Q. In a recent column you suggested paying off a mortgage. Of course, if the desired effect is peace of mind, I would agree. Many people would be well-served to pay off their mortgage. However, I am always amazed at the thinking process in calculating, for example, a 6.8 percent interest rate with regard to tax savings and possible earnings from other investments.
Anyone who has looked at an amortization schedule would immediately see that one pays much more than 6.8 percent at the beginning of the loan and much less than 6.8 percent toward the end. Taking that into account, how can you advise homeowners to pay off those late-stage mortgages? It would be easy to earn a higher interest rate on the money that would be used to pay off the mortgage.---S.S., by email from Seattle
A. Many readers sent similar questions, so let’s take a close look at home mortgages and understand them a little better.
An amortization table shows you how a direct-reduction mortgage works. Your initial monthly payment is mostly interest and a tiny bit of principal. Few people realize it, but in the first 7 years of a typical 30-year mortgage, only about 10 percent of the amount owed is paid down. It takes about 20 years to pay off only half of a 30-year mortgage.
But the amount of principal paid increases year by year. In the last five years the role of principal and interest is reversed--- the monthly payment is mostly principal and very little interest.
Two things are important here.
First, no matter how small the interest payment is as portion of the payment, you are still paying at the interest rate of the loan. If your interest rate is 6.8 percent, it is 6.8 percent at the beginning of the loan and 6.8 percent at the end of the loan. The interest you pay is 6.8 percent of the amount outstanding in any given year. The dollar amount of interest you pay goes down because the dollar amount you owe has gone down. The interest rate you pay is constant throughout the life of the loan.
Earning that much interest on a typical investment isn’t easy. Most riskless investments (CDs, Treasury obligations) currently earn less than 3 percent. For most people, most of the time, paying off a mortgage is a good way to earn a relatively high yield on their money with great safety.
Second, the payment structure of a mortgage is very important. Let’s consider a 30-year mortgage at 5.5 percent. It would have a monthly payment of $5.68 per $1,000 originally borrowed. That’s $68.16 a year or 6.8 percent of the original amount borrowed. By the 20th year, however, you’re still paying $68.16 a year--- but the debt has declined to $500. So the payment is equal to 13.6 percent of the amount owed. In the 25th year of the mortgage, the principal amount owed is less than $300, so your payment is more than 23 percent of the amount still owed. (Readers can get a better sense of this by visiting one of the websites that will calculate and present a mortgage amortization table such as bankrate.com.)
This is important. For one thing, it means that paying off a mortgage (or other loan) will dramatically reduce your required monthly income. Equally important, it means any offsetting investment would have to be very safe and stable because you’ve got to be making huge withdrawals, relative to the amount invested, to make the payment. That’s why the older a loan is, the more you benefit from paying it off.
Q. Each year I give my adult son $11,000. Is it possible to subtract that amount from my taxable income? ---R.V., by email from Las Vegas, NV
A. Sorry, you can't do that. Gifts are entirely related to your estate. They are not related to your income. For 2009 you can give $13,000 each to an unlimited number of recipients. The gifts may reduce your taxable estate, but you won't have to pay estate taxes on them. If you give more than $13,000 per recipient, you will reduce the size of your estate tax exclusion. This year you can have an estate of $3.5 million and not have a federal estate tax to pay.