This one is long…most likely will be the longest in this series but it’s worth it. This topic cannot be “glossed” over if a paradigm shift in your thinking is to occur. I heard recently,
“Have you probed your paradigm lately?”
Thought that was funny and yet so great of a question. Let’s face it, even the Bible tells us to ensure those who teach the Word are in fact teaching accurately…basically, don’t take anyone’s word for it. We have to stay diligent in our learning or we can simply become dead in our thinking. Or worse yet, a blind follower of that which is not true. Case in point here with Dave’s mortgage advice.
YOU OR THE BANK
In the previous post, we discussed a basic financial truth: you finance EVERYTHING you buy. This happens because you either keep your cash and borrow thus paying interest (finance) or you use your cash to purchase (Dave Ramsey’s method) and thereby lose interest you could have earned on that money going forward (lost opportunity costs – aka a finance expense).
So it begs the following two questions:
- Which of these two situations will cause the least amount of wealth transfer for you personally?
- Which option makes the most money for the bank?
I’ve yet to meet an individual who intentionally desires to transfer large amounts of money away. Also, I do not know one single person who wishes to make financial decisions that benefit the bank the most. Unfortunately, very smart and well-minded individuals do this everyday…and the mortgage is just the tip of the iceberg.
So, will a large down-payment save you more money on your mortgage over time than a small down-payment?
Yes or No?
ROCKY ROAD ICE CREAM and INSULIN
If you said “Yes”…you’re wrong. Remember, it’s NOT my opinion but rather it’s the MATH that proves it wrong. Unfortunately, Dave Ramsey’s advice, compared to that which is mathematically true, is similar to the comparison of Rocky Road Ice Cream and Insulin.
Dave is saying that Rocky Road Ice Cream is the best (Subjective Opinion – you see, I think Mint Chocolate Chip is the best) yet he’s presenting it as an Objective Truth. His teaching on this (make a large down payment to save you money) is only backed up by his personal attitude and feelings. It’s like Dave saying that Rocky Road Ice Cream is medicine to help the diabetic. That’s just false. Insulin is the medicine that helps the diabetic (Objective Truth – doesn’t matter if you like it or not).
When we present our opinion as an objective truth we set ourselves up to be proven wrong…that’s what Dave has done.
Dave can claim all day that the above statement from our quiz is True but it’s not. He’s giving you ice cream to heal your diabetes (your financial plan). We give you Insulin.
So, if something you thought to be true turned out not to be, when would you want to know about it?
If you believe that a large down-payment saves you money then logic would follow that you feel the best down-payment is paying cash in order to pay no interest on a mortgage. So, if “cash” is the best down-payment, then let’s take a look.
EQUITY HAS NO RATE-OF-RETURN
First, you have to understand that equity has no rate-of-return. A down-payment, or paying cash for a home, is like putting money in a tin can and burying it in the back yard. The day you sell the home you get to dig the can up and blow off the dust. Since a home appreciates or depreciates the same if it is financed 100% or is free-and-clear, makes the cost of having our money tied up in the house something we should consider.
As a matter of fact, every dollar you pay to equity actually decreases in value each year due to inflation. If you put $10,000 towards your equity this year that same $10,000 is available to you in the future (assuming of course the bank allowed you access or you sold the home), but, at that future date it has less buying power because of the inflation factor. Yes your home may have appreciated but it would have appreciated anyway whether you put the extra $10,000 towards equity or not. Now, most “wise” mortgage Ramsey followers will say “No, what I pay in principle DOES have a return because I’m paying less in interest.” Not so fast. Keep reading.
$31,693,128…now that’s a MISTAKE Dave!
Recently, some news came out about Dave Ramsey’s new house. I contacted Peter who heads up the blog I read about Ramsey (and just linked to) and I sent him a quick video on the math for Dave’s very own purchase. This video is personalized for Peter but go ahead and take a look of Dave’s HUGE mistake. If you recall earlier, in my first mortgage post…this is where you either start to get a bigger box or you choose to keep following an opinion because it “feels” good.
Banks aren’t in the business to make me “feel good”. They’re in the business to make money from my money…period!
Let’s recap the video:
Dave has $4.9 million to buy his home. He decides to pay cash. What Dave must understand is that it costs him the same amount of money to live in the home whether he finances it or not. How’s that possible? Well, with math…that’s the whole point. Remember, this is Insulin not Rocky Road Ice Cream.
If he could have invested that $4.9 million at 5% he would have a balance of $21,891,947 after 30 years. If he financed $4.9 million at 5% he’d have a monthly payment of $26,304. If that $26,304 is going to the bank and not being invested at 5% then the principle and interest PLUS the lost opportunity costs (not able to invest those payments if they’re going to the mortgage) equal $21,891,947. They are identical.
Now, you Ramsey followers are told, and very foolishly by the way, that if you put your money in a “good growth mutual fund” you can average 8-12%.
Unfortunately, his position here is even wrong because the average rate-of-return means nothing…only the actual rate-of-return is what you should concern yourself with regarding your money. Watch this video of us explaining this very thing.
So, if Dave took his own advice, because he certainly claims that over the “long haul” you can in fact average 8-12% so it would only make sense that he could also, then his $4.9 million could have been invested at these rates. Let’s take the 8% and be nice (keep in mind, you have to take the Expense Ratio and 12b1 fees into this as well so you can typically add another 1 -1.25% on top of this “average”). If he invested the $4.9 at 8% in 30 years his account would be $53,585,075.
Wait, you mean, if he took a mortgage at 5% it would cost him $21,891,947 (far more that what he even claims because he only takes the principle and interest into consideration we add the lost opportunity costs because let’s face it, he’s making a mortgage payment and that payment can’t be saved anymore) and if he took his own investing advice that $4.9 million could become $53,585,075? Yep. Ummm…that’s a $31,693,128 difference! No small change here folks.
If he can’t sell that home in 30 years for $53,585,000 then Dave Ramsey made a minor financial error. But there’s more.
BEGS THE QUESTION DAVE!
A lady on the blog I mentioned above made this comment to me,
“But Kelly you are not taking the risk factor into this. He could lose everything.” (not an exact quote)
She’s right; however, does Dave ever say that statement concerning his recommendations? Does he ever say that if you invest in a “good growth mutual fund” that has a track record of at least five years that you could lose everything? Nope. As a matter of fact, all of his calculations assume that the 10-12% WILL in fact happen (by the way, feel free to send me any mutual fund that you think would make Dave happy and I’ll break down the ACTUAL rate-of-return for you).
Take me up on that last offer!
Even though he believes that it WILL happen, let’s say that he could in fact lose everything (which he can) and chose to NOT take on the risk to ensure he wasn’t under risk of foreclosure if the “Fit-Hit-The-Shan”. Let’s break it down.
As a matter of fact, that’s exactly what he recommends (and wisely too):
“You’ve compared a zero risk investment [free and clear home] with a risk investment [investing in mutual funds] , and you don’t do that.”
He’s right but that does beg the question: Dave, can we take a zero risk investment with a zero risk investment? Maybe we’d want to do that if we could.
What would it look like, assuming he decides to go with his own recommendation here and take no risk, if he chose something that has guarantees at a measly 5%? Remember, this account CANNOT lose so it’s an absolute certainty that the 5% will happen. Well, we’ve already proved earlier that investing the lump sum at 5% and paying a mortgage at 5% would come out the same. So what are we missing?
Any guesses? His tax deduction. You see, this new home of his is a primary residence. Let’s be nice and say he’s at a 35% tax bracket. This changes his GROSS rate of 5% to a NET rate of 3.25% after the tax break. Now, once we consider the mortgage payments at 3.25% that we can’t invest since they’re going to the bank (again, opportunity costs), it’s costing him $12,973,610…no longer the $21 million figure.
His puny, wimpy, guaranteed account earned him $21,891,947 and his mortgage cost him $12,973,610. A difference of $8,918,337! With how much risk? COME ON, with how much risk!?
NONE! It was all guaranteed.
Who had control of the money? HE DID!
What happens if values plummet? THE BANK FREAKS OUT NOT DAVE!
What happens if his income stream completely dries up? HE’S LIQUID!
Dave’s all about emergency funds so what happens in case of emergency? HE HAS THE MONEY NOT THE BANK!
What happens if he comes across an investment opportunity? HE HAS LIQUIDITY AS OPPOSED TO EQUITY!
Here’s two bonus questions:
What if the account where he has this money has no penalties to access?
What if this account can be used later tax-free?
Answer me this: do you think that banks have a faulty model of making money?
I mean that seriously. Do you? Can you literally “look me in the eye” and say that the way banks make money is ineffective?
Of course you can’t. Yet you then discredit the same model when it’s presented on a personal level. Maybe not you…but Dave sure does! You see, in this example Dave did exactly what a bank does:
- He borrowed money with a low cost (3.25%). (He’s all about getting a deal)
- He used his money in a guaranteed and predictable environment (at 5%) to earn a spread. (Remember, he said no risk)
- His mortgage is fixed so it will NEVER go up or cost him more and
- His earnings are FIXED because it’s in a guaranteed environment.
No matter what happens he wins. He created a banking environment for himself because both of these two financial tools were guaranteed to happen.
REMEMBER…YOU’RE A FINANCIAL IDIOT!
You see, I just about exploded when Dave’s right-hand man (I won’t use his name or title because he is an old friend of mine from church), told me (after seeing this math for himself) that “80% of our clients Kelly are financial idiots”. Honestly, that pissed me off…in a big way. I asked him, “Then why are you following his advice?” He had no answer.
You’re not idiots. You’re just being served Rocky Road Ice Cream for your diabetes. It’s time for some Insulin.
Next up, the math behind his bogus advice about 15-year mortgages versus 30-year mortgages. The banks would love for you to choose a 15-year mortgage…that’s the problem!
You don’t want to miss this one.
Kelly O’Connor – email@example.com