“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.
Quote of the Day
If you think it's messy there, said Albert Einstein of his paper-strewn office, you should see it up here, he smiled, pointing to his head.~.
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