Dave Ramsey: Pay Off Your Mortgage Early or Not

Should You Pay Off Your Mortgage Early? This is an age-old question with no definitive answer. There are people who believe paying off mortgage as fast as possible is better, and there are people believe investing the difference is better. Dave Ramsey advocates paying off your home loan early in his book The Total Money Makeover. I believe this to be a great advice for his audience.

In general, if you are uncomfortable with investing, you’re better off prepaying your home mortgage. However, investing instead of prepaying could be a more financially rewarding option for many people.

Advantages and Disadvantages of Mortgage Prepayment

Since the right answer depends on so many factors, I cannot say that mortgage prepayment or investing is better. Instead, let’s examine the key factors that will help you make the final decision for yourself.

Prepay versus Invest

Advantages of Prepaying Your Mortgage

  • Interest payment savings — I believe this to be the most significant benefit of prepaying your mortgage. You’ll ended up saving a good amount of money on interest payments. The money saved is risk-free and guaranteed. Not to mention you’ll get out of a major debt obligation and own your home sooner.
  • Investment risk — Since you can’t beat prepaying with risk-free investments like certificates of deposit, money market and savings, you’ll have to utilize investments that provide higher returns, such as investing in the stock market. With prepaying, there’s no investment risk involved.
  • Investment gains are taxable — Your investments gains are taxed at your marginal tax rate for dividend and interest gains, and at the long-term capital gains tax rate. Therefore, you do not recognize the full value of your investment gains. For instance, if your investment gained $6,000 in value and you have to pay 18% on taxes (average), that’s only equivalent to $4,920 net gain.

Disadvantages of Prepaying Your Mortgage

  • Opportunity cost — Depending on your interest rate, investing could provide you with superior return on your investment. So it’s possible to come out financially behind if you prepay.
  • Lack of diversification — Your house could be a significant portion of your assets (it is for me). By prepaying, you are not increasing your real estate investment (it’s still the same, you are just lowering your debt). By opting to invest your money elsewhere instead of prepaying, you are increasing your investment in other asset classes, thus effectively reducing your real estate exposure and overall financial risk through diversification.
  • Tax deductionsYour interest payment could be a significant portion of your tax deductions (it is for me). If you prepay, you are also reducing the amount you could use for tax deductions. For example, if you saved $5,000 on interest and your marginal tax rate is 25%, you’ll lose $1,250 in tax deduction — therefore, your net saving is only $3,750. Since long-term capital gains is only 15%, to match the $3,750 savings, you’ll need an investment gain of about $4,412, i.e., $3,750 / (1 – 0.15). However, this factor also depends on how much you itemize because the IRS offers standard deduction — as such, your true deduction is only the difference between your itemized deductions minus the standard deduction.
  • Inflation — When you owe money and you pay back over the course of 30 years, inflation is your friend. Assuming an average 3.5% inflation rate, your $1,000 mortgage payment is only worth about $340 on the 30th year. If you prepay, you will lose this advantage, and it in fact, works against you.
  • Liquidity — Your mortgage is a secured loan.  Prepayment doesn’t earn you any favor with the bank. The bank still owns your house until you pay off that last penny. So if you hit some rough patches down the road and cannot make your payments, you could lose your home. By investing instead of prepaying, you maintain liquidity and give yourself a little insurance against potential financial hardship. Sure, you could sell your home to avoid foreclosure…but selling under pressure is not fun.

Swing Factors — It could go either way…

  • Mortgage type — There are many types of mortgage. That, and the prepayment clause, could play a major role in you prepaying versus investing decision.
  • Mortgage maturity — The age of your mortgage determines how much interest savings you will realize. Prepaying a newer mortgage is more beneficial than prepaying a mortgage that only has a few years left.
  • Mortgage Interest Rate — Obviously, it’s better to prepay (or refinance) a mortgage with high interest rate. Since the long-term return on investment for the stock market is about 8-10%, it’s most likely better to prepay if your mortgage interest rate is higher than about 6%. On the other hand, if your mortgage interest is lower, it’s probably better to invest.
  • Investing skill — The premise of this argument depends on your investing skill. If you can’t, and unwilling to hire someone to help, the point is moot and you’re better of prepaying.
  • Financial Stability — As mentioned earlier under liquidity, if your financial situation is unstable, it’s probably better to invest and stay liquid. This gives you some cushion against financial emergencies or losses.

Is it better to pay a house off or not?

To sum it up, there are many factors that affect your decision to prepay your mortgage or invest your money. In order to find the right answers, all of these factors must be considered carefully.

Personally, my mortgages have low interest rates (3.75% and 4.25%), I am in a high tax bracket, and I have long investment horizon; so here is what I do:

  1. Make sure I have plenty of emergency fund,
  2. Make sure I fully fund my retirement savings in tax-advantaged accounts, and
  3. Make small prepayments along with my normal mortgage payments.

Essentially, I chose not to make any commitment to one specific area and spread my money out.

Some additional readings about prepay versus invest

Other articles in the Dave Ramsey’s Baby Steps Series

The article was part of the M-Network series highlighting Dave Ramsey’s 7 Baby Steps for getting out of debt and getting your life on the right track financially. You can read about all of the steps over on Cash Money Life who kicked things off with a great introduction. As other members of the network add their articles, I’ll add them to the end of this post.

About the Author

By , on Dec 23, 2016
Pinyo
Pinyo is the owner of Moolanomy Personal Finance. He is a licensed Realtor specializing in residential homes in the Northern Virginia area. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, and financial literacy author.

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Leave Your Comment (137 Comments)

  1. RobSC says:

    I think it would be worthwhile to sit down with a CPA

  2. J says:

    Is there any benefit to paying off mortgage on house early. I have the money however I cannot work b/c of medical reasons and was wondering if paying off the house would effect any chances of getting any type of loan in the future (not sure if i could get one anyway). Right now excellent credit and pay mortgage on time. Mortgage left is around $50000 on 12 yrs. I do not do itemized tax so I dont get any interest back. Dont know much about mortgages

  3. CharlieBoy says:

    I have paid attention to dividend stocks, especially ETFs; however, I will focus on individual stocks for a couple of years in order to test an investment system that I have developed. We’ll see what happens.

    I do LOVE dividends and interest payments. For the first time in my LIFE, I am proud (amazed, astonished) to say that I am receiving more money from dividends and interest than paying. That’s thanks to paying off my mortgage.

    I will soon be receiving some type of interest or dividend every day of the week. That’s all compounded, I never actually see a penny of that money, but I see it in the accounts (CDs, savings, etc).

  4. RobSC says:

    I mentioned concentrating one’s portfolio. A single stock is pretty extreme, but the company man who knows the company would be the sole example of that type of investing. My advice would be to consider the an approach with a focus on value. Low P/E stocks are available. Screen them for consistent sales/revenue growth, consistent dividend growth, consistent earning growth. Many pass this test, and some barely missed a step in 2008-09. For me personally, 10 stocks is about right for diversity. 15 to 20 start to overwhelm the senses. The Dividend Aristocrats Index is a good place to start mining. Do a search defining entry into this Index. Pretty impressive hurdles. A larger group of stock called the Dividend Achievers Index.

  5. CharlieBoy says:

    I forgot to say why I don’t trust banks, but it’s because of Wells Fargo. Last year, I called them to refinance my mortgage. They told me that I could lower the interest rate IF I paid off my HELOC. No big deal, I said, it has a low balance anyway. BUT they failed to tell me that I had to pay it off prior to starting the refinancing process. Weeks later, I called them to ask when the closing date was, and I was astonished to find out that they had cancelled it without telling me BECAUSE I didn’t pay off my HELOC first, which I didn’t know I had to do. It’s a corrupt bank!

  6. CharlieBoy says:

    Ralph, it sounds like your mortgage terms do not allow for early pre-payment without a penalty. The recording fee is probably about $15 though. Ask them how much the penalty is for you to pay it off. I would carefully read my original mortgage papers to see if what it says about pre-payment penalties. I don’t trust mortgage companies! You may have to wait, but $17,920.10 means you are almost there regardless.

  7. Ralph Earles says:

    I was just told that if I pay my mortgage off that I would have to pay a penalty of in interest and a recording fee. I only owe 17,920.10 (seventeen thousand nine hundred twenty Dollars and twenty cents) why am I being charged these fees?

    • Pinyo says:

      @Ralph – It sounds like your lender doesn’t allow pre-payment and charges a pre-payment penalty. You should ask for a manager and see if they would waive the penalty.

  8. CharlieBoy says:

    Obama is digging a hole large enough to bury the entire nation.

  9. Ethan says:

    If you sell your home, where would you bury the gold?

  10. Jett Subercuseaux says:

    The way things are going, I say, sell your home and use the mortgage payment money to buy gold, make a big hole in your backyard or some place known only to you and bury it. Just make sure to let your responsible children know where it is before you die.

  11. CharlieBoy says:

    RobSC, I have been investing in the stock market since the 90’s, and I learned my painful lessons the hard way. Back in the late 90’s, I sold everything and invested 100% in a single stock because I was “sure” that it was going to be a winner. Well, putting all my eggs into a single nest turned out to be an expensive lesson, but I learned.

    Unfortunately, in our 401(K)s, we don’t have the option to invest in individual stocks, or I would be doing it. But I will NOT invest in any index fund or mutual funds in my ROTH IRA. But my 401(K) did well for me mostly because I actually moved almost everything out of my mutual funds and into a money market near the top, and again back into mutual funds a couple of years ago. And I switched to ROTH 401(K), which helped when I cashed it out (at the top) to pay off my house.

    Now I am getting ready to invest in individual stocks only, except for the 5% that will be invested in my 401(k) at work.

    Now, having said that, I may open a separate ROTH IRA and invest a little in peer-to-peer lending because that too can be diversified and return much better results than the stock market.

    Most people claiming to be “expert” investors are unable to beat the S&P 500, and a lot of those people are some of the highly-paid managers in our 401(K) funds. It’s pathetic!

  12. RobSC says:

    Blaming the Index for your troubles is short sighted. Lerarn to invest (this is not the sam as trading) in individual stocks. Most people get rich in the stock market in two ways. Years of contibuting/saving and reinvesting the dividends. Time overcomes stupidity and market flucuations. Secondly, Owning a single stock (ie… the 30 year company employee) and reinvesting. Again time is the key factor. Have you ever wondered why a mutual fund may tout itself as a growth fund or value fund yet have 100% portfolio turnover? Something of an oxymoron. Learn to value and invest inindividual companies. Own the stock, don’t rent it for short term gain. Read the Buffett Paradox and interesting report on Mutual funds in comparison to Buffett. I beat the Index by an average of 5 points because I know how top value, employ patience, and maximize gains by concentrating on a handful of stocks thatI know very well and follow closely. Why water down the few good investments with dozens of subpar investments and call it a mutual fund?

  13. Charlie says:

    I bought my last house in January 1998 for $174,000. I sold it in 2008 for $325,000. The housing boom did it.

    It doesn’t matter anyway because I would rather invest in the stock market and not have with tenants. Been there, done that. But a commercial property is not out of question. The main thing now that my mortgage is gone is to invest the same amount. Maxing out a ROTH is my top priority.

    As for the stock market return, here’s a little table:
    YEAR: % RETURN:
    2010 14.32
    2009 27.11
    2008 -37.22
    2007 5.46
    2006 15.74
    2005 4.79
    2004 10.82
    2003 28.72
    2002 -22.27
    2001 -11.98
    2000 -9.11
    1999 21.11

    Terrible!!! I took all these things into consideration when I decided to cash out my 401(K) at the top and pay off my house.

    Charlie.

  14. Dave says:

    @ Jason by paying off your mortgage you get a guaranteed tax free return of 5% or more. The S&P 500 return was zero from 2000 to 2010 so stocks have a lot of risk involved. Getting a guaranteed tax free 5% return from your mortgage beats yours 1 yr 1% CD after taxes.

  15. Pinyo says:

    @CharlieBoy – “Besides, in the long run, real estate comes out ahead of other investments, especially the stock market.”

    That’s inaccurate real estate usually keeps up with inflation in the long-term and may change up/down depending on the condition of the market and the neighborhood (e.g., growing or declining); whereas the stock market are tied to real businesses with the common aim of increasing profitability. The past 10 years may not be representative, but in the long-long-term, real estate cannot keep up with stocks.

  16. CharlieBoy says:

    I don’t care how much a house is worth, it’s not like one has invested $1M in real estate by prepaying one’s house. Besides, in the long run, real estate comes out ahead of other investments, especially the stock market.

  17. Pinyo says:

    @Jason – I am with you 100% about inflation. If your mortgage rate is low enough, buying TIPS instead of prepaying might be the safest arbitrage yet.

    @Charlie – Congratulation. I don’t think there’s a right or wrong decision that applies equally to everyone. If what you did make you feel better, I think it’s a good thing.

    @Roy – You are correct and that is what I am trying to explain. Prepaying doesn’t change your real estate exposure, but using that money to invest in something else reduces your overall real estate exposure. I will tweak my sentences to clarify that.

    @CharlieBoy – There are plenty of people who buy too much house or sink too much money into a house. Why is that not a reality when we see this happening all the time? I have a neighbor who spent too much on renovation and ended up losing both money and the house.

  18. CharlieBoy says:

    Too much real estate by owning the house my family depends on for survival? That is not even close to reality.

  19. Roy G says:

    This is wrong: “Lack of diversification — Your house could be a significant portion of your assets (it is for me). By prepaying, you are adding to your real estate asset class, which could result in too much investment in real estate. By opting to invest your money instead of prepaying, you are reducing your overall financial risk through diversification.”

    This is wrong because I own the same house whether I pay off my mortgage or not. I still am exposed to the same real estate risk. However, percentage wise, I am less exposed to real estate risk by borrowing and investing in other assets. The actual dollar value of the exposure is the same, but I have borrowed to invest in other assets, which decreases the percentage of my portfolio in real estate. The offset to this, of course, is that leverage brings its own risk and volatility.

    But the real estate risk is identical with our without the mortgage.

  20. RobSC says:

    I certainly understand the value of paying off the mortgage from an emotonal standpoint. Cashing out and paying taxes on the the retirement money is not something I would have done. However, you would have paid that money in interest anyway,so you might call it a wash. As an earlier post mentioned, inflation is a huge factor. I have reconsidered paying extra, because inflation would mean paying it off with ever cheaper dollars in the future, so it is better to be invested in the market. But I’m self employed and see a bright future. Still have a ways to go to max out every retirement vehicle. There is really no right or wrong answer. If it has conditioned you to save, then this will be a long term positive. Savers always prosper and sleep easier in troubled times.

  21. CharlieBoy says:

    MY EXTREME MEASURE: I cashed out my 401(K)!

    I realize that my decision was extreme, and I do not recommend it to most people, especially to those who would pay off their mortgage and just waste the extra money every month.

    But only in the self-destructive economy of debt people think it’s ok to buy one house and pay for two. If you don’t think that a culture of debt is self destructive, you have not followed international news. One word, Greece.

    For me, paying off my mortgage was my dream. I am now 47. I TOOK AN EXTREME measure to pay off my mortgage in May/June; I cashed out my 401(K) in May (2011) and did it. I was driven by the dream of living mortgage free. To me, it was more than just doing the math. Historic returns tell us that keeping money in the stock market will outperform our mortgage rates, especially my 3.75% fixed rate; however, even Warren Buffet has said that investors can expect returns of 4% this CENTURY. 4%, not the historic 7%.

    I am paying (they withdrew 20% automatically) income taxes on the money that I took out of my 401(K) to pay off my mortgage, but I know that I am taxed at a lower rate now than I will be in the future with the way federal spending is going. I didn’t feel that it was not worth keeping a huge financial obligation just to get a tax deduction.

    I took a 10% penalty to cash out my 401(K) to finally make my mortgage-free dream come true. I know I will never regret my decision. It wasn’t an easy decision, and I lost several nights and almost developed ulcers thinking about it. The economy looked shaky, and I feared that the stock market could tank, and that it could potentially take years to recover.

    Since I made the decision to take a 10% penalty to pay off my mortgage, the stock has gone down 16% as of yesterday’s closing price. I took all my 401(K) money out of of the stock market on 05/24/2011. The S&P 500 closed at $1,316.28 that day. Yesterday, 10/04/2001, it closed at $1,099.23. That’s a 16% drop. My 10% penalty looks small at the moment.

    I know the stock market will turn around, but its performance in the past decade is nothing to brag about. I am not interested in how the stock market or any other investment vehicle has performed in the past couple of years. Let’s look at a decade. Here’s the dreadful reality of the past decade: If you had started investing in the stock market with $5,000 on 01/01/2001, and if you had contributed $500 every month until 07/01/2011, you would have contributed a total of $68,000 in the past decade. Your account balance would have been $79,295.98 on July 1st, 2011. That’s a total return of 16.6% in 10 years. Total INFLATION was 27%. After inflation, that’s a net LOSS of 10%. You would have been much better off investing in your mortgage!!!!

    When I paid off my mortgage in June, I instantly developed a savings habit. Every two weeks, I invest $1,000. I am investing in CDs at the moment, but I will be maxing a ROTH IRA starting in the spring. I am also looking at other investment vehicles, such as peer-to-peer lending, commodities, etc. Getting rid of my mortgage will create more investment opportunities for me.

    I need a lot less to survive without a mortgage, and I sleep so much better at night. I have zero debt now. I have no car loans, no credit card debt and no consumer debt of any type. My debt to income ratio is 0% for the first time. The smile on my face would need to be surgically removed.

    I opened an online savings account to manage my own escrow. It will pay ME a little bit of interest, as opposed to the 0% I was getting by letting my mortgage company manage it for me.

    “The borrower is servant to the lender.”

    Charlie.

  22. Jason says:

    Also, just to further clarify, I said you effectively pay $2600 a year to have that loan. While this may seem like a lot, making up that $80k over 30 years is pretty much guaranteed and then some. Even if you find an investment that does nothing more than keep up with inflation at 3%, you are still making more than that $80k you spent.

    So instead of paying that one extra payment every year, take that $2000 and put it into a very low-risk, low-yield investment that makes about 3% a year (there are plenty out there). After 30 years you’ve got just over $100k. There, you just made up your $80k spent in interest with a very low risk investment.

    Why don’t people understand this?

    Disclaimer: I’m not a financial adviser, I don’t hold a degree in finance, I’m not pretending to be an expert, I’m just a simple military medical officer who likes to make my salary work for me.

  23. Jason says:

    I’m confused how people can completely look over inflation.

    Yes, paying off your home early probably isn’t a bad idea just because of the peace of mind it leaves you with. However, there is more to it than that.

    For just a moment let’s aside all of these side discussions about how risky the stock market it and whether or not the standard deduction will be more than your itemized deduction including interest and just look at the rate of inflation.

    Over the last ~100 years the average rate of inflation has been about 3.4%. Of course year to year things do change, but I don’t think we have to worry much about long term deflation. So lets assume a $400,000 mortgage at 4.5% over 30 years and an average inflation rate of 3%. Entering this into a simple mortgage calculator shows that by the end of the mortgage, you are only effectively paying about $800/mo (versus the ~$2000 it was to start). Your $400k loan when you don’t account for inflation will cost you $730k, but adjusted for inflation is only $480k. So you effectively paid $80k (or $2600 a year) for that $400k loan. You could even go further and account for a conservative 2% annual pay raise and you end up even further ahead.

    Also, while homes may not be appreciating much now, over the long term a well-maintained home in a decent neighborhood will appreciate at least enough to match inflation over the long term. So you also have that to think about.

    I guess this wouldn’t apply as much for someone in their 40’s or 50’s right now, but for the younger crowd, I don’t quite understand how anyone could think paying off a mortgage early is a good idea for ANYTHING other than simple peace of mind (which I’ll admit can be very valuable sometimes).

    Just my $0.02, but my $0.02 have made me a fairly wealthy man on an only slightly above average income ($65k/year post-tax)

  24. ann says:

    Hi, Lindsay. I think in most cases it is better to pay off your house, but if you will be selling your house soon you may not get the price you want. For me this is not a good time to try to pay off my loan because my job is not secure (my work may only last 2-3 years). What i am trying to do now is get my monthly payment to be as low as possible. Rates will be low for awhile, I am taking advantage of this situation by paying down my principle when i can refinance with the same rate or less. This way i keep my monthly mortgage as low as possible as i am also paying my loan off early. By the way, i have been putting in an extra $500 each month anyway because i have good amount of cushion money, but i will pay down another $20K when i refinance my house sometime soon in the next few months.

  25. Lindsay says:

    Am I missing something? I’ve been searching all over trying to find clarification on this… regardless of how long you have a mortgage, or how much the home depreciates in value, a loan is a loan and has to be paid back, right?

    I still owe about $90,000 on my home and am about 6 years into a 30 year mortgage. I will probably not be living there the full 30 years. Maybe I’ll try to sell in more like 5-10 years.

    I have plenty of backup money for any kind of large emergency that would come up, so that isn’t a factor. I do once in awhile accumulate an extra thousand or two beyond that large backup “cushion” of money. For example, I currently have about 1-2 thousand that I was considering putting down on my mortgage as an extra principal payment.

    I’m seeing all these comments about why that’s not a good idea if I plan to move. But I have this $90,000 loan and that has to get paid back regardless. So doesn’t it make sense to pay off that part as quickly as I can, regardless of whether I stay or move, and then in the process my monthly payment each month will be paying off more principal and less interest?

    This seems like a no-brainer to me but I am afraid I’m missing something big. Any replies would be appreciated. Thank you!!

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