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Pay off the house is Dave Ramsey’s Baby Step #6
Why should you pay off the house early?
The American dream is to own your own home (white picket fences are optional). Owning a home free-and-clear means you don’t pay rent or a monthly mortgage payment – you have no obligations on for the place you hang your hat!
No mortgage means complete debt freedom! Monthly cash-flow increases and the grass starts to feel different when you walk barefoot through it.
You also own an appreciating asset with tax benefits. You pay no capital gains while the value of your property increases and much, if not all, of your profit is exempt from taxation when you sell it.
What you should remember when paying off the mortgage
Even if you own a house free-and-clear you still need to purchase home owner’s insurance. This covers loss or damage to your house – a cost most people can not self-insure.
Also, you will have to pay property taxes. Many people forget this because their bank collects a little bit of money each month via your escrow payment (portion of the monthly payment that is not principal or interest). I recommend you divide your annual real estate tax bill, divide the number by 12, and budget to save that much every month.
You could always borrow on your home again. I’m not sure why you would do this. You’ve worked too hard to get out of debt and have increased your cash flow to strap yourself to a monthly payment again.
Should I keep a mortgage for the tax deduction?
This is the most common question when people are about to pay off their mortgage (or are talking to a Realtor about buying a house). Doing the math will help you to understand that the benefit really isn’t there:
Here are some of the items you might have that can reduce your taxes whether you have a mortgage or not. I’ve also given a value to items the normal American household could have (we will refer to them as Bob and Shirley):
- Out-of-pocket medical and dental expenses greater than 7.5% of earned income: Most people don’t benefit from this deduction
- State and Local taxes paid (where applicable): In Missouri we reported about $2,500
- Real Estate taxes: We paid about $2,000
- Personal Property tax: About $500
- Gifts to charity (ie: church or Salvation Army): This varies by family so we’ll just assume $2,000
- Casualty and Theft Losses (rare)
- Job Expenses and Miscellaneous Deductions greater than 2% of earned income (useful to some, not common in all households)
This example assumes Bob and Shirley will have $7,500 in allowable itemized deduction items. It would not make sense for them to itemize because they can take the Standard Deduction and write off $11,900 (the amount for a married couple filing jointly in 2012) from their income without having to work through a complicated form. This means Bob and Shirley will base their Federal income tax calculation on $88,100 ($100,000 – $11,900 = $88,100) and have a tax liability of $14,091.
Itemizing with Schedule A
If they choose to itemize on Schedule A then they need to have more than $11,900 in certain allowable deduction for it to make sense. If they have a mortgage then they can add the interest portion of their payments to the other itemized deduction items ($7,500 from above). For example: If they paid $10,000 in mortgage interest then they could deduct a total of $17,500 from their income. This equates to paying taxes on $82,500 and Bob and Shirley will pay taxes on $12,691.
Did you get that? If they send the bank $10,000 in interest and itemize their return with the other non-debt items they reduce their taxable by only $1,400. Trading $10,000 for $1,400 in tax savings isn’t a good deal and isn’t worth keeping a mortgage for.
Continue saving for retirement and kid’s college
The house is paid off. You have no debt, including a mortgage, and thousands of dollars in a fully funded emergency fund. This puts you in Baby Step 4 & 5 (15% into retirement and saving for kid’s college). While continuing to save for these goals you still should have some money left over. So what are you going to do with it? That’s what we will talk about in the next episode.
In the meantime: Find ways to complete each Baby Step until you complete Baby Step 5. Then work on paying off the house early. Complete debt freedom awaits!
I just finished listening baby step 6 and am concerned about your explanation of taxes and the standard deduction. While I think the interest deduction is a poor reason to keep a mortgage, I think you need to be careful when explaining why. In your example you demonstrate that the interest deduction only works to the extend your itemized deductions exceed the standard deduction. You go through all the other itemized deductions and I think you are fair with most of them. But then you come to charitable deductions. Your example of a family with a $100,000 income gives a very generous $2,500 to charity. Come on Steve (2.5%??) For many of your listeners including fundamental Christians, giving begins at the 10% tithe and goes up from there. But even if you didn’t use 10% as a basis, I feel sorry for any family making $100,000 a year that gives less than $50 per week to any form of deductible charity. Since we both agree that it is a good thing to pay off the mortgage, let me encourage you not to be sloppy in the explanation so you don’t leave yourself open for criticism by those who would not agree with us.
Hi,
Long time follower and Dave fan. I’m 65 and might retire at 70. About $1.8 million net worth on $240,000 a year income. Should have retirement balance of about $1.3 million at retirement and my mortgage balance will be about $210,000 at that time. Heard not to pay it off with one check from 401K, but rather pay over a few years to avoid a big tax rate. I’m thinking maybe $70,000 a year until it’s paid off. Can’t wait to see that last debt go. Suggestions?? We can live on our combined social security checks alone at retirement.
Best regards,
Doug in Mississippi