A difficult choice?
Let’s talk about debt …
I have an ambivalent relationship with debt: personally, I never had much and now have none. On the other hand, my remaining legacy business — a finance origination company — couldn’t exist without it.
Along the way, I’ve learned that debt is not intrinsically evil and, once you have it, it is neither good nor bad.
Debt is just a financial instrument, one that — once you have it — is simply cheap or expensive.
Debt is a means, not an end ...
That’s why I understand and (mostly) agree with the idea of no consumer debt, but have never understood the pay down all debt movement.
Perhaps, the best-known proponent of the debt-free movement is the personal finance author, radio show host, and guru: Dave Ramsey.
Via Twitter, Dave Ramsey recently said:
Robert Kiyosaki and I are friends. Highly recommend Rich Dad Poor Dad book. We disagree on debt.
Debt, savings, and the like are just tools to help you achieve some personal goal, something like: “I want to be financially free”, which might mean replacing your pre-retirement salary at age 65.
Or, you might want to be “rich” (fancy a Ferrari?).
For me, the ‘financially free’ goal is too little, and the ‘rich’ goal is too much.
My financial goal was: “I want to be (& stay) wealthy”.
I see these three different points of view perhaps as Goldilocks saw Baby Bear’s porridge:
I don’t want my porridge to be too hot ($$$) or too cold ($) but just right ($$).
If you prefer your porridge too hot or too cold, my personal journey will not be relevant to yours.
The case for zero debt
One of the earliest, and best known, personal finance blogs that I follow is Get Rich Slowly.
According to Get Rich Slowly founder, J.D. Roth, Dave Ramsey and his influential book “The Total Money Makeover” changed his life:
“In the fall of 2004, I had over $35,000 in consumer debt. I was making a solid middle-class salary, but I lived paycheck to paycheck. My money habits were terrible. When I looked into the future, all I saw were years of toil to pay for the things I’d already purchased.
“Then a friend loaned me a copy of The Total Money Makeover, a book by some guy I’d never heard of named Dave Ramsey.
“I had nothing to lose — I read the book and then followed his plan. I was amazed to find that I had eliminated most of my smaller debts in just six months. Over the next two and a half years, I paid off the big debts too.”
By following Dave Ramsey’s plan, in less than 3 years JD Roth eliminated all of his non-mortgage debt, and was finally ready to tackle the second-last stage of Dave Ramsey’s The 7 Baby Steps personal finance plan Step 6: Pay off your home mortgage, although he added his own, small twist:
Our February mortgage bill was $1681.79. If I include an extra $267.44 with my payment, I’ll also knock off the next month’s payment from my mortgage.
After discussing the pros and cons, [my partner] Kris and I have agreed to follow a modified version of [discredited personal finance author] Givens’ plan. To make things simple, we’re using round numbers. During 2008, for example, we’re going to pay $2,000 toward our mortgage each month.
Without a mortgage … this would provide tremendous freedom, granting me an opportunity to try things that I might not otherwise be able to do.
It’s important to note that this is not the end … this is not the last step of Dave Ramsey’s master plan: the first 6 steps simply lead you to a debt-free future, so that you can (according to Ramsey) finally begin Step 7: Build Wealth and Give.
Dave Ramsey and I seem to agree on the penultimate goal, it seems we just disagree on the timing.
Let me show you why …
The case for cheap debt
Remember: if you already have it, debt is either cheap or expensive.
If it’s cheap, don’t pay it off … keep to your regular (or, minimum) payments and put your money to better use elsewhere.
Right now (in 2016 USA) money is on sale … and, whenever 30 year fixed mortgage rates are below 5% to 6% money is on sale. This may anger some people, but, if you want to be wealthy, you should safely acquire as much of this cheap money as you can and put it to good use.
… but, only when money (i.e. debt) is cheap.
There’s no doubt that expensive debt … mostly, credit card debt (even auto loans are cheap today, if you have good credit) … is a blight on your finances, and should be retired as fast as you possibly can.
Not so, cheap debt.
But ….
If you will feel psychologically better by having zero debt, and that’s all you care about, there’s no need to read any further. If you religiously follow Dave Ramsey’s Baby Steps, you will still get around to saving ... once your mortgage is paid off.
And, that’s the key question: when should you start investing?
Obviously, if you have already paid off all of your expensive debt, my answer is: today!
Let’s take a look:
When JD Roth took out his mortgage, US mortgage rates were fixed at 6.5%, not so cheap, not so expensive ... somewhere right in the middle.
Not so today, in the USA, where you can get a mortgage, fixed for 30 years, for less than 3.5% (with good credit).
So, let’s put you in JD Roth’s situation — but, in today’s low interest rate environment — and, see what you would do?
For example, at 3.7% (I chose a number slightly higher), you could have bought a $400k house ($50k deposit, excluding closing costs) with a $350k mortgage, fixed for 30 years, leaving you with monthly payments of $1,611 … fairly close to the $1,682 that JD Roth mentioned in his article.
With $300 extra to invest in your mortgage each month (a nice round number, slightly more than the $267 that JD Roth says he freed up over 2.5 years by paying off all of his other debts), you could have paid off your mortgage in 89 months … nearly 7.5 years early.
Whilst it’s useful to know that you could have saved nearly $64k in interest (probably, costing yourself over $15k in tax breaks), it’s more important to know that paying off your mortgage early and keeping up the savings discipline for another 7.5 years could have allowed you to put an extra ~$180k ($1611 + $300 x 12 months x 7.5 years) literally ‘in the bank’.
If so, at the end of 30 years you would have … pretty much risk-free:
- a fully paid-off house (7.5 years early), and
- $180k cash in the bank (at the end of 30 years).
Nice.
But, is there a safe, yet better, alternative?
Proponents of becoming debt free would say there’s nowhere safer to invest than in your own mortgage.
But, let’s look at the stock market for a minute …
These days, you can buy very low cost (i.e. 0.05% fees) index funds that track the entire S&P500 (that’s the top 500 stocks currently trading in the USA).
Far from being something too risky to contemplate, this is the exact low-risk strategy recommended by Warren Buffett for his own heirs:
My advice to the trustee [of my estate] couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.)
But, I wanted to see how risky investing in the S&P500 index would be …
So, I found Shiller’s (the Nobel Prize-winning Yale University Professor of Economics who predicted the 2007 US housing crash) own data for monthly returns from the US stock market (again, the S&P500) both with and without dividends reinvested.
I gave it to an actuary to look at, before finding this handy-dandy online calculator, which makes analysing the data a breeze:
I then paid a Speedlancer $100 to churn the handle on the calculator ~400 times (quite accurately, I might add, after checking a good cross-section of the results); here is the file.
My analysis of Shiller’s data showed that the average 10 year, 20 year, & 30 year returns of the S&P500 ranged from 9.2% to 9.4%
Shiller’s data assumes all dividends are reinvested; without reinvesting dividends returns drop to around 4.5%. Fortunately, most index funds, like Vanguard’s, make reinvesting dividends cheap & easy.
Dave Ramsey in his book The Total Money Makeover says that you can expect a 12% return from the stock market, safely, even over a 10 year period. Shiller’s data clearly says ‘no’.
But, average returns are meaningless, if we don’t also examine the downside (what can we lose?) and upside (what can we gain?):
Firstly, as JD Roth says, the stock market can be risky because it fluctuates, sometimes wildly, year-over-year:
Investing in the stock market provides an average annual return of about 9% — but that return isn’t guaranteed. Some years the market is up 30%, but other years it drops by 40%. When you pay down a credit card, you earn a guaranteed return of 20% (or whatever your interest rate is). That’s tough to beat.
But, that’s not the case here, for three reasons:
- We’re not trying to beat a 20% credit card interest rate (pay those suckers off!), we’re only trying to do better than a low-cost mortgage interest rate (i.e. 3.7%, even up to 5% or 6%), and
- We’re not investing in a few stocks in one year and hoping to cash out the next (that’s gambling, not investing); rather, we’re investing in the entire US stock market (at least, the 500 biggest stocks), and
- We’re investing in the stock market exactly like we would if we were paying down a 30 year mortgage: we’re investing small amounts (e.g. $300), every month, for 30 years. Our returns after doing this consistently over 30 years will be boringly reliable, yet lucrative.
Still, let’s look at the possible upside and downside of long-term investing in the stock market:
Downside: With dividends reinvested, analysing Shiller’s data, there were NO 30 year periods that returned less than 5%. And, there were NO 20 year periods that lost money. Only ONE (out of 126 possible such 20 year periods from 1871 to 2016) returned less than 4% (i.e. 1929–1949 produced only a 2% return).
Upside: Average returns were 9.3%. There were 46 x 20 year periods (and, almost half of all 30 year periods) where returns were greater than 10% (17 of them higher than 14%) .
Note: Shiller’s own data assumed a 1.5% p.a. management fee, much higher than the 0.05% charged by Vanguard and others.
It was high management fees that prompted Buffett to recommend the trustee of his estate steer away from typical mutual funds, such as the ones probably comprising your 401k (& the ones Dave Ramsey says will give you a 12% return), and simply invest via a low-cost index fund:
The trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.
So, let’s take all of this and revisit our plan:
Your hypothetical $350k, 30 year fixed at 3.7% mortgage requires a monthly payment of $1611. We can’t change that … it’s fixed, by the bank.
What we can play with is the extra $300 a month that you had earmarked to fast-track your mortgage …
What would happen if you just let the mortgage run its full 30 year course and made a monthly stock market index fund investment of $300, instead?
For that, I found another handy-dandy calculator on the same site — one that uses the same Shiller dataset:
This one, (plus another $50 to my trusted Speedlancer for another ~100 runs through the calc to produce this file) allowed me to dollar-cost-average $300 a month for 30 years into the US stock market, testing against actual stock market returns (with dividends reinvested) for every 30 year period since 1871.
Here’s what I found:
The approx. $108k total ($300 x 12 months x 30 years) invested in the stock market over 30 years returned $507k, whereas investing the same amount into your mortgage only produced $180k in savings, even after 30 years.
Note: with lower fees (e.g. 0.05% fees for Vanguard) the return from stocks would be even greater. It’s also worth noting that taxes have been paid on the dividends (that, plus the overstated management fees, explain why these average returns are slightly lower than Shiller’s raw data), yet we haven’t factored in the tax benefits of keeping your mortgage longer.
Again, we have to look at both the downside and upside risks:
Downside: Of the 115 x 30 year periods analysed (the oldest ending in 1901, the most recent ending in Sept, 2016), the lowest return was $206,000. There were only 9 periods (from 115) that returned between $206k and $250k. All other 30 year periods returned more than $250k.
Upside: in the same 115 x 30 year periods, the highest return was $1.4 million. There were 24 periods that returned more than $750k. The average return produced $507k.
At the end of 30 years, that’s:
- a 100% chance of at least matching your ‘mortgage paid early’ outcome: a fully paid-off house + at least $180k in the bank
- a 90% chance of: a fully paid-off house + at least $250k
- a 50% outcome of: a fully paid-off house + at least $425k (median)
- a 20% chance of: a fully paid-off house + at least $750k
Remember, the average bank savings was $507k (plus the fully-paid-for house)
Note: rather than this table, I wanted to be able to give you an even simpler statement like “after 30 years, you’ll have both a fully paid off house and $x in the bank, to a 95% confidence level”, but the mathematician that I had asked to look at that exact problem said: “classical statistics cannot be applied to rolling returns. For example confidence intervals, and the like, require all the samples to be independent of each other, which is not the case for rolling returns.” Doesn’t change anything, but useful to know.
So, what’s the catch?
This is the real world … not a calculated simulation … so, what does happen if your health, job, and the economy really do falter all at once?
Well, for the bulk of the first 22.5 years, I don’t see any difference: you still have a mortgage and the bank still expects their $1,611 a month.
In his book, Dave Ramsey suggests you build a 3 to 6 months of expenses emergency fund. That’s probably close to a full year of mortgage payments covered (assuming you find another way to cover your other expenses).
Except that, by investing the $300 monthly into the whole/diversified stock market, as I suggest, you will have quite a sizeable emergency fund accumulated in your Index Fund account (& reasonably accessible) to help you through the rough times e.g.:
Year 10: ~$60k (3 year mortgage payments buffer)
Year 15: ~$120k (6 year buffer)
Year 20: ~$220k (11 year buffer)
Year 25: ~$380k (20 year buffer)
It’s not all beer and skittles
Warning: for periods of less than 10 years, due to short-term volatility in the stock market, it could be that you are financially worse off, but only if you had the worst possible timing and if you suddenly had to liquidate everything.
Here’s one scenario: If you started my plan anytime during 2006 or 2007 and had to suddenly liquidate (e.g. due to that disastrous ‘failing health, job & economy’ scenario) … and, it happened in 2008 , during the worst stock market crash in our lifetimes, you could have lost half your savings (50% of up to $7,200 already invested in the stock market i.e. @ $300 x 24 months) if you had to cash out.
But, if you somehow held on (e.g. dipped into your emergency fund or borrowed from your 401k), just 12 months later you would have almost all of it back, losing little.
What about the mortgage?
Well, in the first 2 to 4 years of your mortgage you’ve only paid down ~$3k of the principal (mortgages are front-end interest loaded); it would make little difference either way.
Here’s another: If you couldn’t hold on financially after, say, 5 years you would still owe the bank ~$345k on a $350k mortgage. But, your emergency fund would have swollen by $18k+.
I’ll remind those who are highly risk-averse that an additional $507,000 buys a lot of piece of mind as you approach retirement.
One more thing
Once the extra payments go into your mortgage, they are committed.
But, on my index fund investment plan you could decide in, say, Year 15 to cash out all or part of the $120k you are most likely to have earned and dump that into your mortgage as an extra payment, then keep going with that extra $300 / month additional mortgage payment.
Nothing is cut and dried in this world but, before you commit to some plan that sees you making one kind of investment (e.g. pay off your inflexible low-cost / low-risk mortgage then save $180k), make sure that you know what you are giving up (e.g. investing in a flexible low-cost / low-risk Index Fund to make an additional $200k to $500k++).
Finally, if your aim really is to eventually build wealth and give (Step 7, the final stage, of Dave Ramsey’s plan), wouldn’t you rather start that part of your journey with your mortgage paid off and a healthy investment account balance?
___________
Much of this discussion focussed on what would happen if we had an extra $300 every month.
Not much of it was aimed at the main game: making sure that you make your (in our example) $1,611 mortgage payment, each and every month, without fail, for up to 30 years.
So, now that you have that extra $300 a month available, let me ask this question:
If you have a 30 year fixed-rate mortgage, and if you could only choose one of these options, which would help you sleep better at night:
- Hoping that you can pay your mortgage off 7.5 years early, or
- Being certain you will be able to make all of your monthly payments?
___________
I’ll add to this article in response to any interesting comments that I receive.
#BP1
