photo credit: rutlo
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.
Generally speaking Ramsey has great advice for the majority of people but it all depends on your personal situation. I had the opportunity to pay off my house in full earlier this year because of a large business profit but I chose not to because I know that the money would make a lot more money for me in the long term reinvested back into my business than it would by paying off my house.
Credit Card Chaser,
Personal finance wouldn’t be personal if the same advice always worked for all people in all situations.
Congratulations for doing well with your business this year!
I’ve never followed the Ramsey plan (although I’m well aware of the ‘baby steps’ plan). In the late 90s and early 2000s, when the stocket market was doing poorly, instead of investing I sent all extra $$ to our mortgage companies. I paid off the mortgages on both our houses. To my dismay, the grass didn’t feel any better under my feet. Why? Because one never owns one’s home outright. We still owe property taxes on them every year, and if we don’t pay them, guess what? We lose the houses. Then there’s the issue of property insurance. Between the two, we pay about $22k per year. So don’t fall for the myth that you can own your home outright, it’s just not true.
Laura,
It seems that you are doing well financially (two paid for houses) without using the Ramsey plan. Congratulations!
About property taxes…ugghh. You are absolutely correct in saying that we must pay them or we could lose the property. I try to be philosophical and consider the school systems and highways and bridges that my property taxes go for, but, well, that doesn’t keep me from becoming disgruntled.
Thanks for stopping by and commenting. I appreciate hearing from you.
Having a home fully paid for is a worthy goal and can give some peace of mind with the economic uncertainties we face. Our personal preference is to be either fully mortgaged or fully paid. That area in between fully mortgaged and fully paid is what we call no-mans-land. The advantages of paying more toward principle each month are outweighed, in our opinion, by the unavailability of those funds if needed for an emergency due to the non-liquid nature of the asset. Banks are less likely to approve meaningful HELOC in a declining real estate market. So that means our extra principle payment is unavailable for use in an emergency. In our view, the debate is not whether being fully paid is good or not, but rather how best to achieve it. Laura raises an additional concern. Various jurisdictions are on the hunt for more revenue as tax revenue streams decline. Real estate is a fixed and tempting target for those tempted to kill the goose that laid the golden egg. The best thing to revive the depressed real estate market and boost tax revenues would be to lower real estate taxes drastically to reflect more realistic appraisals. If they don’t do this many more jurisdictions will find themselves in the position of Detroit where they end up seizing, holding, and maintaining properties that bring in zero tax revenue.
Steven and Debra,
I totally agree with your statement, “the debate is not whether being fully paid is good or not, but rather how best to achieve it”. Having a paid for home, for example, with no emergency fund, is not being wise. Dave Ramsey does not recommend paying off a home mortgage until a fully funded emergency fund is in place, retirement investments are in order and kids’ college funding is established. Once at that point, paying off one’s home completely is sweet.
Absolutely a fully funded emergency fund should be in place before making the effort to pay off a mortgage. Although I disagree with Dave Ramsey’s recommendation to have a 3-6 month emergency fund, especially in this economy. With jobs painfully difficult to get, I’d consider a one year emergency fund as more realistic/safe.
I also don’t agree with Ramsey’s recommendation for a 15 year fixed. Even though the interest rate will be slightly higher for a 30 year fixed, the homeowner is obligated to the higher payment of a 15 year mortgage. Should hard times happen, this threatens the home more. I would only consider a mortgage with no pre-payment penalty, so it’s easy enough to turn a 30 year mortgage in to a 15, 10, or 5 year mortgage by paying extra on the principle each month.
Actually there’s a lot of Ramsey’s advice I disagree with, but that’s another story. 🙂
Laura,
I really don’t think that DR would find you all that disagreeable. You are thinking through your personal finance situation, which he would certainly applaud. And he, like you, is all about minimizing risk, so I doubt that he would quibble about a one year emergency fund. He qualifies the size of the emergency fund by the number of income streams and volatility of income. Two working partners in diverse jobs is less risky than one income. Three or four income streams is even less risky.
About the 15 year fixed…Dave qualifies the size of the loan by recommending that your payments are not more than 25% of your take home pay. So, rather than try to squeeze a 30 year down to a 15 year, he is saying to buy less house. Certainly he would agree to not consider a mortgage unless it has a no pre-payment penalty.
We agree that there is no magic potion one-size-fits-all solution to managing risk. The solutions are as varied and practical as the situations they are applied to. The end-game, at least in our view, is to smooth out the ups and downs of a sometimes volitile world so we can focus our energies, talents, and abilities in harmony with our core values.
Steven and Debra,
Well stated! We are each responsible for our own decisions, so the challenge is not to go by some formula, but to think through our goals, dreams and values and plan accordingly. Great living is being able to, as you said, “focus our energies, talents, abilities in harmony with our core values”.
I like that phrase! I might even “borrow” it sometime.
“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.”
Ok, I have to comment on this. In Ramsey’s first objection to not paying extra on a mortgage, he mentions the the tax advantage some folks cite as the reason to not pay a mortgage is faulty. Ok, I agree with that. But in the second objection, he completley ignores the tax deduction of the interest. In the paragraph I quoted above, he mentions the capital gains tax on the investment, but completely ignores the tax deduction on the mortage interest. Assuming a 25% tax bracket, the difference between the two strategies in his example would be a gain of 3% if money is invested instead of paid on the mortgage (gain of 8% on investment becomes 6% cleared, and the 4% mortgage interest becomes 3% after tax deduction). So what makes this a bad idea? It’s this type of over-simplification on Dave Ramsey’s part that bugs me on a consistent basis.
Laura,
I too had thought of how DR ignored the advantage of a tax deduction on mortgage interest. I can’t say I blame you for being perplexed at his reasoning. There is, of course, the risk factor…you don’t have any guarantee of what your investment will bring while you do have a guarantee that paying off a loan will “earn” whatever the rate of the loan is (less the deduction you no longer have). This being said, why doesn’t Dave lay all the cards on the table and point out the risk factor? I can’t answer that one.
Thanks for reading and challenging my thinking. I appreciate it!
I think Dave Ramsey’s advice is great. So many people waste away their money and don’t even notice it.
His plan keeps you focused.
Right now, I am on step 6, trying to pay off my $86,000 mortage by age 30, less than 5 years after I got it.
And yes, I am also in the stock market.
It’s a tough challenge, but blogging about it has helped me stay focused!
Thanks for finally talking about >Dave Ramsey’s Baby Step
6: Pay Off the House Early <Loved it!