Q. In the September/October issues of AARP Magazine a column advises a soon-to-retire couple to switch their small mortgage to a much larger one at 6 percent, interest-only, and invest the left over proceeds in municipal bonds at 4.5 percent. Apparently the reason is to gain a tax deduction. I feel this is potentially harmful advice. What is your opinion?

---B.I., by e-mail, from Seattle, WA

 

A. I agree with you.  For the vast majority of people soon to retire in America borrowing is a bad idea. The broad strokes may sound good, but a multitude of details and conditions make it a very poor risk. Here's the broad brush: A couple can replace an old 6 percent mortgage with high monthly payments with a new and larger 6 percent mortgage that is interest only for 10 years. As a consequence, they will have more tax deductions, lower income taxes, more investment income, and they may live happily ever after.

(The article is at: http://www.aarpmagazine.org/money/paying_house.html)

Unfortunately, there is something called the fine print. Here are a few things that weren't mentioned:

---Deductible Isn't Free.  In the example, the couple exchanges a $550 monthly payment on a $50,000 balance for a $625 interest only monthly payment on a $125,000 balance. In the process, they give up $300 a month in mortgage amortization, which was increasing their net worth, in order to "gain" $4,500 of additional interest payments since their interest payments will increase from $3,000 a year to $7,500 a year. Even if every dime of interest is tax deductible and they are in the 33 percent tax bracket, they will still have an after-tax cost of interest of $3,000 a year.

So what have they gained?  They've gained $75,000 to invest which may produce income that is tax-free (invested in municipal bonds) or taxed low (invested in common stocks so dividends and capital gains would be taxed at 15 percent). Basically, they are giving up a sure thing--- the $300 a month in amortization--- for a not-sure thing. Do it with other assets and the pros call it "risk arbitrage."  Risk arbitrage can be a good thing for young people. It's not good for those about to retire.

---Risk is real. Risk arbitrage can work to your advantage or disadvantage. Interest only mortgages are variable rate mortgages. So your payment will rise and fall with interest rates. If interest rates go down your monthly payment will also go down. Better still; the value of bonds you've purchased will rise because interest rates have fallen. That's a big win.

But it can also work the other way.

If interest rates rise, your mortgage payment will go up and the value of the bonds you have purchased will go down. This will make it more difficult to cure the problem by paying off the mortgage.

---Deductions may not be deductible. The standard deduction for a couple, this year, is $10,000.  Unless your itemized deductions are greater than $10,000, you will be better off taking the standard deduction. Worse, you will only benefit from the portion of your itemized deductions that exceeds $10,000.

As I have pointed out in many other columns, most home owners and most of America will only benefit from homeownership tax deductions if their other deductions from state income taxes and charitable donations exceed the $10,000 standard deduction. Only then will their homeownership deductions reduce their income taxes.

Retired people can often obtain the lowest risk benefit by paying off an old mortgage. It reduces the income they need to meet their expenses. It also means they can have a $10,000 standard deduction with little or nothing in itemized deductions. So their tax bill goes down with no risk. Since the standard deduction is indexed to inflation, it rises. Only relatively affluent retirees are in a position to benefit from itemized tax deductions.

---Tax-free income doesn't necessarily lower your taxes. The formula for the taxation of Social Security benefits includes income from tax-free bonds. So even if the newly borrowed mortgage money is invested in municipal bonds, the additional income may cause Social Security benefits to become taxable.

---Fees can reduce your income and benefits. It costs money to refinance a home mortgage. It also costs money to have others manage your investments. The average municipal bond fund, according to Morningstar, has expenses over 1 percent a year while 10 year maturity AAA rated bonds are yielding about 4 percent. So you can net 3 percent and still have interest rate risk by borrowing when you can get twice that, 6 percent, simply by paying down the existing mortgage.

On balance, borrowing in retirement is a very "iffy" proposition.