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Dave Ramsey’s Early Mortgage Pay Off Advice, Good Idea?

Dave Ramsey’s Early Mortgage Pay Off Advice, Good Idea?

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Should You Pay Off Your Mortgage Early? This is a popular question among homeowners. Some people believe paying off the mortgage as fast as possible is better, and some people believe investing the difference is better. In his book The Total Money Makeover, Dave Ramsey’s Baby Step #6 advocates paying off your home loan early. I think this is a good advice for his audience, and probably, the majority of people out there.

Dave says you should first invest 15% of your income for retirement before you work toward paying off your mortgage.

The Right Answer

I think there are many factors to consider to find the right answer, but for the most part, it can be summed up into three main choices.

  • Pay Off Early. If you are not proficient with investing and your mortgage rate is relatively high, you’re better off prepaying your home mortgage. If your interest rate is higher than 6.5%, you should definitely pay off early or refinance your loan (see: 1.4x Investing vs. Debt Pay Down Rule for explanation). This is also a great choice if you are paying a Private Mortgage Insurance and you can get rid of it by increasing your equity.
  • Invest. If you have a low mortgage rate, and you are a proficient investor, investing instead of prepaying is probably the more financially rewarding option.
  • Dave Ramsey’s Approach. This is a balanced approach. Invest 15%, then use any extra money to pay off your mortgage early.

Our Approach

I feel mortgage debt is the lowest priority and you should prepay only if you already maxed out all of your retirement contributions and paid off your higher interest rate debts. Here is a graphic showing how we rank mortgage prepayment relative to other debts and investments (mortgage is at the very bottom):

Pay Off Debt versus Investing

Early Mortgage Pay Off vs. Invest

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

Dave Ramsey's Early Mortgage Pay Off Advice, Good Idea? 1

Advantages of Prepaying Your Mortgage

1. Reduce or Eliminate Private Mortgage Insurance

If you paid less than 20% down payment, then you have to pay a Private Mortgage Insurance (PMI) each month. Getting rid of your PMI is a good reason for prepaying your mortgage. If I have to pay PMI, I would definitely pay down my mortgage to get rid of PMI before I start investing in a taxable account.

2. Lower Your Lifetime Mortgage Interest Paid

I believe this to be the second most significant benefit of prepaying your mortgage. You’ll end 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.

3. No Investment Risks

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.

If you are not a proficient investor, paying off your mortgage early is a good choice.

4. No Taxes on Money Saved

You have to pay the long-term capital gains tax on your investment gains, plus the dividend and interest payments are taxed at your marginal tax rate. Therefore, you do not recognize the full value of your investment gains.

For example, if your investment gained $6,000 in value and you have to pay 20% in taxes (15% for Federal and about 5% for State), that’s only equivalent to $4,800 net gain.

Disadvantages of Prepaying Your Mortgage

1. Opportunity Cost

Depending on your interest rate, investing could provide you with a superior return on your investment. So it’s possible to come out financially behind if you prepay. This is especially true if you have the opportunity to fund a retirement account like a 401(k) or an IRA due to their tax benefits.

This is why I think it’s better to max out your retirement contributions before you even think about making an extra payment toward your mortgage.

2. 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 the debt you owe).

By opting to invest your money elsewhere instead of prepaying, you are increasing your investment in other asset classes. This effectively reduces your real estate exposure and overall financial risk through diversification.

3. Fewer 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. For example, if you saved $500 on interest and your marginal tax rate is 27% (State plus Federal), you’ll lose $135 in tax deduction — therefore, your net saving is only $365.

Since long-term capital gain taxes add up to about 20% (15% for Federal and about 5% for State), you’ll need an investment gain of about $456  to match the $365 savings (i.e., $365 ÷ (1 – 0.2)).

However, this factor 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.

4. Less Inflation Hedge

When you owe money, and you pay back over 30 years, inflation is your best friend. Assuming an average 3.0% inflation rate, your $1,000 mortgage payment is only worth about $415 thirty years from now.

5. Less Liquidity

Your mortgage is a secured loan.  Prepayment doesn’t earn you any favor with the bank. The bank still has a lien on your house until you pay off that last penny.

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.

The Swing Factors — It could go either way…

1. Mortgage Type

There are many types of mortgage. Your decision to pay off your mortgage early or not could depend mainly on the mortgage terms and the prepayment clause.

For example, you might not prepay if there is a prepayment penalty, or you might prepay if you have an Adjustable Rate Mortgage (ARM).

2. Mortgage Age

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.

3. Mortgage Interest Rate

Obviously, it’s better to prepay (or refinance) a mortgage with a high interest rate. Since the long-term return on investment for the stock market is about 9%, it’s most likely better to prepay if your mortgage interest rate is higher than about 6.5%. On the other hand, if your mortgage interest is lower, it’s probably better to invest.

4. Investing Skill

The whole premise of this argument depends on your investing skill. If you can’t or won’t invest, and ended up spending the money, you’re better off prepaying.

5. Financial Stability

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.

Prepay vs. Invest Calculation

Here is an example of Prepay versus Invest calculation using my own situation as an example. I will be using two calculators that you can use to calculate your own numbers.

The variables are:

  • $188,000 loan amount
  • 4.25% interest rate
  • 30 years fixed loan
  • $116 principal prepayment per month

Using the Mortgage Payoff Calculator at Calculator.net, I found out that I saved $32,406.46 in interest and will shave off 5 years and 11 months.

Original Prepayment
Monthly Payment  $924.85  $1,040.85
Total Payments  $332,944.92  $300,538.46
Total Interest  $144,944.92  $112,538.46

The saving is not bad. If I factor in the loss in tax deduction, then my NET saving is probably about $21,000.

Now, using the Investment Calculator at Calculator.net, if I instead invest the $116 per month for 24 years at 9% average annualized gain, I would end up with $111,232….after 20% federal capital gains tax plus state tax, this is about $89,000!

For my specific situation, investing would be about 4.25 times more beneficial!

Dave Ramsey Mortgage Payoff Calculator

Dave Ramsey also has a very user-friendly Mortgage Payoff Calculator that you could check out.

Dave Ramsey Mortgage Payoff Calculator
Screenshot of Dave Ramsey Mortgage Payoff Calculator take July 2019

The caveat here is that Dave Ramsey encourages people to pay off their mortgages early, so the calculator is only showing the benefit of making extra payments and leaving out the opportunity cost.

Is It Better to Pay a House Off Early or Not?

To sum it up, many factors affect your decision to prepay your mortgage or invest your money. 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.

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OneCheapChick
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OneCheapChick

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… Read more »

Steve
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Steve

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.

The Happy Rock
Guest

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… Read more »

bdslack
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bdslack

I would be interested to hear how everyone’s opinion has been shaped by the recent events. I am paying off my house in the next three months and have never felt better about this decision (I’m 35 years old).

BOA – Thanks for the loan, but I’m going to keep the extra 200K in interest for my family. Safe, sound, and tucked away in our paid for – family owned home that we really enjoy and will continue to use as the center hub of our family for a long time.

Max
Guest

Awesome post & discussion. I’ll add this gem:

100% of foreclosures happen on homes with mortgages.

FourPillars
Guest

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

AJC
Guest

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… Read more »

Susannah
Guest

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… Read more »

Phil Taylor
Member

Great read, Pinyo. This is a highly debated topic amongst our friends. I’m all for keeping the mortgage around for 30 years.

Rob
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Rob

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… Read more »

kentuckyliz
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kentuckyliz

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… Read more »

Merch
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Merch

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… Read more »

Tom
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Tom

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… Read more »

elaine
Guest
elaine

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… Read more »

Zeke
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Zeke

Back in 1978 my second wife and I were faced with buying a house due to having moved cross country. Her style was to spend any money that wasn’t absolutely dedicated to a bill due right now. In those days I didn’t have the benefit of blogs such as this one to help persuade her but I was desperately interested in getting into investment mode. Mortgage interest was very high: 9.75%! My solution was to get the shortest term loan for which we could handle the payments. This turned out to be 15 years, so over everyones objections I insisted… Read more »

bdslack
Guest
bdslack

One more thing on this huge “tax savings”. If you want to get a reduction in taxes so bad – don’t send your bank 10,000.00 a year in interest to do it. Give 10,000.00 to your church, the boy scouts, your college, a needy family. The tax deduction is the same and honestly after what just happened in America who do you think is going to need it more? The “great mortgage tax break” is a total scam. Pay for what you bought, and THEN save huge amounts of money! House money is “play money”. Nobody really gets rich on… Read more »

Brock
Guest
Brock

I have a question for all of your expertise. I find myself in an unusual situation at an unusual time. I work overseas and make much more than I usually would. In the next month I will have 100k saved and I am glad I did not take the advice of a financial advisor and invest it in mutual funds after watching the market most recently. At first before research I was going to just pay off a house outright as soon as I have the cash and avoid any interest. I feel with the housing market as low as… Read more »

Steve
Guest
Steve

I’ve heard that Ric Edelman & some other experts are big fans of keeping a mortgage for the tax break. I’m more a fan of DR view of pay the damn thing off either on time or early if possible. Then take what use to be the mortgage payment & put it into a CD or something safe. The key to this scenario is doing something constructive with the old mortgage payment. I haven’t done the math but I’m almost positive that for most of the people in this country they willl end up with more money in their pocket… Read more »

Matt
Guest
Matt

It amazes me that people can be so led off course with this question. The fact of the matter is very simple. It is never better to pay off your mortgage early. You can analyze any aspect of it. At the end of the day, paying off your mortgage does not increase the value of your home. You are simply transferring money from one side of your balance sheet (liquid assets) to the other side (non liquid). Even if you saved the money by putting it under the mattress (0% return), you will have created more wealth by NOT paying… Read more »

Jamey
Guest
Jamey

The fact is, you must have shelter. I can think of nothing better security wise than to own you own shelter outright…then in the worst of times you simply need to come up with HO insurance and property taxes, bills and food. The Ramsey plan does diversify in that 15% of your savings are going into mutual funds through retirement…it isnt really liquid but that is what the emergency fund is for. This plans assumes you have good disability and life in case of disaster and that otherwise you plan to work until you can access retirement. It also assumes… Read more »

larry
Guest
larry

larry- look i saved 60000 by pre paying .I work 32 hrs week 14 hr im 42yrs old. and as you know the gov will be my retirment 2500 mo. and growing with this president . i will be payed off in 3 yrs. with 70000 eq. i dont want to work when i am 50 but i live very small.

larry
Guest
larry

should i get a c card w/ 0% intrest intro. and pay it off . or i can get a loan for 15000 at 3% that i wood only use for e.fund. im debt free now but little savings. and a unstable job- econome

Dave Ramsey’s Early Mortgage Pay Off Advice, Good Idea?

by Pinyo Bhulipongsanon time to read: 6 min
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