Dave Ramsey’s Baby Step 6: Pay Off Home Early

March 5, 2008 by Pinyo.

The M-Network is currently doing a 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.

This is an age-old question with no definitive answer. There are people who’d say paying off mortgage as fast as possible is better, and there are people who’d say investing the difference is better. I know that Dave Ramsey advocates paying off home loan early in his book The Total Money Makeover. I believe this to be a great advice given his audience demographics. In general, if you are uncomfortable with investing for the long-term, you’re better off prepaying your home mortgage. However, investing as opposed to prepaying is a real and financially sensible option for many people.

Advantages and Disadvantages of Mortgage Prepayment

Since the right answer depends on so many factors, I will not 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 debt and own your home sooner.
Investment risk – Since you can’t beat prepaying with risk-free investments like money market, savings, and CDs, 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 15% for long-term capital gains. 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 (averaged), 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 behind financially if you prepay.
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 a significant over investment in real estate. By opting to invest your money instead of prepaying, you are reducing your overall financial risk through diversification.
Tax deductions — Your 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. It’s important to note an effect of prepaying your mortgage. Basically, 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 = $3,750 / (1 - 0.15).
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 – 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 payment, you could lose your home. By investing instead of prepaying, you maintain liquidity and give yourself a little insurance against potential financial hardship.

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 newer mortgage is more beneficial than prepaying mortgage that only has a few years left.
Mortgage Interest Rate — Obviously, it’s better to prepay, or even refinance, for mortgages with high interest rates. Since the long-term return on investment for the stock market is about 10%, it’s most likely better to prepay if your mortgage interest rate is higher than that. On the other hand, if your mortgage interest is lower, it’s probably better to invest. Please note that the effect of long-term capital gains tax and other taxes (15% upto your marginal tax rate), essentially cancel out the lost of tax deduction on your mortgage interest expenses at your marginal tax rate.
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.

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.

Some additional readings about prepay versus invest:

The Case Against Mortgage Pre-Payment at Consumerism Commentary
Paying Off the Mortgage - Good or Bad? at DebtFREE-Revolution
Investing Versus Paying Ahead on Your Mortgage: Which Makes More Sense? at The Simple Dollar
My Mortgage Dilemma - Prepay or Invest at A Penny Closer
Should You Prepay Your Mortgage and Mutual Fund Opportunities at Brian Preston’s

Other posts in the Dave Ramsey’s Baby Step Series:

Overview at Cash Money Life
Step 0 - No More Debt at Debt Free Revolution and Single Guy Money
Step 1 - $1000.00 Emergency Fund at Gather Little By Little
Step 2 - Pay off all debt using the Debt Snowball at I’ve Paid For This Twice Already
Step 3 - 3 to 6 months of expenses in savings at Being Frugal
Step 4 - Invest 15% of household income into Roth IRAs and pre-tax retirement at The Dough Roller
Step 5 - College funding for children at at My Two Dollars
Step 6 - Pay off your mortgage at Moolanomy
Step 7 - Build wealth and give! at Plonkee Money
Series Wrap Up at Being Frugal and I’ve Paid For This Twice Already

This article was featured in:

The Money Hacks Carnival #3 - What is a Hack? Edition hosted by My Dollar Plan. For more information please visit the Money Hacks Carnival.

21 Comments

FourPillars, 5. March 2008, 7:07

Very good points for either decision.

One other consideration is interest rate risk - if you have a mortgage that is variable or only locked in for a few years then at the end of the term you will have to renew at the current interest rate (at that time) which might be a lot higher than it is now. Reducing your mortgage helps mitigate this risk.

Mike
Steve, 5. March 2008, 8:12

I’m not sure I consider losing the opportunity to get $2500 back in taxes after paying $10000 in interest much of a disadvantage. Seems like I come out $7500 better off with no mortgage and no tax deduction.
Pinyo, 5. March 2008, 8:30

Steve - I agree. In fact you just made me realized something and I will be adjusting my post.

Basically, if you save $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. So my original statement about your investment gain must beat your interest savings is inaccurate because long-term capital gains is only 15%. For instance, to match the $3,750 savings, you’ll need about $4,412 = $3,750 / (1 - 0.15).

Thank you for your comment.
The Happy Rock, 5. March 2008, 11:29

I echo the sentiment on the tax savings for mortgage interest. It is nice that the government encourages home ownership, but I don’t think it is a reason to buy a house or stay in a mortgage. It is a nice benefit why you are paying a mortgage, but not something to be tied too.

If you pay $700 a month for a mortgage, say $500 goes towards interest you get a tax break of $6000 a year. If you didn’t have a mortgage and gave the full $700 to a charity of choice, you would receive an $8400 dollar tax break. You give others the benefit instead of banks, and you get a bigger tax break.
Pinyo, 5. March 2008, 12:40

@FourPillars - That’s a good clarification. I didn’t do a good job of elaborating on the “Mortgage Type” factor. Thank you.
7million7years, 5. March 2008, 15:56

Look, Dave Ramsey is great and I’m all for SAVING (prepaying your house can be a great way to save … just compare the after-tax interest that you are SAVING against the after-tax ’safe as houses’ return that you can get elsewhere e.g. CD’s, Bonds, possibly Index Funds IF you have a 30 year outlook).

However, I’m also all for INVESTING: instead of REDUCING my mortgage, I would be REDUCING MY EQUITY in my own home to no more than 20% of my Net Worth … and investing the rest, taking full advantage by locking in historically low interest rates in BOTH my own home and on my INVESTMENTS.

In 20 or 30 years, when I’m still/only paying a few $k a month on real-estate worth a few $m, I’ll be pretty happy … AJC.
Susannah, 5. March 2008, 21:16

I have to think that the diversification of assets issue is a big one–particularly if you are not fully funding tax-protected retirement accounts such as a 401(k) or a Roth. If you’re making $50k a year and funding your 401(k) at $7500, you’re doing great. But if there’s $500 a month left to pay down the mortgage or invest, putting it in the 401(k) knocks down your tax costs, keeps the interest advantage of the mortgage, and STILL doesn’t hit your maximum contribution. And it’s going to be worth a lot more in 25 years at 10% than you would save on a 6% mortgage.

You do have a $250,000-per-owner tax break on home appreciation, but your appreciation will stay the same whether it’s the bank holding the note or yours outright (the joys of leverage), so that’s not an argument to prepay.

I believe Free Money Finance just had a post about a woman who has a valuable home but few other assets. What if you’re 45 and have no money but what’s in the house? In this market, if you sell, you may lose a lot of your investment. If the money’s stuck in a 401(k), you may be eligible for a hardship withdrawal that requires paying taxes but no penalties. Or you may be stuck with a 10% penalty. But remember, if you sell your home, your “penalty” includes realtor costs, seller-paid inspection costs, and the cost of actually finding somewhere else to live. If you’ve followed Ramsey’s other baby steps, you have some cushion against this happening, but I believe the woman FMF discussed was suffering from long-term disabilities, had a spouse who died young, and was looking at living off the house and her savings FOR THE REST OF HER LIFE. At the age of 54. That’s a mandatory, unplanned early retirement, and one in which she was basically living on Social Security disability checks and worrying about the future.

In my mind, that’s a big argument for a more liquid asset base. And just about anything is more liquid than real estate.
OneCheapChick, 5. March 2008, 21:31

You just can’t discount the security factor in owning your home outright. Through a strange set of circumstances, I wound up with enough cash to pay off my home at the end of 2007. I did the math, and I think it would have been fiscally smarter to invest the money and keep the home mortgaged. But I paid the house off. Now, every time I hear the death-knell bells ringing about the economy, I take such great comfort in knowing that no matter what happens to the economy and my income, all I have to do to keep a roof over my family’s head is to pay the property taxes. We can stand in a soup line if we can’t afford food, huddle under a blanket if we can’t afford heat, and walk if we can’t gas up the car, but we will always have a roof over our head. It helps me to breathe every time I look at CNBC.

Math counts, but it doesn’t always give you the straight answer.
Dave, 5. March 2008, 22:08

Here’s a link to a column by Scott Burns which nudged me into paying off my mortgage. It is a little dated, written in 1999, but the concept is the same: Imputed income i.e. not having to pay for housing thanks to a paid off mortgage, can have tremendous tax-free returns.

Here’s the link:

http://www.dallasnews.com/shar.....0525TU.htm
Fixemup Terry, 5. March 2008, 23:01

I particulary like your point on the inflation factor. Once you have a mortgage locked in, the relative value of that loan will continuously drop. It’s better to pay your mortgage off in the future (with future dollars), which will be worth a fraction of the value of today’s dollars.

I wrote an article aimed at real estate investors entitled “Don’t Pay Down Your Mortgage” at http://www.fixemup.org/2007/12.....gage.html, which I humbly submit for your review.
Pinyo, 6. March 2008, 17:44

@Susannah - Thank you for bringing up 401k and Roth — I should have in my article although it’s already covered in step 4.

If you’re not already taking advantage of 401k (with the potential company matching) and IRA, there’s no argument — invest in your retirement first!

@Dave — Thank you for sharing the article. It’s interesting and worth further analysis.

@Terry — Hey Terry! I am beginning to read your book. Great introduction. I think I am going to share it with my readers…very inspiring.
PT, 8. March 2008, 20:06

Great read, Pinyo. This is a highly debated topic amongst our friends. I’m all for keeping the mortgage around for 30 years.
Rob, 11. March 2008, 20:27

Should also take into account how far along you are in your mortgage. If you’ve been making minimum payments for 20 years out of your 30, you’ve already paid the largest portion of your total interest costs, so the tax shield and interest savings are both diminishing as your mortgage reaches maturity.

Another thing to take into account is whether you plan on living on that house as your primary residence. True, you never really know… but if you think you’re going to retire in that house and never sell it, it’s becomes less of an asset because you won’t realize it’s appreciation in value. All else equal, you want to own an appreciating asset as quickly as you can (ie prepay your mortgage). However, if you don’t plan on ever selling it, you can more or less take property appreciation out of the decision making process. Of course, this whole property appreciation thing we probably won’t be worrying about for the next few years…
kentuckyliz, 12. March 2008, 5:57

Yeah, I think DR is a little too crazed about paying off the mortgage. But I agree, if one isn’t very knowledgeable about investing and doesn’t have the stomach for it (beyond what’s already happening in Baby Step 4 and 5), then paying off the house is probably a better next step for the nervous nellies.

I say let it run and increase investments instead. Perhaps have the house paid off by retirement, to lower expenses.

Ric Edelman says keep the mortgage and stay fully invested, period. But he lives on the East Coast with plenty of high-paying jobs. If I owned a house and lost my high paying job where I live, there are no other high paying jobs. I’d have to move. Hopefully I wouldn’t lose the house before I could sell it!

The risk of the house payment isn’t relieved until the house is paid off. Prepaying to me doesn’t seem to make sense unless you’ve piled up enough assets to pay it off outright. (Through inheritance, lottery winnings, winning a lawsuit, or saving and investing and piling it up.) If you haven’t paid it off outright, the risk of next month’s mortgage payment is always there, and the danger is losing your income for a long enough period to not be able to make the payment and then losing the house.

I’m a happy permarenter and don’t need a house, and invest instead, so I should issue the disclaimer of taking my comments with a pound of salt because I’m not a mortgageowner. LOL
Merch, 13. March 2008, 14:54

One thing I think is missed is that people don’t take a long term look at savings. In other words, if people had $50k sitting in account, most people would spend it on something (finishing the basement, buying a new car, taking a nice vacation). I don’t think that people have the discipline to let that money grew for 30 years without touching it.

And I think that’s the true issue. If you can honestly invest the money without touching it, then investing makes sense. If you would be tempted to spend that money, then paying off your mortgage is better.

If you prepay your mortgage, that money is gone. It’s not tempting you to consume.

I was actually looking at DR’s plan. I calculated that after I paid off my debt and saved for college and retirement, I could probably pay my 30 year mortgage in about 7-8 years.

At that time, I would have set up a behavior of living well below what I make. So investing and being tempted would be less of a risk.

Just a thought.
Pinyo, 13. March 2008, 17:01

@PT — Thank you. I am for keeping the difference for investing too.

@Rob — Great point. That’s one thing I haven’t considered in my post. It definitely makes a difference.

@Kentuckyliz — good add about your location. Another good point I haven’t considered.

@Merch — Agreed. It takes a lot of discipline not to touch money that is sitting “out there.” Definitely something worth considering when making this type of decision.
kentuckyliz, 21. March 2008, 8:20

@Susannah–your example wouldn’t happen on Dave Ramsey’s plan, because the woman would have already been saving 15% of her gross income in retirement investing (not counting the employer contributions), been debt free, and had a 3-6 month emergency fund; and if she had college-bound kids, she would have funded their college investment program first. Even earlier than that, establishing her basic safety net, she would have had disability insurance; and her spouse would have had 10x his annual salary in term life insurance. In effect, she wouldn’t be in the pickle she is now. You can’t describe that case then say, see, Dave Ramsey’s plan doesn’t work…because she wasn’t following Dave Ramsey’s plan!

Dave Ramsey puts the baby steps in that particular order, taking into account an accurate assessment of life risks, because it works. Especially for ordinary people.
Tom, 9. April 2008, 12:44

I see a lot of people talking about paying their mortgage off early as the safe thing to do. I respectfully disagree. If you have a rate of 6.5% or lower why on earth would you want to build extra equity? What does it buy you? You already own the house so why exchange the most liquid form of capital (cash) for one of the most illiquid forms (Home Equity) in the name of safety. Once this money is paid into your house the only way to get it back out if a need arises is to sell the house or refinance through a new mortgage or a home equity line. The better place to put your money is in a diversified mix of investments that you feel comfortable with.

Letâ€™s use this situation as an example. We have two people A & B. A overpays their mortgage in order to pay it off in 10 years instead of 30. B Takes the extra money and invests it in a conservative mix of stocks and bonds that earns 6.5%. Five years in both A & B loose their jobs and have no current income. Who would you rather be?

A has spent all there money paying down their mortgage, but does the bank let them slide on any payments? No, as soon as the payments are missed A will be treated just like any other late payer. What are Aâ€™s options here? Slim and none. Even though A has a large amount of equity, A has no current income. Good luck getting a loan! A may be forced to sell under pressure in a market that may or may not be favorable!

Now letâ€™s look at B! 5 years in B has a large stash of liquid securities that he or she can sell to continue making payments and living on until he or she finds another job! B is still in complete control of his or her own destiny.

What did it cost B for this insurance against disaster? Nothing! The money earned on the investments offset the interest paid on the loan. And 6.5% growth is a very conservative # here. You can achieve this without taking much risk at all. And once your liquid fund equals the amount owed on the mortgage you can pay it off if you like. Although at this point I doubt that you will because:
â€¢ the psychological burden of the mortgage magically evaporates when you realize that you can pay it off at any time
â€¢ the money is still better placed in liquid assets
â€¢ And by this time you have figured out that you can safely get 7.5 to 8% off those investments.

A lot of people say that paying a mortgage off early is the safe thing to do. It is safe; for the company holding your mortgage, not for you! Every extra dime you pay in lowers the risk that they will loose money if they foreclose on your house and sell it latter.
Pinyo, 10. April 2008, 8:07

@Tom — Great comment. That’s exactly how I feel with my 5.25% mortgage

Now, I don’t know if I am going crazy, but I’ve been considering refinancing to take money OUT of my home so that I can do something with it.
elaine, 6. August 2008, 14:42

The problem with most of the analysis with this step is that you’ve forgotten all the previous steps that lead up to paying off the mortgage early. At this step you already have a healthy emergency fund in place (to the tune of 10s of thousands of dollars, 6 months of expenses) so the chance of you needing to invest the difference for liquidity reasons is pointless. Another point is that you can’t predict your return rates on unfixed investments. Stocks go up and down, at one point you may be paying more in interest to your mortgage company then the bank is paying you on your funds, CDs are a great example of this. Everytime it is wise to be completely debt free, house and all. There is no chance of foreclosure when your house is paid for! There is no chance of a repo when the asset is paid for! Giving to charitable organizations is a better way to recover from the tax break of interest paid on a mortgage.
Ethan, 6. August 2008, 15:47

@Tom - Both examples you give would be a rough situation to be in. In your example of quickly needing liquidity, it seems that person B’s stocks haven’t also fallen in value. That isn’t a fair assumption, as the present market conditions can attest to. B would be in just as much of a pickle of he/she then had to sell thos “liquid” investments in a down market. These calculations never take risk into account, and that is statistically inaccurate.