Dave cautions people who reach this step that they are in grave danger: danger of settling for “good enough" when, if they keep the course, they will experience “best". People need to remember that the financial plan is like a marathon; slow and steady wins the race. However, the 18 mile mark for many marathoners is when they hit the wall and drop out.
Baby Step 6 is the 18 mile mark of the Total Money Makeover. Arriving at step 6 generally means you have been on the plan for several years. You have paid off all debt except your house. You have saved at least three months of expenses into an emergency fund and have started investing 15% of your income toward retirement. You are saving for your kid’s college and are now poised to pay your home off early. Dave points out that the time frame from beginning on Baby Step One until getting the home paid off is commonly seven to eight years.
Just to be perfectly clear about how the Baby Steps work, we need to explain that Steps 4, 5 and 6 work together. Step 4 is investing 15% of your income for retirement, but all cash flow above that 15% needs a name or else it will disappear. Step 5, saving for college, is your first priority for this “extra" cash flow and all above what is needed for college should be used to pay extra on the house.
Responses to Two Common Objections to Paying Off Mortgage Early
Objection One: “It is wise for me to keep my home mortgage so I can get the tax deduction". Dave uses this example: if a person is pays $10,000 interest on his mortgage in a year, he can pay taxes on $10,000 less income that year. If he is in the 30% bracket he will save $3,000. It is not smart to intentionally pay $10,000 in order to save $3,000.
Objection Two: “It is wise to borrow all I can against my house because I can make a higher return investing than the interest rate I pay on my mortgage". According to Dave, there are two problems with this plan.
The first is that taxes or capital gains will eat up much of what you plan on making. For example, if you are paying 4% interest on your mortgage and you can make 8% with an investment, you aren’t really clearing that 4% difference.
The second is the risk. Suppose you intentionally did not pay down $100,000 on your house and you are injured or your job gets downsized or the real estate market nosedives? These are the very problems that brought on many foreclosures in the recent recession and exactly what Dave Ramsey has been warning people about for years. One of his favorite quotes is, “100% of all foreclosures had mortgages on them."
Types of Loans to Avoid
The problem with a 30 year loan is the huge interest one pays. For example, with a $110,000, 7% mortgage, one would pay $256 more per month for a 15 year loan when compared to a 30 year loan. However, the total payout on the 15 year term is $177,840 compared to $263,520 on the 30 year loan…a savings of $85,680!
Dave also strongly advises against Adjustable Rate Mortgages (ARMs) and Balloon Payments. Why? Too much risk. Rates seldom adjust downward and you are not positive you will be able to refinance or sell when a balloon comes due. Again, these risks have been huge factors in the foreclosures in the past few years.
Dave likes a 15 year fixed rate loan. No surprises and get it paid off as soon as possible.
The Grass Feels Better Under Your Feet
While the financial purpose of getting the house paid off is to free up that cash flow for building wealth and being very generous (see Baby Step 7), there is an emotional aspect too: the grass simply feels better under your feet. You want to go out and roll in the yard because it is totally yours. The freedom of owning your own house outright is extremely liberating. You were already debt free except for the house; now you are totally debt free. You owe no one anything. It is hard to put this in financial terms, but we are talking about financial peace here and having a paid for house is a pinnacle of peace.
My Own House Story
Janice and I bought our house on a 15 year fixed rate loan in 1973, but over the years we kept taking out home improvement loans. We even refinanced one time and rolled our car debt onto our house loan. Janice mentioned several times that we should get serious about paying it off, but I was the “genius" who didn’t want to get rid of the tax deduction. Only after we started our own Baby Step plan and worked our way to Baby Step 6 did we focus on paying off our house. We accomplished Step 6 about four years ago and I have to admit that Janice was right all along. Having a paid for house and being totally debt free is much more liberating than I would have ever dreamed. The grass really does feel better under my feet. Guys…listen to your wives.