When it comes to debt, few people are as opposed to it as Dave Ramsey. He argues that people should avoid debt like the plague. Car loans and student loans, borrowing instruments utilized by many people to access transportation and education, are verboten.
Most people’s definition of a good debt is a debt that can improve your financial situation over the long term. While many people might argue for student loans because of increased earning potential, people like Ramsey still advise steering clear.
However, there is one type of debt Ramsey allows for: mortgage debt. He won’t argue that it’s “good debt,” but he will argue that a mortgage is sometimes necessary to get into a house. Those who borrow money for a home will usually see their net worth increase as equity in the home builds, along with increased home values. Most other financial experts would argue that this makes a home loan a type of good debt.
Many financial experts recommend stretching out a mortgage payoff as long as possible. The lower monthly payments that come with the longer amortization schedule should free up additional money for investments. Even Ramsey, who hates debt with a passion, recommends saving 15% for retirement in the fourth of his seven “Baby Steps.” This comes before starting to accelerate mortgage payoff. After reaching 15% of your income going to retirement, he recommends putting every available dollar toward paying off your mortgage.
The reason many personal finance gurus recommend holding onto a mortgage as long as possible is tied to the ability to build wealth more quickly by investing in a vehicle that will provide higher returns over time. For example, Dave Ramsey is frequently panned for claiming that a “good growth-stock mutual fund” will return an average of 12% annually. While this might be a little high, the average return of the S&P 500 over the long run has been closer to 10%. These returns have been well in excess of the rate of both inflation and average mortgage rates.
The past 20 years have also tended to see low mortgage rates. Even the relatively low inflation that’s been common over the past four decades has seen the real cost of a monthly mortgage payment decrease over time in real terms as people pay back earlier loans with inflated dollars. This has allowed those who chose to invest in stocks to grow their wealth more rapidly than those who chose to accelerate paying off their mortgages.
Low interest rates with stock prices that have tended to increase have made paying off the mortgage less attractive. However, this might change in the future.
Holding onto a 3% or 4% (or even a 5%) mortgage in an inflationary environment that makes the effective rate 1% or 2% can make quite a bit of sense. Every dollar of debt paid off returns an amount equal to the interest rate. That’s why paying off a credit card with an 18% rate can make a big impact on a household budget. Paying debt with an interest rate of 3% does not provide as big a guaranteed return.
However, the sub-5% rates that have been common since the Great Recession have now been replaced with rates that just crossed the 7% mark for the first time in more than two decades. This makes borrowing for a home more expensive. Despite higher borrowing costs leading to lower numbers of mortgage applications, many Americans will need housing as they move for a new job or for a new life in retirement. A large percentage of these folks will need a mortgage at the new 7% rate. The longer these rates last, the higher the number of people who will need to access loans that charge them.
How will these rates affect the calculus on accelerating mortgage payments in the future? The answer depends on how long they last. A recession will come at some point in the future. Many analysts think it will hit in 2023. If the recession tends to dampen demand for goods and services, it will likely reduce inflationary pressure. This could lead to lower interest rates from the Federal Reserve, which would likely lead to lower mortgage rates. In this scenario, those who borrow at 7% will likely refinance to a lower rate in a year or two to save money on interest costs while also improving their monthly cash flow.
However, it is not a given that this scenario plays out. Thirty-year Mortgage rates in the 7% range (or higher) were common in the 1970s through the 1990s. Inflation was relatively low for a portion of this time frame, yet mortgage rates stayed relatively high.
Mortgage Payoff vs. Stocks
Paying down a mortgage with a 7% or higher interest rate suddenly becomes a more attractive scenario when compared with investing in the stock market, which can be volatile. Stocks provide no guaranteed return. Between 1999 and 2009, the S&P 500 (SPY) was basically flat (an average annual return of -0.9%). This lost decade was painful for investors, and it included two very deep recessions. Without dividends, the broad index lost money for investors for a decade.
Mortgage rates throughout the decade were generally in the 5% to 7% range. Every dollar paid off early provided an automatic return equal to the interest rate. Of course, those who invested money at the market trough in 2009 would have seen a much better return that exceeded this automatic return going forward. However, sticking with a plan to save 10% to 15% for retirement (the latter being Ramsey’s recommendation for retirement savings before starting to pre-pay the mortgage) would have provided benefits on both accounts.
When people start to weigh these scenarios, they may decide that the guaranteed return on the early payoff will make more sense. This would become even more pronounced should rates stay relatively high for several years. More people would become locked into mortgages with the higher rates as time progresses. If they do, it is entirely possible that fewer people will have an interest in maximizing their investments in the stock market, which could lead to lower average returns on the S&P 500 over the medium term because of lower demand for stocks. Of course, that might just provide a good opportunity to buy at a discount.
Should higher mortgage rates suppress stock prices for a few years, Ramsey’s advice to put 15% of gross income toward retirement and then putting everything in excess that’s available to the mortgage could make great sense. The retirement funding would likely recover over the long run after purchasing shares at a discount while any additional “investment dollars” that went to pre-paying a mortgage would see an automatic 7% return. Once the mortgage is gone, cash flow would automatically increase and allow for a higher rate of equity investment at an earlier age.