AssetBuilder Inc. Registered Investment Advisor - Simple Investing. Smart Future.

Hi Scott, I have read your answer on home mortgage and tax benefits in the forum, but it was for a house over $2M. I think that range is not applicable to my family. I am similar to that person in that we pay off everything each month like credit card, car, etc. We feel like we are throwing money away if we pay intertests. We would rather go without it than buying and paying interest on any items. Our situation, we currently owned our house and is paid for. It is appraised at $225K. We are looking to buy a new home in the neighborhood of $450K. We have short term saving, not touching the retirement and college savings, that along with the sale from our current home, we can pay off the new house. My broker told me that I should take out a mortgage and down only about 30% to 40%, and put the rest of the money in mutual funds that will grow faster than the mortgage interest rate. Perhaps the mutual fund can average 8-10% a year, but I would have to pay interest on the mortgage along with capital gain taxes on the mutual fund. I can't seem to figure out the math that show this benefit. We are in the 33% tax bracket. For every dollar in interest, I will only save 33 cent for the tax deduction. I know that my broker knows what she's talking about, but I can't seem to figure out the benefits of taking out a mortgage and deduct the interest on my tax rather pay off the house and not pay any interest at all. Thanks in advance for any advice. Richard

 Richard,

    Most people focus on the wrong thing when they think about mortgages. It's not the interest rate and tax benefits that make them interesting for younger people. It's the certainty of long term appreciation.         Let  me give you an extreme example from the early 70s. Back then I wrote a column Vogue magazine on personal finance--- I had to write about things very affluent people did.

    So I wrote about the economics of second homes. Back then you could borrow money at 7 percent and save 2.3 percent in tax benefits, giving you a net cost of 4.7 percent. That was well below the annual appreciation rate for second homes in primo places. In effect, you were taking money out of your income pocket and it was magically appearing in your net worth pocket. The only issue was whether you could earn enough to cover the mortgage payments.

    This relationship was strong for nearly three decades, weakening only recently.

    Today, the vacation property case is weaker and the general residence case is weaker still, but if typical home prices track inflation (rather than exceed it) over the long term, your 6 percent mortgage will cost you 4 percent net of tax benefits and 3 percent of the remaining 4 percent payment will be offset by price inflation, leaving you with a 1 percent out of pocket cost. (The 3 percent and amortization will go directly to your net worth.)

    Since this cost is also fixed, it makes your mortgage a very nice hedge against inflation. If you use sophisticated financial planning software such as ESPlanner it generally shows that owning a mortgaged home will increase your lifetime ability to consume rather than decrease it.

    As with most things, there are some very specific caveats. Having a mortgaged home works best when you are young, working and in a high tax bracket.

Being young allows you to ride inflation better than being old.

Working means you're making payments with labor earnings, not dividends and interest.

And being in a high tax bracket means you'll get that important tax benefit. Many middle income (and virtually all realtors!) assume that you'll have tax benefits galore from home ownership. But if you live in a lower cost area it's very possible that the sum of your mortgage interest and real estate taxes will be less than the standard deduction on a joint return, $10,700 this year, so there would be no real tax benefit to ownership.

    Like you, I have an aversion to debt. Older people certainly should be because (1) they have less time for inflation to work in their favor, (2) they often don't have itemizable tax deductions because they've paid their mortgages down, and (3) they often have to make mortgage payments from investment income. All three factors make mortgages a poor deal for people who are approaching retirement or retired.

Scott 

     

   
 

Dear Scott,

I too have a mortgage, and at age 58, would like it paid down to a reasonable level before I retire. Having gone through a recent period of unemployment, I'm now a bit more respectful of how wildcard events can impact an otherwise sound financial plan.

I recently purchased a copy of your 1972 book Squeeze It Till The Eagle Grins. The section on the true net cost of a mortgage (pages 73-79, graph on page 77) was especially interesting. I was wondering if you might write a similar article or two on this subject in the future. I believe this subject is overlooked in the literature, but the message, in quantifiable terms, bears repeating. It might serve to make many homeowners feel a bit more comfortable with their long term mortgage commitment.

 I truly enjoy reading about your approach to life and finances. I have printed a significant number of your various articles for future enjoyment and reference. Thank you for doing what you do.

 Tom Young

 Tom,

    Talk about ancient times! That analysis was based on a program written in Dartmouth Basic in the late 60s and tested on a Bolt, Beranek and Newman time-sharing terminal running at a grand speed of about 30 baud, if I recall. Today you could do it pretty quickly in Excel and you can find the impact in a broader context using ESPlanner, the financial planning program that uses dynamic programming to calculate lifetime level consumption impacts for different decisions.

   Using that program, we've found very counterintuitive results. For instance, buying a house in San Diego make sense today even if it depreciates long term IF you plan to live there for the rest of your life. (That, of course, is a very big if.) Similarly, having a mortgage still makes sense for a young person buying an average priced house in an average city--- not because of the tax breaks but because the borrower will return so much less in real purchasing power.

   As we get older the benefit of borrowing is smaller because the horizon is shorter and because we end up arbitraging investment returns vs. mortgage rates rather than labor income vs. mortgage rates.  Right now I'm working on a column that will  show the stability benefit of NOT having a mortgage if you are retired. It should run later this month or early in January.

Scott