Last time we looked at Baby Step 5, college funding for your children. We talked about how and when you should save for their education. Today we’ll be looking at taking extra money and paying off your home early. Before we jump in, once again, here are the 7 Baby Steps.
Dave Ramsey’s 7 Baby Steps
- Step 1 – $1,000 to start an Emergency Fund
- Step 2 – Pay off all debt using the Debt Snowball
- Step 3 – 3 to 6 months of expenses in savings
- Step 4 - Invest 15% of household income into Roth IRAs and pre-tax retirement
- Step 5 - College funding for children
- Step 6 – Pay off home early
- Step 7 – Build wealth and give!
Baby Step 6: Paying Off Your Home Early
After having saved for your retirement and putting money away for your children’s college expenses, the next thing Dave Ramsey suggest doing is paying extra on your mortgage, and paying off the home early.
To start with Ramsey suggests getting no more than a 15 year fixed rate mortgage, that is no more than 25% of your income. If you don’t already have a 15 year fixed mortgage, now may be a good time to refinance your home with the “Making Home Affordable Refinance Program“. A 15 year mortgage may mean higher payments, but it also means you’ll be paying the loan off earlier, and you’ll be paying less in interest. Pay it quicker that 15 years, and you’ll save even more because most of the interest is paid at the front end of the loan period.
By paying off the mortgage early you’re also going to be giving yourself a huge peace of mind knowing that your house is paid off, and if the worst happens, you’ll be able to get by on a whole lot less. After all, the house is paid for!
Arguments For Paying Off The House
There are a lot of arguments surrounding this baby step, and whether it really is the best thing to do psychologically and financially. I know I won’t solve that debate here today, but I thought I would look at some of the points in favor and against this plan, so you can make the decision for yourself.
Points in favor of paying off the mortgage early:
- Interest Savings: You’ll be saving thousands of d0llars in interest payments on the mortgage. For example, on a 200,000 dollar mortgage over 30 years, with an interest rate of 6%, you’ll end up paying over 250,000 in interest. Cut that to a 15 year mortgage and you’re only paying 115,000 in interest. The faster you can pay the mortgage up front (when you’re paying the most interest), the less interest you’ll pay!
- Less Risk: By prepaying your mortgage you’ll have less risk in your life because you’ll have a paid off house. When you have a paid off house you have a lot less to worry about because you know you’ll at least have a place to live as long as you cover the few bills you have left. Plus, trying to beat the the benefit of pre-paying the house by investing the extra money instead means added risk because investing isn’t a sure thing. (As we’ve seen for sure these past few months.)
- Peace Of Mind: Having a paid off house means having peace of mind. I don’t think the importance of that can be underestimated. Having debt of any kind can really be a extra weight on your shoulders, and it can weigh you down. Don’t underestimate the psychology of personal finance, and that burden is very real. Remove it and you will feel a lot more free to save, invest, build wealth and give!
- Less Stress: You’ll have less stress when having to deal with a job change, or wanting to have a spouse stay home to raise the children. Because you have a paid off house you’ll only have a few small bills to worry about. You’ll have walkaway power – power to walk away from any job you don’t love or enjoy because you only have minimal expenses!
- It’s Like Getting A Raise: Without having to pay that large bill every month, it’s like getting an instant raise! You can take the extra money every month -and start investing!
While reading about the baby steps on another site, I read one story of someone who has paid off their mortgage. It really emphasized why paying off a mortgage can be a good idea.
A friend of mine is in his mid-thirties and paid his mortgage off completely. This allowed his wife to quit work and stay at home to raise their three children. They have no other debts, and he recently took a lower paying job because it brought him more satisfaction at the end of the day. He wasn’t trapped by an enormous mortgage, or saddled with other debt. Being debt free allowed his family to make these decisions to live the life they want to live, not live the life they are force to live to just to repay debt.
Being debt free brings freedom, and sometimes that’s better than a few extra dollars made through investments.
Arguments Against Paying Off The House
I’ve read a lot of arguments against paying off the house on other blogs. I have to admit that many of them make a good argument against paying off the house. Some of the better ones:
- Liquidity And Flexibility: By not prepaying your mortgage and instead investing the money, you are more liquid in your holdings. Your money is more accessible if it is in investments as opposed to in a house. This can give you some flexibility if you need the extra money. Of course, having your 3-6 fully funded emergency fund should preclude needing any large amount of money right away.
- Investing Returns Could Be Higher: If your expected returns on your investments will be higher than the interest and money saved by pre-paying, investing instead of repaying may be the better choice.
- Inflation Works With You: As inflation goes up by 3-4% annually, by not prepaying you are in essence paying less for the house every year. You pay the same in 2039 to live in your house as you are in 2009. So basically you’re getting more for your money as time goes on.
- Lack Of Diversification: One could argue that paying off your house first means you’re investing in only one type of asset, and unnecessarily means more risk. Better to invest in good mutual fund where your holdings are diversified, instead of investing in only one thing, real estate.
The arguments against paying off the house first do have some merit. It really makes the decision a tougher one.
My Conclusion.
When looking at all of the arguments in favor and against paying off your house early, both sides of the debate make valid points. That makes the decision on what to do a tough one.
On the one hand, the psychological and peace of mind benefits of paying off the house early are very apparent and powerful to me. I can’t even imagine how freeing it would be to pay off our house, and to have all that extra money every month to save, invest and give away to those in need. Complete debt freedom would be amazing!
On the other hand if you look at the numbers logically, not paying off the house early really does seem to make more financial sense. With a historical stock market return of almost 12% in the long run, there aren’t many cases in which prepaying the mortgage can make more financial sense. In fact, if you’re looking at a 15 to 20 year window of home ownership, in the past an investment in the S&P 500 index would have been a better investment 100% of the time!
Still, it comes down to weighing the benefits, the risks and balance sheets on both sides of the equation. For me, after considering both the financial and emotional/psychological sides of the equations, I’m still coming down on the side of pre-paying the mortgage. It just seems to me to be such a powerfully motivating goal to have – a debt free life. I really relate with the story I linked above about not having a house payment, and the freedom that brought to the family – being able to have one spouse stay at home, and having the power to walk away from a job that wasn’t ideal.
While I realize that some may do better financially by not paying off the house, to me it is more motivating to be living a life without debt and to have the freedom that goes along with that. The few extra dollars we might make by investing the extra money instead doesn’t matter as much to me. The answer may be different for you.
Another idea? Do a combination of the two paradigms, pay a little extra, and invest a little extra!
What do you think about paying off the house early? Do you think it’s a good idea or a bad idea? Which path are you choosing if you’re at that point? Tell us in the comments!
Next Time – Baby Step 7: Build Wealth And Give
Next time we’ll be looking at the last baby step. Baby step 7 talks about continuing to build wealth and stresses the importance of giving to others.
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We’re actually hoping to move this step along by refinancing to a 15 year or a 20 year loan. (15 year is preferable.) Interest rates have almost hit that points where they are 1.5% below what we have right now. Crossing our fingers…
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Thanks for these helpful real estate tips. Real estate purchases go all the way back to the time of Genesis. Abraham insisted on paying the full price for the plot of land that would be his wife Sarah’s burial site, even though he could have gotten it for free. The full citation is at bibleconomy-dot-com
I think the point is tied to some of the other positives, but cash flow is a major win. Instead of shelling out thousands a month, you are free to direct that money anywhere you want. It is like getting a $20,000 a year raise.
You can also consider the tax benefits of mortgage interest too, although often that is a misleading ‘disadvantage’. You can get the same write off by giving the money to a charity rather than the bank.
I fall completely on the pay it off ASAP side. I want to use my money and my stress/energy for things that serve others and bring me joy.
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What price do you place on the ‘peace of mind’ because ultimately that is what it comes down to. Let’s say you have a 30 year mortgage and you decide that you can afford to make additional $x payments every month and payoff the mortgage in 20 years, at let’s say, 6% rate of interest. Also, let’s consider the alternative of investing $x everymonth in a S&P index fund in a separate ‘paying of house in 20 years’ account and realistically expecting 12% average return over the same period of 20 years. In this scenario, I would recommend to invest these excess dollars and at the end of 20 years, payoff the remaining mortgage using your investments. You will still have money left over in your investments this way as you earned a higher return than the rate of interest you are paying on the mortgage.
End result is the same, you paid off your house in the same amount of time either way. You probably had greater peace of mind when you invested as your money was more liquid.
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I too fall on the side of pay it off ASAP. About the last argument against paying off early, if you are following the Baby Steps, then you are already putting 15% toward your retirement, so by paying off the house you are diversifying your portfolio further (adding real estate to the mix) rather than being un-diversified.
I am all for paying off the house as soon as you can; as long as its where you want live for a very long time!
We have moved from Florida to CA to Nevada to Texas to Georgia to Indiana; all in the last 10 years because of my husband’s job; and have own/sold our home each time. After many years of doing that, we have finally decided to buy a home – where we want to live and retire – and pay it off.
It will be sooo nice to have that burden lifted from out shoulders; knowing we have a place to live; no matter what happens in this economy.
I am in favor paying of the home early. Remember that when it comes to personal finance it is not always about the returns on investment but we must let our heart lead us and 9 times out of 10 our heart will lead us to the paying of the home early. As far as not being diversified enough, if you are at this baby step you have 3-6 months of expenses in cash and you are investing 15% of you income in good growth stock mutual funds for investing. As Dave says the best investments are real estate and mutual funds!
My wife and I bought our first house in June 2002 which was right before the price of houses went up dramatically. We put more than 20% down. We both work in an industry where we are at constant risk of being let go so for peace of mind we more than doubled our house payment which allowed us to pay of our house in December 2007. I read so many articles and blogs about why paying off the house early was not a good idea but I knew that for us it was the right decision. Most of those articles and blogs said that it wasn’t a good idea because you are tying up your money in a house and that it would be better to diversify. Of course, when they say “diversify” they mean to spread your money out in various kinds of mutual funds. Well, had I listened to them my money would be sitting in a mutual fund somewhere right now and would have lost half it’s value. But paying off our mortgage early has allowed us to save cash unbelievably fast and that gives me and my family a peace of mind in this terrible economy. I don’t have to worry about losing my house. I don’t have to worry about losing my job but even if I do we can continue to send our kids to a Christian school. Living without a mortgage is just “right” in so many ways. I don’t want to be perceived as a nut but after maxing out my 401k for years and years and seeing it drop it’s value so rapidly so many times I’m only contributing what my employer matches now. I know there are tax consequences for doing that but it just seems to me that the whole stock market thing is a big scam – they’ll tell you that the market has averaged over 10% growth… really? It sure doesn’t look like it when I get my 401k statements. The bottom line is that the bulk of my money is going in to CDs and some in gold because at least there I know my money isn’t going to vanish. And I know that I never have to worry about taking care of my family. I’m not convinced that I’ll realize a higher rate of return by investing in the stock market and even if I would I wouldn’t trade the peace of mind that I get by having my money in cash. I understand that by making less than 3% on a CD that I’m actually losing money when you take in to consider inflation but if I lost half of my 401k (or mutual funds) from a bad economy would I not be way ahead if that money was in cash? Lastly, and most importantly, I believe that God put it in my heart to pay off our house early and it’s truly been a blessing from Him. He’s been so loving and wonderful to my family (even when I haven’t been very lovable). Thank God for the work of Jesus Christ and the grace he has given us!
Hi Dave,
My church has us preparing for the possibility of a financial collapse. They believe if you can be debt free you will be able to handle whatever happens. Apparently during the depression, those that did well owned their homes and were able to grow some food items.
As a church we are all trying to stock up with 6 months worth of food for ourselves and 6 months worth to give to those who aren’t prepared.
I figure if I can pay off my house I can save the money until needed and I can share my home by offering someone a place to live if needed.
It’s a little scary taking all that money out of retirment acts but in the end I think I will feel safer.
Joanne
No one mentioned that the borrow is slave to the lender. That includes mortages. People somehow have got the notion that there is ‘good’ debt and ‘bad’ debt. Granted, there is some debt that is worse than others, but debt is debt and the master – slave relationship is there.
I have weighed the pros and cons as well and I can’t seem to shake the security of what a paid off house is like. I setup a blog at http://www.payingoffmyhouse.com to keep me motivated towards my goal. I know if I have this in to keep updated it will encourage me to finish my goal. I am in the process of refinancing to a 15 year loan, I can’t believe how low the rates are right now.
I know a few people who have lost their jobs and they are facing the horror of a forclosure. I think this is the kicking point for me to be financially secure with a paid off house. I can see how quickly a job loss could make you end up homeless on the street. I never want to have the happen to me.
I am currently on baby-step 3 and in a couple months I will start paying off my mortgage. I can’t wait to see my statements to see how much is going towards interest and how much is going towards principal.
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