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

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? 3

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.

OriginalPrepayment
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
OneCheapChick
12 years ago

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
Steve
12 years ago

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
12 years ago

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
bdslack
11 years ago

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.

bdslack
bdslack
11 years ago

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 »

Erik W
Erik W
10 years ago

Here is a question for everyone. I currently live in MA and my wife and I are planning on moving to Florida as soon as we can find jobs down there. I am a CPA and she has an MBA. So while jobs are hard to come by in every state I think eventually we will be able to find something. I bought a condo years ago in MA which we will be selling and through some inheritance, savings and proceeds from the sale of the condo in MA we could buy a home outright in Florida for $300K, still… Read more »

Greg
Greg
10 years ago

Couple things… have a home and have saved enough to pay it off. Today’s economy and the way government seems to be acting, Bernacke, etc… and the amount of friends and family that watched their investments, 401k’s, etc… drop out of sight over night….

I will pay off the home! Bird in hand… is worth?

Like OneCheapChick said, if all else fails, we can just pay the taxes and still have shelter.

JB
JB
10 years ago

Here’s another simplified way I look at it (full disclosure – I am a Ramsey fan) Assume a 6% mortgage. If I pay extra on my home, there is an automatic 6% return, minus any tax deductions. Those strictly into the math of this will quickly shred that statement…..but…. Add in the security of a paid for home and no longer being a slave to the mortgage lender anymore… What is that worth to a person? It’s a personal question that math can’t answer. I had a paid for home 6 years ago before we decided to move. When your… Read more »

Max
10 years ago

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

100% of foreclosures happen on homes with mortgages.

David
David
10 years ago

I prefer to pay off my mortgage as soon as possible. After my mortgage is paid off then I only have to pay $0 per year.

Retire Early
Retire Early
10 years ago

Paying off a mortgage IS an investment that pays at the rate of the note. For example, if you have a 5% mortgage, ever dollar you pay extra, accumulates interest at 5% from the day you send it in, until the mortgage is paid in full. That extra dollar will compound and help reduce the term of the loan. An extra dollar paid in the first month of a 30 year 5% loan, accumulates to saving you $3.45 in interest payments. Some say there is no “payout” for paying extra. To that, I say wait until it’s paid off and… Read more »

Val
Val
10 years ago

I read most the posts here but not all. From what I read, nothing was mentioned about the home owners age. I think how old you are, is very important as well. The poster above, makes a solid point which is the way I see it. Pay off your house. You don’t know what the next moment will bring. If you’re not rolling in dough but you accumulate the dough to pay off your house, by all means do it. I don’t care if you do have only 3 years left to pay it off. Pay it off NOW if… Read more »

Ed
Ed
9 years ago

Great stuff, but I would much rather pay off my mortgage sooner, to save on the interest and to get my home sooner… Plus be out of debt.

Shawn McCarter
Shawn McCarter
9 years ago

How stupid is this topic? Just look at a 30 year amortization schedule. That will exactly pinpoint how ridiculous it is to spend 30 years donating a great portion of your income to a mortgage holder. Pay it off… pay it off… pay… it… off…

A debtor is in business to keep you in debt for one reason. Because it’s profitable for them to keep you in debt.

Always remember… a bird in the hand is worth two in the bush.

bill
bill
9 years ago

We made extra payments on our home and for my 38th birthday we got full title to our house. It was a great decision and would do it over again. Since then we have been methodical on socking half the previous payment in various forms of savings. The other half, I will admit, has been spent on goodies: A new car (paid cash for it), some nice vacations, and some toys I have coveted for years but not bought…It was tough those years…working extra jobs and dumping the money into our house…but now I feel free and have “extra cash”… Read more »

David
David
9 years ago

It is better to pay off your mortgage than to invest. With stocks you have to pay corporate income tax which is 35%, capital gains tax and dividend tax which diminishes your return rate. You don’t have to pay any capital gains tax on your house if your profit is less than quarter of a million dollars. The stock market is unpredictable, there are no guarantees that you will make 10% a year on your money. In 2008 the S&P 500 return rate was -37.22 which we still haven’t recovered from yet. Once you pay off the money you borrowed… Read more »

Danny
Danny
9 years ago

Having low investment knowledge or a low risk tolorance has nothing to do with paying off your house. Everyone should always pay their house off as quick as possible so that you can invest like crazy with what used to be your house payment.

If your house payment was $2,000, well guess what, you have $2,000 extra to invest every month. That’s $240,000 in decade you can invest because you have a paid off house.

MortgagesByMark
MortgagesByMark
9 years ago

@Matt who said: 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… Read more »

Danny
Danny
9 years ago

@MortgagesByMark I agree, Matt is an idiot. When you have no mortgage payment, you have power. While the average sheep is paying $1,500 – $2,500/month toward a mortgage, I’m putting that money in mutual funds. Within a decade, I have enough money in those mutual fund to buy 2 – 3 houses with cash if I want.

David
David
9 years ago

@Mark Can’t you see that if you pay off your home then your mortgage will be $0 per month times 12 months = $0 per year times 10 = $0 every decade

CharlieBoy
CharlieBoy
8 years ago

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… Read more »

Mind Sanity
Mind Sanity
8 years ago

Good article and I like the fact you acknowledge the things you missed as people bring them up. My mortgages started in 1977, along with the car payment, the credit card bills and other debts. Looking back there are so many times where they all could have been paid off. Now approaching retirement even though it looks like there will be enough for my wife and I to retire comfortably we still have a mortgage. In the last 7 years my car payments went away, my toy payments disappeared and credit cards are paid each month with no interest charged.… Read more »

Jeff
Jeff
8 years ago

Too many variables to consider. Will food double again in the next 2 years? Will cancer rates continue to rise? Will a new car cost $100k in 20 years? Go for the disposable income, don’t pay extra on the mortgage, live now and know your life expectancy based on your habits. Owning in my opinion is cheaper than renting. But i’d rather give my my money to a dirty banker now @ 4% than pay a dirty politician 40%, 20 years from now on a 401k. Work hard get nothing. We’re going down.

FourPillars
12 years ago

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
12 years ago

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 »

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

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