At least at this current time in history, getting a 15-year mortgage or prepaying any 30-year mortgage is foolish. I make this statement with these assumptions:
- You plan to stay in the home for at least 10 years.
- You and your spouse are younger than 50 years old.
- The monthly costs to own your home are less than 30% of your monthly income.
- You have 25% or more equity/downpayment for your home.
- Any difference in savings from prepaying or having a shorter, 15-year mortgage will go into investments.
- The home you purchase is an average–sized, 2,000-square-foot home and not some McMansion.
- You are a disciplined saver and don't carry any consumer debt.
I'm not giving you carte blanche to buy a 5,000-square-foot home. If anything, quite the reverse. I suggest living in a modest home in a good neighborhood. Take the difference and invest in the stock market instead. Any time you refinance and get a lower monthly amount, invest that difference. At current mortgage rates, compared to the average rate of inflation and stock market returns, you'll come out much farther ahead.
There are two opposing camps to the mortgage argument: Ric Edelman and Dave Ramsey.
You will not see me state, like Dave Ramsey, that all debt is the work of the devil. In our current economic environment, I tend to agree with Ric Edelman. Mortgage rates are at historic lows, and affordability is at near all-time lows. In plain English: It's cheaper to own a home than rent in many parts of the country.
Here are the reasons you should get a 30-year fixed mortgage:
1. A home is an illiquid asset
A home is a very illiquid asset. If you are buying a home, it's for the long haul of 10 years or more. Once you make payments into a home, it's much harder to get cash out. Yes, you can refinance or get a HELOC, but only if there is enough equity in the property, and you have a job.
Let's say you lose your job. If you followed the Dave Ramsey route, in many situations, you haven't paid off your mortgage yet, have minimal investments, and should have at least some emergency savings. You would have considerably fewer savings via Dave Ramsey's method than if instead, you followed Ric Edelman. The money within your home will be very hard to tap, and you could wind up foreclosing on your home anyway. This is the exact issue Dave Ramsey is suggesting you avoid by eliminating your debt. This proves my point of cash flow is more important than net worth.
The problem with putting most of your money into your home comes down to asset allocation. As we've found during the housing bubble, too many people had too much equity in their primary residence. Your home should not be a primary part of your net worth. If anything, it should be less than 1/3 of your total net worth. You should have much more liquid assets you can tap into should an emergency arise.
2. Your primary residence is not an investment
Robert Kiyosaki made this statement in his book “Rich Dad, Poor Dad“:
“As we've found out during the real estate bubble, your primary residence is not an asset. Your home is just a place to live. I'll go out on a limb to state it's no different than renting, but with some advantages. Typically, it's recommended to buy a home only if you will live at the same location for five years or more. I suggest an even greater period of 10 years or more. Otherwise, you are usually best to rent instead. Owning a home for 5–7 years is too risky. It's too much equity to have stored in one asset, and it can be difficult to sell when you need to move.”
3. Best to invest instead of a shorter-term mortgage
This is perhaps the biggest fallacy from Dave Ramsey. With current mortgage rates in the sub-4% range, you are at or below the average rate of inflation. Also, over the long haul,
stocks average 8% annually. So in effect, you are using the leverage of a low fixed-rate loan to invest the difference in the stock market.
Let me give you a comparison: Two homeowners, both of which have a mortgage of $300,000 and both live in their home for ten years. Let's not consider inflation for this example.
- Suze Shorterm — Suze gets a 15-year mortgage at 3.25%. Her monthly payment is $2,108.01. After ten years, she will have $116,592.72 left on the mortgage balance or $183,407.28 in equity. She did not invest any money into the stock market but instead used it to shorten the term of her mortgage.
- Ivan Investor — Ivan gets a 30-year fixed mortgage at 3.75%. His monthly payment is $1,389.35. After ten years, he will have $234,334.89 left on the mortgage or $65,665.11 in equity. Ivan took the difference from the 15-year mortgage ($718.66) and invested in the stock market. Assuming an average of 8% per year for those ten years, he will have $131,476.00 in the stock market after ten years.
So, in total, Ivan comes out ahead. In ten years, he will have $197,141.11 in total equity, whereas Suze has $183,407.28. Keep in mind this is after only ten years and gets much more obvious the longer you go out.
Let's assume both lived in their home for 15 years. Ivan comes out even farther ahead, with $357,636.18 of equity and investments versus $300,000 in home equity and no investments that Suze has. Is approximately $57k worth the difference in risk? I think so and would go with stocks instead.
If your mortgage rate were similar to the early 1980s when 8%–10% APR was not uncommon, you would be best to prepay your mortgage. This is because it would be challenging to find fixed-rate investments or stocks that could beat that amount every year. Right now, cheap credit is available, and it is best to use it to your advantage.
4. A mortgage is tax deductible
This assumes you itemize your taxes. We just refinanced our mortgage at 3.75% APR, but the real rate after the tax deduction is much lower. Bankrate.com has a great calculator to get your real mortgage rate after-tax deductions. In our case, our real rate is 2.59%: the higher your tax bracket, the lower your effective mortgage APR. When you live in a high-tax state, it makes even more sense. In our case, it is also “free” money in terms of real dollars when compared to the average 3% rate of inflation.
Also, even in this low-interest-rate environment, it is still possible to beat this rate with fixed-income investments. However, since this is a 30-year time frame, you should be investing (to compare apples to apples) with a 60%/40% asset allocation. Historically, that mixture of stocks/bonds has returned 6% before inflation, or 3% annually after inflation.
If the government removes the tax deduction as some have suggested, the effective rate will go back up to 3.75%. This is still an excellent rate and yet relatively easy to beat by investing.
5. You will always have house payments
One of the more common emotional reasons I hear people want to eliminate a mortgage is getting rid of the monthly nut. They state they want to own their home free and clear! Is that true, though?
The fact of the matter is that even after your mortgage is completely paid for, you always have other expenses: property taxes, insurance, and annual upkeep. So you will always have expenses to pay, and these aren't cheap either. If money was tight, try to stop making property tax payments. Do that, and you can expect to see the taxman at your doorstep. So while it's true the amount paid out each month will decrease once the mortgage is paid off, considering inflation, it will be just a small portion of your monthly expenses. Individuals and businesses, for that matter, get into trouble with a lack of cash flow, not a huge amount of illiquid net worth.
How many readers have parents who paid $30,000 for their home in the early '70s, where their monthly payment was only $220/month? Property taxes, insurance, and upkeep expenses all increased at the rate of inflation. If you have a fixed 30-year mortgage, your payment amount remained the same.
In some cases, these expenses increased much more than the average rate of inflation. For example, where I currently live, Nassau County, NY, I pay almost $10,000 annually for a 2,000-square-foot residence. Let me remind readers that Nassau County is broke, and more than likely will have to raise taxes even higher to meet its budget gap. You can expect taxes to go up nationally, as most municipalities have a shortfall in revenue.
Dave Ramsey makes the assumption you do not have the willpower to invest the difference saved. If you are one of those lost souls, then more than likely, you shouldn't invest. Dave takes it one step further and suggests you pay cash for your home.
“But think how much fun that would be! No mortgage! No payments! If paying cash for a house seems too far out of reach, you can still buy a house if you make wise choices.”
Dave is all about the amount saved in mortgage interest. If we had zero percent inflation every year, Dave would be correct. Unfortunately, with inflation, the mortgage gets cheaper every year in real dollars.
The bottom line
Of course, I make the assumption we will have at least the same rate of inflation we've seen the prior 30 years. Let's say we experience a massive bout of deflation, what then? Doesn't my statement make this a foolish idea? No, not really. You can start making prepayments on your mortgage at any time. My point is once the cash is within your home, it's much harder to take it out. Assuming you have been investing, you could use your investments to prepay or pay off your mortgage at any time. Do keep in mind the Federal Reserve wants inflation at any cost. It's been said they will drop money from helicopters, to generate inflation if they have to.
For me, the only valid reason to completely pay off your mortgage at the current interest rates is that you have retired. Even then, depending upon your investments and net worth, it still might not make sense.
UPDATE: When I first wrote this article five years ago, I believed it made more sense not to prepay your mortgage. Today (September 3, 2018), with rising interest rates and current valuations of the stock market, prepaying some of your mortgages might make sense. Like any financial advice, it's very personal and time-sensitive. What made sense five years ago, might not make sense today in the current financial climate.
