You Shouldn't Pay Off Your Mortgage Early. Here's Why.
How A Mortgage Creates Wealth
We've all been fed the same stuff growing up in the United States: you go to college, graduate and get a job, then settle down and buy a house. "Buying a house is the fastest way to grow your wealth" you hear your parents say as they write another check to pay the mortgage. The great part about this is: they're right!
Owning a home with a mortgage is a mathematical wealth-building miracle: you put a (relatively) small percentage of cash down and the bank gives you the rest. In exchange, you agree to a set period of time to repay the bank's loan at a fairly minor interest rate. Theoretically, you're now building wealth in two ways:
You now own an appreciating asset. When you sell your house, it should have appreciated in price between 3.5%-3.8% per year on average (though these last few years have been insane).
You are paying down the debt to the bank, which in turn builds out the original equity on the home price you paid.
These two factors essentially act like the Silicon Valley "middle out" method. You're building out wealth on one side with compounding appreciation, while paying down the debt on the other side.
This isn't a new concept: people have been doing this for generations, using this method to amass real estate empires, or just purchase a few rental properties to take advantage of the leverage and eventually skyrocket their net worth. However, in this new era where anyone can stand up a blog and shout about money (hey, by the way), there are now detractors to the mortgage process. The loudest and baldest of these is financial guru Dave Ramsey.
The Dave Ramsey Mortgage Philosophy
Dave Ramsey is...aggressive...in his mortgage philosophy. He instructs his listeners that the best way to pay for a house is in an all-cash deal, which is admittedly tough. Knowing that, he instructs the average home buyer to take out a 15-year mortgage, rather than a 30-year, even referring to the 30-year mortgage term as "Thirty-year mortgages are for people who enjoy slavery so much they want to extend it for 15 more years." Harsh.
Look, Ramsey has a point about the 15-year mortgage. Not the slavery thing, because again "wow," but he has a point on the interest payments. 15-year mortgage terms do typically have lower interest rates on their loan agreements, and you do obviously pay the mortgage off faster, saving potentially tens of thousands of dollars in interest payments along the way over a conventional 30-year mortgage.
However, the monthly payments you'll make in a 15-year mortgage over a 30-year mortgage are obviously much larger in principal, as you're condensing the time frame required to pay off the same amount of money. With many Americans in a savings crisis, this likely won't be possible to achieve for most, let alone paying the mortgage off completely in the near-term. But do you really want to pay your home off early anyway?
When You Shouldn't Pay Off Your Mortgage Early
So if it's so great to pay off your mortgage immediately, then why doesn't everyone do it? Even personal finance experts that rake in millions of dollars per month keep their mortgages around, despite having the assets to pay their home off without a second thought. What gives?
Each person's financial situation is different and unique to them, so please do not view the below points as "advice." Please contact a tax and investment professional for your individual situation. Right, with that covered, let's talk about why you may not want to pay your mortgage off early:
1. If You'll Obliterate Your Cash Reserves
Unless you inherited a large amount of money from a relative or struck oil under your front yard like the Beverly fucking Hillbilly's, paying off your mortgage early is going to take a concerted effort on your part. It'll either involve saving a lump sum to pay the mortgage off early, or extra cash every month to throw at the principal. Either way, this extra money could quickly wipe out your cash reserves like an emergency fund.
If you're serious about paying your mortgage off early, make sure you have your emergency fund in a completely separate account that is unrelated to what you're throwing at your home's principal. You never know when your car could end up in the shop, or your wife could declare war on your garage door. Just me?
2. If You Haven't Been Saving For Retirement
If you're on this site, then you've likely read my "Investing By Decade" series that outlines the right money moves to make during each phase of life leading up to retirement. The umbrella story there is "make sure you're saving SOMETHING for retirement." A study by Fidelity found that most Americans are dramatically under-saving for retirement. Don't let a reason for this be that you want to pay your house down early. It makes 0 sense to have a fully-paid off house but you're still clocking in every weekday at 75 years old because you still need to eat.
3. If You Have A Pre-Payment Clause
One silver lining of the 2008 Housing Crisis (other than Bitcoin) is the Dodd-Frank Act. The Dodd-Frank Act essentially put a choke collar around banks to ensure they stop screwing (or screw a little less?) the average home buyer. No more deceptive adjustable-rate mortgages with balloon rates, no more pre-approval for $1 million mortgages on a $50,000 salary and no more pre-payment penalties if you want to pay your home down early. However, some mortgages do still (somehow) include pre-payment penalties. This is essentially a fee that you owe to the bank if you decide to pay off your home early, and it's in place to offset the risk to the lender in the early years of the loan.
Pre-payment penalties are typically percentages of the loan amount that are prorated to the number of years you've already paid. According to Rocket Mortgage, one of the largest home loan companies in the U.S, these fees and percentages can vary dramatically by lender, and even by the state you live in. If you want to pay your mortgage off early, make sure you're not shooting yourself in the foot by checking with your lender first.
4. If You Qualify for Big Tax Deductions
The Trump-era tax cuts took a baseball bat to the kneecaps of this one thanks to the expansion of the standardized deduction, but your mortgage can provide some serious tax breaks if you qualify. Again, widening the standard deduction and neutering the value of itemized deductions has made this situation much more complicated after 2017, so speak to a tax professional about how to best take advantage of your unique situation. This article from Nerdwallet is a good starting point.
5. You Should Be Investing Instead
Let's talk about a tried and true rule in investing that not enough people talk about: The Rule of 7. The Rule of 7 states that any debt with a 7% interest rate or higher should be paid off immediately, and any debt with under a 7% interest rate should be paid off using the minimum term payments, and you should put the rest of the money you were planning on using into an index fund to invest for the long term.
This rule is based on the historical 7% return that an index fund provides each year. Interpret this rule for a mortgage and you start to see some big numbers.
Let's use my own mortgage as an example. I currently have a mortgage at a 2.875% interest rate (shout out to Jerome Powell for that one baby) and I have $285,000 remaining on my 30-year mortgage that's three years old, leaving 27 years remaining. My monthly mortgage payment is $1,808 to the bank, which includes principal, interest, taxes and insurance.
Let's say I paid an extra $100 per month towards our principal mortgage amount. Using Dave Ramsey's own calculator, here are the results:
I would essentially save $14,000 in interest over the course of 30 years, and save three years of payments. But now if I put that $100 in an index fund that returned 7% per year over the same time frame?
$83,000. That's a hell of a lot of money, and shows the remarkable difference when you apply The Rule of 7: I made $69,000 by applying the rule and not paying my home off early.
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When Paying Off Your Mortgage Early Makes Sense
This article is not to completely dissuade you from paying off your mortgage early. Really, it's to point out the opposite side of Dave Ramsey's most famous war cry. However, there are some reasons to pay off your mortgage early.
Paying off your mortgage early can be an extremely important step psychologically. Waking up on the due date after getting your paycheck and not having to see that paycheck fly out the door immediately can be a powerful thing for your psyche, and I'm not here to argue.
There's also the "I can, so I will" argument. If you do happen to be an oil tycoon or tangentially related to an NFL team owner, then you likely have the cash to pay your house off without destroying your emergency fund. You also likely won't benefit from the tax breaks and you just want to lower your overall interest bill. In that case, go for it!
The Bottom Line
If it gives you any indication of where I'm going here, my wife and I are not planning on paying our home off early. As I mentioned earlier, we were able to refinance into a 2.875% interest rate on our 30-year fixed rate mortgage, which is basically government sponsored stealing. Thanks to the Federal Reserve tanking rates here in the United States prior to the pandemic, rates continued to fall to the point where it made too much sense to refinance. We even got paid by our mortgage lender to refinance, which was a fun surprise!
Again, each individual financial situation is different, so please do not take this article as advice. If you are interested in paying off your mortgage early (or not!), then contact a financial professional prior to doing anything.
Are you paying off your home early? Are you not? Do you listen to Dave Ramsey? Let me know in the comments below, and don't forget to sign up for my email list so you never miss a post! Thanks for reading!