A Tale of Two Houses…
Here’s a email I received:
Brett,
Dave Ramsey claims that "debt is dumb and "cash" is king...the paid off mortgage is the new status symbol of choice".
Question for you.
How would you advise someone that locked in a low mortgage interest rate of 2.50% back in 2020? Should that individual take the advice of Dave Ramsey and pay off his mortgage as quick as possible or keep the mortgage as is and invest in a tax-free growth Roth IRA with the extra money that he could be using to pay down his mortgage? I eagerly await your response!
- A Friend
So, what’s going on here? This one takes a little thinking, so to better illustrate the question, here’s today’s story:
Bill Bullish and David Downer met in kindergarten, and quickly developed one of those friendships that never goes away. They went to the same high school, graduated from the same college with the same degree, worked the same job, had the same hobbies, and married twin sisters. It was no surprise then when they bought identical houses right next to each other in the same neighborhood ($300,000 each). Both made pretty good money and had about $3,000 a month to pay off their houses. That’s when things started to change.
David took out a 15-year fixed-rate mortgage at 2.5%. This means that David had to pay $2,000 a month for 15 years to own his home. David listens to a lot of radio, and he took Ramsey’s advice to pay off his home early. He takes his extra $1,000 and makes an extra half payment every month. As a result, it only takes him 9 years and 5 months to pay off his house, something he’s very proud of. He goes over to Bill’s house to brag.
Bill took out the same mortgage, at the same rate (nobody was surprised). However, instead of putting his extra $1,000 into his mortgage, he decided to invest it in the stock market. So, after 9 years and 5 months, when David came over to brag, Bill still had about $125,000 left to pay on his mortgage. Here’s where it gets interesting. The stock market did fantastic during those years, so Bill’s $1,000 monthly investments had grown at a rate of 12% annually, resulting in a grand total of about $210,000. Essentially, Bill had enough money to pay off what he still owes on his house, and still have $85,000 left over. Green with envy, David ends their friendship right then and there.
It seems like a no-brainer. However, this story has an alternative ending that goes something like this:
Bill still takes out the same mortgage at the same rate, and still invests his extra $1,000. However, this time the stock market experiences a series of mediocre years, followed by a massive recession. As a result, his investment total looks more like $95,000. In this scenario, even if he puts all his investment money into his mortgage, he will still owe $30,000. When David comes over to brag about his paid-off house, Bill gets so jealous he ends their friendship right then and there.
Obviously, the moral of this story has nothing to do with friendship. Instead, it has everything to do with understanding your investments and their risk/reward possibilities. Also, I have to say that there are a lot of holes in this story, such as investment contribution limits and tax implications of withdrawals, but those are for another post. My direct answer to the question is probably going to be a pretty common theme throughout the blog:
“It depends”.
One route offers safety and peace of mind, the other offers potential for great reward. The main takeaway here is; understand what you’re signing up for, and when in doubt, find a financial professional and talk it through.
Unsatisfactory answer? Want a little clarification? Have a different question entirely?
brett@centennialsec.com, or use the “Contact” tab above.
