortgage interest = 4% and savings returns 5% and a 10% deduction in the principal on the mortgage annually) and scenario 1 outperforms number 2 (we don’t live in the US).
By tom, February 25, 2010 @ 9:25 am

I came across this while trying to decide what to do myself. But if everyone followed Dave’s advice we would not be in this financial mess!
By Voting_Libertarian_in2010, February 28, 2010 @ 4:34 am

“…meaning that your payments to the bank are (usually) subsidized by the government.” What? How are they subsidizing what was MY money in the first place! We are taxed at every corner of our lives (something our Founding Fathers gave their lives to prevent) and then the media and pundits such as yourself come out to numb our senses by telling us that the government is somehow doing us this great favor. We need to end capital gains and this incredibly horrible tax system that forces us to waste time trying to decide where to “hide” our money. Congratulations America, we are rapidly losing our “Economic Freedom”:
http://online.wsj.com/article/SB10001424052748704541004575011684172064228.html
By Craig, March 4, 2010 @ 12:15 am

I have decided to pay off my 5.25% 30 year fixed mortgage in year 5. I’m already maxing out my 401k, HSA, 529 contributions. While I could invest the money, I can’t bear the thought that sometime in years to come, I find that either I spend or lose part of the money and end up not having the funds to pay off the house. It only takes spending 10% of the invested funds to make your whole argument about investing instead of paying off go bad wrong.
By Mike, March 13, 2010 @ 12:26 am

One other factor that one *might* want to consider: if you buy into the thesis of US dollar inflation spiraling out of control in the next few years, then paying off the mortgage early wouldn’t necessarily be the right course. Look back to the 1970s- early 1980s: even if wage increases lagged behind inflation, they still made the mortgage payments on a 30-year mortgage taken out in, say, 1975, become increasingly tiny over time. Meanwhile, despite the rough going in the stock market before 1982, if you had bought blue chip shares (say, Coca Cola and McDonalds and IBM) then the dividend increases did, over time, keep up with inflation. Which would you rather have in 1988: a paid-off house and finally the ability to *start* investing; or an ongoing mortgage payment whose monthly amount now seemed really tiny compared to your salary, even as the stocks you had bought during the horrible bear market were steadily increasing their dividends?

So it really does depend on your thesis about whether inflation is approaching. If it is, then you don’t need a great stock market in order to make holding on to your mortgage a good idea; you would only need to own companies capable of raising their product prices and dividends at the rate of inflation.