I made the statement on a previous post that if you think proper mortgage planning is primarily about the amount of interest you pay (i.e. Dave Ramsey) then **you’re hugely mistaken**. So what else is there?

Please read Ramsey’s link above. It is important to understand this type of conventional thinking. It’s a wonderful mis-direction that ironically benefits the bank the most.

So, let’s look at it from the bank’s perspective: remember, they do NOT have your best interests at heart but instead their priority is to make a profit for their shareholders. So, get ready for the “bigger box” here folks. This is data that you must understand in order to properly address the answer to the question: “Which mortgage strategy produces the least amount of wealth transfer (a video link) for me personally?”

**30 Year vs. 15 Year**

This one is fun. The old 30 year vs. the 15 year mortgage.

So let’s start with a couple of questions. You’ve heard this one already: do the banks have your best interests at heart? If you answered that “no” (which you should have) then have you ever thought about why the bank offers you a lower rate on a 15 year mortgage than a 30 year? Please don’t just skim over that question.

If they [banks] are in the business of collecting interest then why would they possibly provide an incentive to a borrower in order to bring in LESS interest? This is the key component to Dave Ramsey’s advice (go 15 year because of the interest savings). So please answer me that previous question. Here it is again: Why would they **give you an incentive** to pay them LESS?

First, if you haven’t read our “Defining Moments” blog posts then please do because the first one plays a major role in this discussion. We’ve even recorded some videos on this – watch this one: Banks and the Velocity of Money.

You see, Defining Moment #1 states that your money will never be worth more than it is today…due to inflation.

So, your money will never have as much buying power as it does today, and banks need money to move and recycle (preferably at a high value), and they offer a lower rate for you on a 15 year, and they advise you to pay it off by **accelerating your principle payments**. Interesting.

Would you believe that banks make far more money on a 15 year mortgage than a 30? They either collect interest for 30 years or they get your most valuable dollars sooner and spin that money out again and again about 5 to 7 times…note the discounted rate.

**Math Behind Defining Moment #1**

Let’s simplify this a little and use Dave Ramsey’s example from his link above. If this month was your first payment on a new 30 year loan at 6% and your payment is $1,349, how much is that $1,349 worth when you make the last payment at month 360 assuming an inflation rate of 3.5%?

Only $481. How much is that $1,349 worth at month 180 (end of year 15) assuming the same inflation rate of 3.5%?

$805…over **65% more valuable** than the last payment at month 360. You see, because of inflation, our fixed monthly payment slowly loses buying power. Which do you think the bank would rather have?

- Your money stretched out over 30 years where the value and buying power of that fixed payment continues to decline as it comes back in to their coffers to re-lend? Or,
- Your money condensed over a shorter period where the money retains as
**much buying power**as possible for them to use again and again and again?

Hmm. Seems pretty simple to me once you apply some math and the first Defining Moment. But there’s even more. Folks, this is where the real math gets good. I will provide links to spreadsheets, past blogs and even video to back up every calculation in this post so please check’em. I always say that math proves Mr. Ramsey wrong and I’ll prove it to you so stay with me because this could be a little long…if anything, I ask you to challenge me. Actually, challenge yourself.

**Life Happens**

Okay, first a quick comment to Ramsey’s human behavior issue. In the link above, his first argument against the 30 year mortgage is the claim that “life happens”. He says:

“You might decide to keep that extra payment and take a vacation. Or maybe it’s time to upgrade your kitchen. What about a new wardrobe? Whatever it is, you’ll find an excuse to spend that money somewhere else.”

First of all, if you don’t have discipline then you are **not a candidate for any financial plan** except a plan of failure. Maybe this is why one of Dave’s top executives told me over the phone that 80% of you are financial idiots. Here’s my issue, why wouldn’t Dave make the same claim about those who take a 15 mortgage and pay it off; after all, these people have to then make every equivalent “mortgage payment” to their savings for another 180 months (15 years). Won’t this same “life” happen to them? Won’t they decide to take a vacation or get a new wardrobe? Ask any sociologist and they will tell you that you have to apply the same conditions and outside forces in your test in order to get an accurate result. The “life happens” issue is therefore a non-issue because it applies to both parties.

**JACK and JILL**

With that being said, here are the conditions: JACK has a 30 year mortgage, $225,000 loan amount, interest rate of 6% and a monthly payment of $1,348.99. JILL who has a 15 year mortgage, $225,000 loan amount, interest rate of 6% and a monthly payment of $1,898.68. Again, these are Dave’s numbers from above.

The monthly payment difference between the two is $549.69. JACK invests the $549.69 each month beginning Month 1 until Month 360 in an account that earns 6% and JILL invests the entire $1,898.68 beginning Month 181 thru 360 (had to pay her mortgage off first) in the same account that earns 6%. Who’s ahead at the end of 30 years?

Ramsey would make you believe that JILL is better off because she paid less interest and had more to invest. The answer:** they are identical** at Month 360. JACK would have his home paid off and an investment account balance of $552,171. JILL would have her home paid off and an investment account balance of $552,171.

They are the exact same but who is in a better position along the way to ward off “when life happens”? JACK. All of JILL’s money is tied up in her house. “But JILL has an emergency fund.” So does JACK and his is much bigger. Let’s go deeper.

What happens if they could earn 8% in the investment account (also known as a ‘side fund’)? Well, JACK would now pull ahead. His account would total $819,234 at the end of year 30 and JILL would have $657,015. That’s interesting. As the side fund begins to achieve a higher rate of return than the mortgage then JACK begins to win big.

**Average vs. Actual Rate of Return**

Now Dave Ramsey tells his followers that they can expect a 10% average rate of return (**Average ROR is garbage** by the way and you must educate yourself on this and understand the Actual ROR).

So what happens if JACK and JILL both get a 10% rate of return? JACK ends up with $1,242,566 and JILL has $786,946. That’s a difference of $455,620! Wait, I thought we should be focused on what the bank makes on our 30 year loan? Unbelievably unwise! Let’s go even deeper.

You might be saying, “But Kelly, in all reality, I can get a lower rate on my 15 year loan so your math is wrong. “ First, that was Dave’s math since we used his example but let’s look at it using a lower rate. Let’s use rates as of today (January 24, 2011) according to Yahoo Finance. A 30 year mortgage is averaging 4.82% and a 15 year is averaging 4.09%. **Perfect.** Now that is a serious discount provided by the bank that does not have our best interest at heart.

**Seriously? That Can’t Be Right.
**

Using these real market rates, what rate of return does JACK need to get between Month 1 and Month 180 (remember, he’s saving the monthly payment difference) in order to have enough in his side fund to write the check if he wanted to payoff his 30 year mortgage at the end of the 15^{th} year? Take a guess. Come on, don’t read further, **take a guess!**

After 15 years, a side fund rate of return of 4.47% net after tax will provide an account balance of $151,413. The loan balance on JACK’s 30 year mortgage after 15 years will also be $151,413. These results are for a tax bracket of 31%. That doesn’t sound too risky to me…only 4.47%.

Now I know what most people say, “You should never put this money at risk because what if you lost it all? What if the market tanked?”

They’re right! What? Yep, **you should not play this game** in a risk-based environment because you could lose it all and be stuck with a mortgage that you couldn’t afford if your savings was depleted. This has happened and many people have lost their home. I know Dave likes to say, “Only homes with mortgages go into foreclosure.” So, how can we combat this point?

Here’s the kicker, what if you could get the 4.47% in aguaranteed and predictableside fund?Meaning you COULD NOT lose your money.No risk. Would that make any sense for you?Of course it would and it exists today.

Here’s a better question: assuming the side fund actually gets a return of 8%, when will its balance be adequate to pay off the 30 year mortgage? If we only need 4.47% then an 8% return should be much better. It is.

**JACK Wins!**

If the side fund returns 8% net after tax it will be larger than the 30 year mortgage balance in 13 years and 3 months (a total of 159 months).

What about the tax savings? JACK continued to save until Month 360 for a total of $62,297 and JILL stopped receiving her tax benefits after Month 180 giving her a total of $23,685. If you read enough of my blog you know it doesn’t end there. You see, a penny saved is not only a penny earned** but also a penny that CAN earn**. JACK’s $62,297 (that he did not have to pay to the IRS) over the 30 years at 8%, earned his portfolio an additional $327,557.85. JILL’s tax savings over 30 years (remember it stopped after year 15) earned her an additional $176,537.96.

Taxes are the largest wealth transfer anyone faces and the second is mortgages. Now, I’m confident that you, the reader, do all you can do to **minimize your taxes**. I’ve yet to meet someone who pays a tax they don’t have to pay. I’m sure you’ve even hired a professional to help you pay as little as possible in taxes. It’s time you took a look at the second largest transfer of wealth – your mortgage. It can literally mean hundreds of thousands of dollars to your family…or, you can keep allowing the bank to win. If what you knew to be true turned out not to be, when would you want to know about it?

Math proves every time that JACK can pay off his mortgage quicker with a 30 year mortgage than a 15 year using the exact same monthly outflow as JILL. It also proves that even in a guaranteed and predictable environment he comes out ahead. You see, you can accomplish this with no risk.

Malcolm Forbes very wisely said, “The dumbest people I know are those who know it all.” Don’t be that person, it’s not worth it.

I’d like to end with this great bit of wisdom from my buddy Dave Ramsey:

“If you think you’re getting a better deal with a 30-year mortgage simply because you save a few hundred bucks each month, thenyou’re only thinking short-term.”

Seriously? Short term? Unbelievable. Since when is 15 and 30 year time frames “short-term”?

My clients, friends and family learn the truth and are ahead of the game year after year.

I’d value your comments and challenges to the math. More importantly, I just hope you decide to challenge your own thinking and be willing to look at your own situation. After all, it’s only your financial future you’re dealing with here.

We call this **Financial Caffeine** because *you* get An Edge On Education.

Kelly O’Connor – kelly.oconnor@mtnfinancial.com

303.578.9708

You’re a freaking moron.

Me paying more interest SURE AS HELL DOESN’T HELP ME.

Go to hell asshole.

That’s just about the funniest comment I’ve read. You’re more than welcome to be a pawn for the banks, I won’t be. What’s great for me is I have math on my side you just have insults and cuss words. Congratulations.

Good points worth considering. I have two comments:

1. I couldn’t find where you would invest in something with guaranteed 5% or higher return.

2. Aren’t you making a straw man out of average ROR? Compounded Annual Growth Rate= CAGR = [(ending value/starting value)]^(1/years) -1 is a standard formula reported by all the mutual funds. No serious company reports average annual return = sum of % returns/(years).

I learned Final = Initial*(1+decimal interest rate)^(years) when I was in junior high school.

I do not feel we created a Straw Man, we just kept it simple. Things get ugly when the CAGR is used to promote investment results without incorporating the risk factor. Mutual fund companies emphasize their CAGRs from different time periods in order to get you to invest in their funds, but they rarely incorporate a risk adjustment. It is also important to read the fine print in order to know what time period is being used. Ads can tout a fund’s 20% CAGR in bold type, but the time period used may be from the peak of the last bubble, which has no bearing on the most recent performance.

The CAGR is a good and valuable tool to evaluate investment options, but it does not tell the whole story. Investors can analyze investment alternatives by comparing their CAGRs from identical time periods. Investors, however, also need to evaluate the relative investment risk. This requires the use of another measure such as standard deviation.

I will never trust the CAGR that is used on any prospectus or statement…in the end, it means nothing since it only deals with the past. The ONLY thing that matters is my balance and that is what we very simply call the Actual Rate of Return. The best way to win is to know the future and that can only happen with use and control of your money to leverage in a guaranteed environment. It’s like only using your rear view mirror on a road-trip…you’re gonna crash. You have to learn to get through it by looking forward through the front window. That’s what we teach our clients and it changes everything for generations to come.

Kelly O’Connor

I think I wasn’t clear.

1. I was responding to your link to the youtube with two men saying that if the performance for two years was 100% and then -60%, some mutual funds could report the average rate of return = (100-60)/2 = +20%. I called this formula, not CAGR, a “straw man” because I’ve never seen any mutual fund say this. Then I gave VG and Fidelity as examples, and said that most mutual funds used CAGR, which = -10.6%.

2. I agree with you that some measure of risk, such as standard deviation, or beta, should be used with CAGR.

3. I agree with you, perhaps more than you do, that past performance on mutual funds is irrelevant. Most mutual funds are glorified indexes. I invest only in ETFs by myself, except for my 403b, because there I’m forced to invest in mutual funds.

4. Please teach me: what is the formula for actual rate of return? I’m confused, because in the example in your youtube link, the person started with $1000, end up with $800. If I use the CAGR formula and substitute -10.6%, I end up with $800. Of course, the standard deviation is huge, but the average rate of return really is -10.6%. I would appreciate knowing your alternative formula.

5. It would be useful to know what investment is guaranteed to give me 4.8%, as that is my mortgage rate. If this is proprietary information, then that’s fine, and I wish you well. I’m not nearly as knowledgable as you are about mortgages, but it seems like if such a guaranteed investment is unavailable, then I would be better off pre-paying my mortgage, unless you think inflation will soon be extreme. I think I read that your two strongest arguments against pre-paying mortgages were these: a) make a higher % on investment than your mortgage rate; and b) inflation will make one’s money worth less. Today’s guaranteed rates are extremely low, as you know.

Thanks for your time in posting a lot of useful information at your site.

Kirk

Kirk,

Thanks for your diligence. I replied to your initial comment about CAGR since that was your topic; however, since the video in question seems to be what is challenged then let’s take a look. First, if we truly look at what is claimed in the video then there is nothing that needs challenging. We never claim a product like “mutual funds” or mention Vanguard or any other entity like you have mentioned. We specifically refer to “planners, advisors and TV experts”…and their brochures and conversations. The Dave Ramsey’s of the world sell Average Rate of Return like it means something. I almost bought some property in Florida and laughed when the brochure said that their properties had averaged over 25% when in reality they had fallen fairly sharply in two years…technically they were right if we concerned ourself with the “average”.

About a year ago a very successful CFP wanted to meet with me. He was sharp and I thought maybe we had some opportunities. Then, he pulled his “sales binder” out and started to show me how their clients had “averaged over the past few years”. Needless to say, I do no business with this man. Our focus in our video was very targeted to financial planners, advisors and the bull-crap we hear on TV. These guys spew “average rate of return” all day long and it’s total garbage. Just read Dave Ramsey’s book, it’s absolutely laughable.

I wonder if you are aware of the two things that your 403b defers? I’ll give you the first one, it defers your taxes. What’s the second?

Also, one of the biggest mistakes, or financial transfers as we call them, is pre-paying your mortgage. Next to taxes, this is the number one wealth transfer individuals experience. Maybe you ought to look into a webinar of ours. You see, if all I do is go right to product, then I’m like every other financial professional. The financial world is like a bunch of golf club salesmen. Each one professes to have the right club for you and each one claims that the other one was silly in his/her club choice for your bag. The problem is if your swing sucks then the club is irrelevant. You must work on the swing first. That’s what we do. The “swing” is eliminating financial transfers. When that is done and you are as cash flow efficient as possible then and only then does a “golf club” define itself. Can you win in a guaranteed and predictable environment? Absolutely, we just have to work on the swing.

Kelly O’Connor

Kirk,

I again was recently challenged on my position concerning 15-yr and 30-yr mortgages…it was a weak challenge; however, I read back through this blog and re-read your comment here. There was something I didn’t respond to which I feel I should have.

You mentioned your rate is currently at 4.8% and referenced what product or tool could provide that type of return in a guaranteed and predictable environment. I’d like to point out that your rate is actually lower. Assuming this is a primary residence then you have your deduction. You see, people erroneously say “Why pay $10,000 only to save 3,000?”. This seems to make sense on the surface but it’s the wrong side of the coin.

The amount paid in interest and saved in interest is irrelevant. What we should pay attention to is how the deduction creates a lower net-cost-to-borrow. You see, if you’re sitting at 4.8% then your net-cost-to-borrow is more like 3.5% because of the deduction; therefore, we only have to match or exceed 3.5% and we’re beating the bank. That’s not difficult to do. There is no “secret” product here but more simply the refusal to get into a product discussion since that’s what most planners do. I’d be happy to lead you through some discussions over the computer…nothing pushy, just education (which it’s apparent you know your stuff so no arrogance here) and conversation. If something comes from it great…if not, no skin off your nose.