Why Ric Edleman is Wrong About the Virtue of Carrying a big 30-Year Mortgage

I listen quite a bit to financial planner Ric Edleman.

I like Ric.  He’s written some worthwhile books on personal finance and has a radio show. Much of his financial advice makes sense.

Here’s where he’s wrong . . .

Ric is a strong advocate of carrying a big mortgage. He says it’s better to have a 30-year mortgage than a 10 or 15 year mortgage.

He says it’s better to have a mortgage than no mortgage.

Ric’s logic is as follows:

1) Mortgage money is the cheapest money you can borrow.

If your credit is decent, you can get a 30-year fixed rate mortgage at about 4 percent per year or even lower today.

So the cost of money is pretty close to free.

2) The stock market (S&P 500) has returned 10% per year on average over time since 1928.

If you are paying 4 percent per year for your mortgage, this frees up your money to invest in the stock market. If the stock market stays true to its historical average of 10 percent annual returns, you can pocket the 6 percent spread — the difference between the 10 percent average annual return for the S&P 500 stock index and the 4 percent your are paying for your mortgage loan.

3) Mortgage interest is tax-deductible up to a $1,000,000 mortgage.

So this makes your mortgage loan even cheaper. If you are in the 35 percent tax bracket, the cuts the interest rate on your mortgage loan from 4 percent to 2.6 percent.

This means you are now pocketing the 7.4 percent difference between the cost of your mortgage loan (now 2.6 percent after deducting the interest from your taxes) and the 10 percent average annual gain from the stock market.

All this makes perfect sense — except a few key facts . . .

FACT #1: Most people don’t keep the homes they bought for the full 30 years.

The average person lives in the home they buy for 13 years.

Mortgage interest is all front-loaded. You pay almost no principal on your house until last phase of your loan.

So if you have a 30-year mortgage and you sell your house after 13 years of living there, you are actually paying more like 7 or 8 percent interest for the money.

But before the real estate crash of 2008, the average length of homeowners staying in the home they bought was just six years.

This means these people are really paying more like 14 percent for their mortgage if they have a 30-year fixed-rate mortgage of 4 percent.

But back in the pre-2008 real estate bubble days, people were paying more like 6 percent for a fixed-rate mortgage,

So if they only kept their home for six years (the average) before moving out and buying a bigger house, they are paying closer to a 20 percent annual interest rate on their mortgage loan . . . again, because interest payments are front-loaded.

This is how the banks make money.

They understand human behavior. They know they really are not just making 4 percent interest on the money they’ve loaned you for your house.

They know, on average, they will earn 10-20 percent annual returns on the money they’ve loaned you.

Plus, the bank owns your house.

So if you lose your job and can’t make your mortgage payments, the bank swoops in and takes your house.

FACT #2: Most people are not disciplined enough to invest the difference wisely.

Most people use their big 30-year mortgage to finance a big lifestyle — a much bigger lifestyle than they can afford.

They buy too big a house. They also buy a fancy car, perhaps several cars.

They end up living paycheck to paycheck, barely able to pay their mortgage, car payments, and cost of living. They end up as slaves to their mortgage payments.

If real estate values decline and they end up underwater on their house (owe more than their house is worth), then lose their income and can’t make their mortgage payments, it’s disaster. Financial ruin.

People tend to think of credit asalmost like free money.

Studies show that people spend 30 percent more on average if they charge what they are buying instead of pay with cash.

When you pay with cash, you are more careful how you spend money.

A mortgage is no different. People see a mortgage is a relatively painless way to finance a big lifestyle — painless that is until real estate values go down and they lose their job or source of income.

Debt is a powerful drug.

Credit is the most heavily marketed drug in America.

When you slap that plastic card down on the counter and walk out of the store with a big bag of stuff, you feel good for the moment. It almost feels like a bag of free stuff — until the credit card bill comes due.

FACT #3: You can’t live in your stock market investments. And you can’t live in your debts.  But you do need a place to live.

Owning your home without a mortgage is just about the best insurance policy you can have.

You have to live somewhere.

If real estate values go down and you lose your job, you still have your home free and clear.

You can still live there.

There’s value in peace of mind.

Ric Edleman argues that you will always have monthly payments on your home even if you don’t have a mortgage because of property taxes and insurance. You also have the cost of maintaining the property.

True.

But you would also have these costs if you rented. They would just be hidden costs in your rent.

If you own your property and something bad happens to your income, you can always sell your property, downsize to something less and pay less in property taxes and insurance.

At least you will still have a place to live.

FACT #4: Having your cash tied up in your home instead of easily available is like a forced savings plan.

When people have a lot of cash in the bank or easily available in stocks (such as an eTrade account), its amazing how fast your cash will disappear.

You tend to spend it.

You can’t spend it if it’s locked up in your house — which appreciates in value about 3 percent per year on average.

That’s not an eye-popping return on your money.

But at least you’re not spending it — not frittering it away.

Owning your own home is basically a hedge against both inflation and the temptation to waste your money on things you really don’t need.

FACT #5: The stock market is not as great an investment as you might think.

While Edleman is right that the S&P 500 has returned an average of 10% since 1928, that’s in nominal dollars, not real value.

Plus, a lot depends on when you get into the market.

Much of this increased value is an illusion.

We keep hearing breathless reports in the news of the stock market hitting record highs.

So people have been stampeding into the stock market hoping not to miss the latest boom (bubble) in stocks.

Everyone’s feeling good when reading their IRA and 401k statements that arrive in the mail each month.

But these record highs do not take into account the declining value of the dollar.

The dollar has lost 40% of its value since 2000. Actually a lot more than 40 percent. That’s just going by official CPI numbers.

But the inflation rate is in reality much higher than the phony official average annual inflation rate of 2.7%

Anyone who goes to the grocery store knows that the real inflation rate has been more like 8% per year on average.

But for the sake of my argument here, we’ll just use the official inflation rate of 2.7 percent per year.

The key point here is that the reported increase in stock prices are in nominal dollars, not real value.

If you invested $1,000 in the Dow Jones Industrial Average in 2000, it would be worth a $1,015 today – a whopping 1.5 % return on your investment over 15 years . . .if you use the official inflation rate of 2.7% per year (which we know is phony and grossly understates the real inflation rate).

If you invested $1,000 in an S&P 500 index fund in 2000, this would be worth $890 today, an 11% decline.

If you invested $1,000 in the Nasdaq average at the peak of the dot com bubble in 2000, it would be worth $630 today – at Nasdaq’s supposed near-record high. This represent a 37% loss over 14 years.

Ouch.

And that doesn’t count management fees charged by mutual funds and brokers.

Assume a 1.5% management fee per year for the typical index mutual fund (if you’re lucky to find management fees that low). That knocks another 21% off your returns (or lack thereof) over this 15 year period.

And there are transaction fees even if you manage your own portfolio.

So if you are in the growth-oriented Nasdaq index, you’ve lost more than half your money over the 14 years.

So much for the advice we get to just “Buy the indexes and hold. Everything will be okay over time.”

Returns are even more bleak when you consider the volatility of the stock market.

Volatility equals risk.

Who wants to risk everything (ala 1929) for the wonderful benefit of breaking even or losing money over a 15 year period?

Imagine if you get into the market now and the market loses 20% or 40% of its value, quickly – a likely scenario (because the recent stock market run-up is built on nothing but hope, not real numbers).

How long would it take for the market to rise back to this level to get you back to even?

You might never break even in your lifetime. There’s certainly no reason to think the economy will get better from here on forward.

People who put their money into the stock mark at its peak in 2000 are still waiting to break even 14 years later.

By the way, the stock market over time pretty well mirrors the overall economy.

The economy has been stagnant since 2000. So it’s not surprising the stock market has produced nothing since then.

The stock market boomed during the Reagan years through 2000 — when the economy was booming.

The economy is far from booming now. It’s hardly growing at all.

So don’t expect much from the stock market — unless you have a crystal ball and can time it perfectly, or just get lucky.

You won’t get rich quick if you pay off your mortgage and settle for an average of 3 percent per year annual growth.

But at least when the shit hits the fan, you’ll have a place to live.