“With respect to your piece on Home Mortgage Deductions, could this reasoning also apply to paying down your mortgage? I feel like such a sap getting a 15-year mortgage at 8% instead of a 30-year at 8.25%. We’re sending about $300 extra to the mortgage company each month. Being in the 15% tax bracket and filing a joint return, are we doing an OK thing? — Mitch”

Don’t feel like a sap, Mitch. By doing this, you are “earning” 8.25% risk-free on all the extra money you use to pay down the mortgage, all those $300 checks. I.e., not having to pay 8.25% for 30 years is as good as earning 8.25%.

That may not sound like much when the stock market is rising 15% in a single quarter, but it won’t sound bad at all in quarters when the market drops 10% or 15%, and we’ll have some quarters like that one of these days, too. (At least, we always have before.) What’s more, the 8.25% you are “earning” on your additional principal payments is “tax-free” if you don’t itemize your deductions, or only lightly taxed at 15% if you do.

(In other words, just as the 8.25% interest you’d pay on a 30-year mortgage really is 8.25% after-tax if you don’t itemize deductions, or else about 7% if you do, so, too, is not having to pay it worth either 8.25% or 7% to you.)

Indeed, it’s even better than this, because not only are you “earning” 8.25% on those extra $300 monthly payments, you are also reducing the interest rate from 8.25% to 8% on the portion of the loan you would have paid even if you had gone for the traditional 30-year mortgage. So that extra $3,600 a year is saving you interest two ways. That bumps the rate you’re earning on it up to about 9% by my Intuitive Calculator. Unfortunately, I couldn’t figure out the way to calculate it precisely on my Real Calculator, but the great thing about the audience for this column is that several of you, I know, will ride to my rescue. I await your e-mail.

The point is: 9% risk-free and virtually tax-free is terrific. What’s more, this is a form of forced saving, and who among us can’t use a little help from time to time saving money? That has some value, too.

If you were in a high tax bracket, the case would be less clear. Say you lived in a high-tax state and between federal and local income tax were around the 50% bracket. That 8.25% 30-year mortgage would really cost you roughly 4.25% in interest after tax, so not having to pay it would be like earning only 4.25%, or perhaps a bit more than 4.5% after giving credit also to the lowered interest rate on the rest of the loan.

If you could afford the risk and thought you could find a company whose stock would grow at 10% compounded over 30 years — free of any tax until you sold it, and then taxable at only the long-term capital gains rate, which is likely to be lower than your current 50% rate — you would clearly come out far ahead taking the 30-year loan.

(But not far ahead of Mitch. Mitch, if he doesn’t itemize, is earning close to 9% after tax by taking the 15-year loan. You, in this example, are earning 10% that is not risk-free and will eventually be taxed.)

Mitch: If you have a safe way to earn 18% instead of 9% — paying off your credit card debt being the only one I can think of — then maybe you are a sap for taking the 15-year loan. Otherwise, 8.25% (or in this case more like 9%) guaranteed, and in easy little increments, is just fine as one element of your investment mix.

 

 

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