Is Dave Ramsey's Advice Outdated?

Dave Ramsey’s Advice

I am a big fan of Dave Ramsey, so much so that for my sister's wedding over a decade ago, I signed she and her husband up for his program and they embraced the idea of family budgeting. My sister was so good at it that she and her husband taught a Dave Ramsey class at their church. This WSJ article, "Dave Ramsey Tells Millions What to Do With Their Money. People Under 40 Say He’s Wrong" calls into question Dave's advice to save money, not go into debt, put 10% down on a house and only get a 15-year mortgage. I will provide some historical context for this advice and re-examine how pertinent this advice is today.

Mortgage Rates and Home Price Appreciation

This historical chart shows the average home price appreciation and the average 30-year fixed mortgage rate in the US going back to 1975. Some really easy math is that if your home is appreciating faster than your cost of mortgage, you are building wealth with your mortgage. The chart shows that between 1980 and around 2002, mortgage borrowers were paying much more for their mortgage than they were getting in home appreciation and therefore taking out a large mortgage destroyed wealth (this of course not putting any value on the fact that one can live in a house).

The Run up in Home Prices Prior to the GFC

Then between 2002 and 2006, this math sharply reversed and those who had taken out the largest mortgages and stretched created a tremendous amount of wealth for themselves. A back of the envelop calculation for the 12 months preceding July 2005 shows that the average home price appreciation was 8.5% higher than the average mortgage rate. This means that if one had a $500,000 mortgage, their wealth would have increased by $42,500 in one year. There were several years with this large spread and those with the largest mortgages benefitted. But we know this ended poorly with the spread dropping to almost -18% in 2008 with the math working in reverse.

2013 to Present

If we consider the time period from 2013 to the present, we see the historical anomaly of home price appreciation outpacing the cost of a mortgage quite steadily through 2022 with an astounding spread of 17% coming in July of 2021. So for a full decade, taking out the largest mortgage you can was very beneficial to wealth creation, and an added benefit was that one got to live in the nicer home that a larger mortgage lets one afford.

With this historical context, the advice that Dave Ramsey provides to not stretch for a mortgage and shoot for paying it down ahead of the payment schedule was extremely sound advice between 1980 and 2012 with the years 2002 to 2006 being anomalous. Yet we have just had a decade when the wealth maximizing advice was actually the exact opposite of what Dave advises in that stretching for a large mortgage generated at tremendous amount of wealth for borrowers.

Forecasting the Home Price Appreciation to Mortgage Rate Spread

So how does a decision maker think incorporate all of this into their current thoughts about home ownership and mortgages? If one can forecast that home prices will appreciate faster than the cost of a mortgage, then one can maximize their borrowing to maximize their wealth. The cost of a mortgage today is easy to measure as websites such as Mortgage News Daily publish near real time pricing of mortgages with today’s rate being 7.14%

Forecasting Home Price Appreciation

The pertinent question then becomes how accurately can home price appreciation be forecasted? This chart excerpted from the paper “Understanding Rationality and Disagreement in House Price Expectations” by Li, Van Nieuwerburgh, and Renxuan shows historical survey forecasts along with the actual home price appreciation. Actual home price growth is shown in black, and the historical forecasts are shown in the colored dotted lines reflecting future forecasts for each year. See that the forecasts generally revert to around a 3% appreciation, but the actual appreciation has had little resemblance to these forecasts. The lesson is that it is exceptionally difficult to forecast home price appreciation accurately.

Home Affordability

The Atlanta Fed has an excellent tool for tracking home affordability which they call the Home Ownership Affordability Index. They have built the index such that affordability is calibrated to 100 so any reading over 100 indicates affordability and any reading below 100 indicates home un-affordability. In July 2006 this metric hit 71.5% which indicates that home prices would have needed to drop by 28.5% to move back to home affordability.

The Case Shiller 20 city composite index dropped by 31% in 26 months as detailed in the chart below. Also notable is the significant drop off in transaction volume that accompanied this drop in price. We have had a similar drop off in transaction volume, yet home prices continue to appreciate.

Long Term Relationship Between Home Prices and Inflation

This chart below is data from Robert Shiller who shows real home price appreciation between 1890 and the present. See that a regression line run through the 1950 to 2000 data shows very little real appreciation of homes. Further, this trend also lines up well with the data from 1890 to 1910 with the data from 1910 to 1945 being very low in comparison to this long term relationship. Then at the turn of the century home prices did something they had never done and appreciated dramatically in comparison to this long term relationship with prices reaching 60% higher than this historical relationship. Prices corrected in the ensuing years and dropped almost all of the way back to the 1950 to 2000 trend. Then prices once again significantly diverged from this trend with prices peaking at over an 80% premium to this historical relationship.

Home Price Appreciation at Inflation

First, let's consider the possibility that home prices appreciate at the future rate of inflation as has been the long-term trend. We can get a market estimate of inflation by looking at both 3- and 5-year TIPS yields. We see that they are currently at 2.14% and 2.23%. These are both around 5% below the current 30-year mortgage rate as reported by Mortgage News Daily indicating that for every $100,000 borrowed, the borrower will be sacrificing $5,000 annually in wealth creation to borrow the money.

Home Price Appreciation Below Inflation

The home affordability metrics and the historical relationship between inflation and home prices suggest that a significant downward correction in prices may occur. But the historical precedent of very poor home affordability and a rapid decline in home sales transactions led to significant drops in prices leading into the GFC but as yet, these two characteristics of today's housing market has not led to the same outcome. The lesson from the home price appreciation survey is that it is exceptionally difficult to forecast home prices accurately. Yet to the extent that home prices do appreciate at lower than inflation, the negative 5% spread between mortgage rates and home price appreciation could potentially increase dramatically which would exacerbate the wealth destroyed by taking on a large mortgage.

Home Price Appreciation Above Inflation

While the poor affordability and the large divergence between home prices and the historical inflation rate suggests it is unlikely that home price appreciation will be higher than inflation, it is certainly a possibility. But to have the spread between mortgage rates and home price appreciation be positive, real home price appreciation would need to be 5%. This was historically anomalous before 2000, but as we have seen over the past several years, sometimes it is better to just throw out historical precedence and be open to the possibility that something that has never happened before will happen.

Conclusion

The past decade has been anomalous in that home price appreciation has consistently outpaced the cost of mortgage debt with a dramatic and unprecedented spread opening up in 2021 and 2022. The result is that those who took out large mortgages have generated a significant amount of wealth for themselves. Yet this is historically the exception to the rule as between 1976 and 2013, it was much more common for large mortgages to actually destroy wealth as the borrowed money was not returning its cost.

It is exceptionally difficult to forecast home price appreciation accurately, but we know that the hurdle to hit to have mortgages create wealth is to have home prices appreciate above 7%. This appears unlikely considering expected inflation is around 2%, home affordability is near pre-GFC lows which precipitated home prices falling by over 30%, and the historical relationship between inflation and home values would require home prices to fall more than they did during the GFC to move back to the historical relationship. Therefore it appears that Dave Ramsey's advice, to not stretch on mortgages, is still sound advice even though it has been poor advice for wealth creation for the past decade.