The HELOC method is essentially you taking a loan to pay off your mortgage sooner. But at the moment, mortgages have one of the lowest interest rates available, unlike other types of loans. A HELOC can work for people with a low interest in personal finance and a history of poor money management. However, investing any extra money brings a greater return.
Dave Ramsey, the financial guru who taught Americans to get debt-free in the 90s, is not a favorite among millennials. This is because many of his methods are outdated and apply only to people who are really bad with their finances.
The new generation of self-made millionaires and financially conscious people love to diminish his claims. He suggests cutting your credit cards once you pay them off.
Sure this is useful when you have low control over your impulse spending. But millennials looking to build good credit scores won’t benefit from not using credit cards.
But one of his steps towards debt-free life is paying off your mortgage. Naturally, people raise their brows on this method because the mortgage is the loan with the lowest interest rate. Read on to find out what’s best for you.
Dave Ramsey’s thoughts on home ownership
Did you know that Dave Ramsey is an advocate for purchasing a home in cash? The median house price in the US in 2021 was $374,900. To save this much money, you need to spend years working and living in rentals. And the rent is not much less than a mortgage payment.
If you start saving 25 and set aside $2,000 each month, you might be a homeowner before your 50s. This is as impossible as it sounds for everyone making an average salary in the US.
It is terrible to have $375,000 in cash and invest them in a non-liquid asset. While a house is your largest asset, it’s not liquid, and it doesn’t earn you any money. The main principle of personal finance is to make your money work for you, hence earning you more each day.
His following advice is to buy a house only when the mortgage payment is no more than 25% of your net salary. In his words, you need to make $6,000 to afford a $1,500 mortgage payment.
But the most controversial of his claims is advising against HELOC. In his words, you need to pay off your house as soon as possible, but you shouldn’t use it as an asset. So, from a financial point of view, what is the purpose of having this significant asset?
What’s HELOC?
HELOC stands for Home Equity Line Of Credit.
It’s a loan you can take against your house when you have paid at least 20% of your home. It’s using your house as collateral and provides lower interest rates than credit cards or uninsured personal loans.
Ramsey advises against HELOC, claiming people can lose their houses if they don’t pay off the loan. However, the same thing can happen if you don’t pay property tax.
HELOC is useful when you need money for big renovations, investments, or debt payoff. For example, you can pay medical bills or pay off your credit cards with a HELOC and pay a lower interest rate on the sum.
How does a HELOC work
Think of HELOC as a credit card. In this case, the lender, which is the bank, determines a credit limit against your equity.
Let’s say you’re approved for $50,000. Then you have a lending period which is 10 to 15 years. You can use all or some of the approved money at this time. But you’re paying back only the interest rate.
After 15 years, it’s time to pay back the loan with a conventional amortization plan.
Approval
Not every homeowner that applies for HELOC gets approved. The process is similar to refinancing your mortgage; you need to prove and document your employment status and income.
Interest Rates
At the end of 2021, the HELOC interest rate was 5.96%. You can get HELOCs with variable or fixed interest rates.
What’s unique about this line of credit is that the interest is tax-deductible. But, only if you used the money towards improvements of the home that serves as collateral.
Using a HELOC to pay off mortgage
If you have a high-interest mortgage, getting a HELOC to pay it off can be a brilliant idea. Perhaps you bought your house in 2000, when the average interest rate on a 30-year mortgage was 8.05%, or in 2007 when it was 6.41%.
Getting a HELOC at the beginning of 2021 with a 5.26% interest rate to pay off the mortgage can save you 1.15% of the interest rate per month.
However, as of the third quarter of 2021, the interest on a 30-year fixed mortgage rate was 2.87%. So taking a HELOC with a 5.5% to pay off seems unreasonable, right? Yes, but until you find out that the interest is tax-deductible!
If you use the HELOC to “buy, build or substantially improve” the home against which you took up the loan, the interest rate is almost if not fully deductible.
Please consult a tax expert for your situation before applying for a HELOC.
Should you pay off your mortgage?
Putting all your money, including a HELOC, towards mortgage payment comes with a cost. And that cost is not the interest rate but lost opportunity.
Dave Ramsey suggests waiting until you’ve paid off all your debt to start investing and only 15% of your income. Paying off your mortgage can take years, even with HELOC. Since mortgages are loans with the lowest interest, it’s better to invest any extra money into a good portfolio.
The S&P 500 Index fund brought investors an average return of 28.71% in 2021.
Since the average mortgage rate for the same year was only 2.87%, an investor with a mortgage earned 25.84% by investing instead of paying off the mortgage.
If you’re new in personal finance and fear that you might go back to bad money habits, you should prioritize paying off your mortgage. Consider refinancing or HELOC as starting points.
Take financial advices from internet personalities with a grain of salt
Dave Ramsey has accumulated a large following through the years. Many people have found his advice helpful and enabled them to stay disciplined with debt payoff. I personally used the snowball method when I first started my debt pay off a few years back.
But we shouldn’t forget that he earns $15 million a year from his courses, books, podcasts, website, and appearing on random shows. So buying a house in full is not something that worries him.
He suggests bringing lunch to work to pay off your mortgage faster. Additionally, he claims that skipping a Starbucks trip can cut your mortgage payoff period by 4 years.
I agree that small purchases can sum up to a significant amount, but if a coffee trip sets you back on your mortgage, there’s a bigger problem.
He’s against investing in ETFs, REITs, bonds, or single stocks and recommends retirement accounts and mutual funds as the best options.
Quick research would open up your eyes to how this approach is wrong. By limiting yourself to two investment options, you’re exposing yourself to a high opportunity expense.
FAQs
Does Dave Ramsey recommend paying off the mortgage?
Dave Ramsey looks at mortgages as a form of debt and recommends paying it off as all your other debts. He suggests mortgage accelerators, refinancing, and extreme savings methods.
How do I pay off my mortgage with HELOC?
After you get approved for HELOC, the lender gives you 80% of your house’s value minus the amount you owe.
Let’s say your home is worth $380,000, and you owe $250,000. The lender will lend you $54,000. Then you draw that amount and send it to your mortgage lender.
You start paying HELOCs interest for the first years and make regular payments after the given period.
Why are HELOCs considered bad?
Home equity line of credit is bad for people who aren’t good with money in general. You can use HELOC for many things, including debt payoff.
Credit cards tend to have high-interest rates, while HELOCs are significantly lower. But if you pay off your credit card just to ramp up new debt again, you’re not using the HELOC benefits.
Bottom line
The internet is flooded with financial advice regarding homeownership, which is the largest purchase regular people make. Should you pay off your mortgage or not is to yourself.
When we purchased our home, my partner’s idea was precisely like Ramsey’s: put all our money towards the mortgage. Unfortunately, this meant minimal savings and decreased quality of life. Sure we would pay off the mortgage in half the time, but at what cost?
So instead, I suggested a more reasonable approach: pay a few payments in advance and invest the rest. This way, we’re still able to enjoy a vacation here and there, comfortable life, and our home is being paid for each month.
If we decide on paying off the mortgage anytime in the future, I would gladly consider the HELOC, as it comes with benefits for those who are disciplined with their payments.
