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Q&A With Scott Burns: Paying Down Your Mortgage Is More Important Than Tax Deductions
I may have to take back what I said about Mr. Burns writing well on personal finance.
The broad analysis here is fine - that keeping cash instead of paying down a mortgage is a losing proposition, but long term investing could be a winner if the mortgage rate is low. But that's not what the headline says, and his arithmetic is off.
He looks at after tax cost of the mortgage: interest rate minus tax savings. Fine. He compares that with pretax income from a CD. Wrong.
You need to compare aftertax cost of the money with aftertax earnings. (This only strengthens the argument that keeping a mortgage and putting the money in a CD is a loser.)
Alternatively, you can compare pretax cost (i.e. the mortgage rate) with pretax earnings (the CD rate). This isn't as good at telling you your net savings (or loss), but it gives the same yes/no answer, without even having to look up your marginal tax rate.
The difference between "paying down a debt" verses "paying off the debt" is important in this decision. "Paying down a debt" shortens the length of repayment, but doesn't remove the monthly payment. "Paying off the debt" removes the monthly payment. An important consideration for someone on a fixed income.
I have tended to take a different approach when it comes to housing costs. Whether you rent or "own a mortgage", try to get these costs as low as possible and try to keep them fixed for as long as possible.
One pretty big advantage to "not paying off" or "not paying down" your mortgage is the flexibility you maintain with the cash you didn't throw at the loan. Paying off the mortgage is always an option, but by maintaining some cash you provide yourself the opportunity to diversify away from a single asset (your home).
There is always added risk to owning property outright. I like the idea of sharing that risk with a lender who is willing to reasonably "rent me their money" as part of my housing costs. Strictly from a risk/return perspective I believe there are many more reason to diversify away from owning a single large asset (a home).
Tax deductions (itemized deductions) can and/or will be altered if one's mortgage interest deduction is large enough to "help" move one into the itemized deductions portion of a tax return. This deduction then allows one to gather all of the other smaller deductions to become a larger value which may be a large enough dollar value to be of benefit to reduce taxable income. 'Course, everyone's circumstance will vary with this.
Many years ago, with the elimination (payoff) of our mortgage; we no longer had enough other deductions to itemize them on the 1040. But, the mortgage interest was gone and all is well.
Didn't read the link. But just from personal experience, I can't think of anything that has had a more favorable impact on me financially than not having a mortgage. I realize though that is not feasible for many, especially younger folks.
Forgetting about the emotional value (which is itself very real), there's a financial planning benefit to being free of mortgage payments.
Those payments must be made each and every month; one way or another you must come up with the cash. That is a significant demand on cash flow. Get rid of that, and you have much more flexibility (expenses are then mostly discretionary).
If your portfolio does poorly, it's easier to cut back on expenses for awhile. So you're free to invest more in equities; your survival doesn't depend so much on what you've got in cash and fixed income.
Tend to agree with bee. Assuming that money is money, it would appear to be a question of whether you want that money invested in the equity of your home or in some other productive asset like mutual funds.
We've always had a mortgage or rent payment of some sort. Guess we've grown used to it. The current one at 3% has about 10 years to run. I'll rather miss it when it's paid off. Think of a fixed rate mortgage as an "anti-bond" - or a bet on higher interest rates. It can serve as an inflation hedge by stabilizing housing costs during periods of rising prices.
I'd argue that you have more control over the money if it's in a highly liquid asset like a fund than in home equity. But, will admit that the home is the "safer" of the two investments and apparently (to many) has a greater emotional value.
I agree. When I bought my condo in 2000, I put 40% down from stock options sold from my Dot Com company. Three months later, I cashed out the rest of them and paid off the mortgage.
My rationale? Simple -- I did not want debt ('good' or 'bad') hanging over my head and/or be beholden to someone for the roof over my head. Some thought I was nuts for doing that, but I did it anyway. Peace of mind!!
Looking back at property appreciation and its retained value (even despite '08) it remains the best investment decision I've ever made.
"I did not want debt ('good' or 'bad') hanging over my head and/or be beholden to someone for the roof over my head."
As far as being beholden to someone else ...
- If your mortgage allows payoff in full at any time you choose, and if your liquid assets far exceed the value of the mortgage, than you're not really "beholden". You can choose if and when to pay off the mortgage in full.
- So the question should be: Which way do you come out ahead financially? Do your investment returns after taxes exceed the interest paid on that mortgage? (Your home is going to appreciate at the same rate whether or not you've got a mortgage on it.)
The "Amen" above highlights that there appears to be a great emotional value in having a paid-off home. Go for it - if that makes you feel so much better. Doesn't do much for me - but I do understand the comfort, peace of mind and emotional appeal it holds for most.
I don't have a mortgage either and it is a nice feeling.
I'm thinking that at some point it may be advantageous to take out a mortgage. With low interest rates AND a fixed rate mortgage AND the offing (I'm guessing in 10 years) might look good.
Think back to the 1960s when people had low interest rates; then in the 70s interest rates rose.
@Hank- Yes, your position on this is perfectly logical, and was my original position also. What drove me to pay off the mortgage early was that after some years it got transferred to BofA due to banking consolidation here in SF. I refuse to be beholden to or associated with BofA for anything for any reason. Just a quirk on my part.
My 120k debt is at ~3.6% fixed and I can do better than that not paying that amount off but investing it. If I could refi at 40y (age 68), I would do so. It all comes down to sleep-at-night factor, that's all, hardly worth discussing in other, absolute terms. Orman vs Edelman, etc.
Thanks to OJ & davidmoran for their thoughtful and considerate thoughts.
I agree a lot has to do with comfort level (the sleep factor as OJ put it).
We deal with a fine local bank. If anything changed in that regard, we'd pay them off and get out fast. The two "re-fi"s in recent years went to pay for a couple additions on the house. So our equity rose along with the debt. Also, I refuse to go out farther than 15 years on a mortgage no matter how attractive the rate.
Actually, have recently considered paying off all of the mortgage - as it's getting harder and harder to earn 3% in the bond/equity markets without going out there quite a bit on the risk curve. Am only around break-even YTD.
No - the term's not original. "Sleep factor" comes up a lot when discussing investments. As it should. So, you really need to look at the mortgage decision in the context of all your investments and liabilities.
Paying off a 3% mortgage seems to me a very conservative/safe move. I'd liken it to buying a Treasury Bond netting holder a guaranteed 3% after taxes. As safe investments go, in an era of minuscule bond & CD rates, that 3% guaranteed return doesn't look bad.
The only fly in the ointment ... that 3% mortgage likely has a "lock". Should interest rates move up to 5-6% during the term of the loan, you'll feel very smart having kept the mortgage. In that case, bragging rights would go to those still holding 3% mortgages. -
PS: I'm in the group that values home ownership. I like to be able to kick that dirt under my feet. However, many in our society lead perfectly normal happy lives as renters. Some of the upper level "rentals" in NYC @$10,000+ a month don't look too shabby!
Personally the best thing my wife and I have done financially was to convert our 30-year mortgage to a 15-year mortgage years ago. We will have no mortgage when we retire. That is huge.
Paying off a 3% mortgage seems to me a very conservative/safe move. I'd liken it to owning a Treasury Bond netting holder a guaranteed 3% after taxes. As safe investments go, in an era of minuscule bond & CD rates, that 3% guaranteed return doesn't look bad.
Assuming you itemize deductions, you need to compare with a Treasury yielding 3% beforetaxes. It's a common mistake - one that Mr. Burns made as well, and that I commented on above.
The pretax cost of the mortgage is 3%. When you itemize, you get to reduce your taxable income. This results in a tax savings (and so lower net cost of the mortgage). So your aftertax cost of the mortgage is 3% x (1 -r%), where r% is your tax rate.
That's exactly the same equation and net yield on a Treasury with a 3% pretax rate. Same idea - income taxes reduce the magnitude of any figure - the yield of a mortgage or the cost of a mortgage.
The "lock" problem cuts both ways. In order to get a Treasury yielding 3% (pretax), you have to go out 30 years. Odds are, your mortgage has fewer years to go. The only way to get a better return on the cash is to take on more risk. As you suggested, rates might rise to 5-6%. In the meantime, you've put money into a lower yielding, shorter term Treasury, hoping (risk) that rates will rise soon enough and fast enough that you come out ahead. Or you've invested in a more risky vehicle to get a higher return.
With respect to the value of mortgage interest deductions, @Catch22 made a good point worth reminding folks.
In order to take advantage of the mortgage interest as a deduction, one must itemize their deductions rather than taking a standard deduction. I can imagine that in states where property taxes are high that the combination of just these two itemized costs (mortgage interest and property tax) would enable a tax payer to itemize.
Itemizing decreases taxable income beyond the benefit of just the interest costs, but can only be realized by itemizing. Itemizing opens the door to additional tax deductions that would not be available to a taxpayer using the standard deduction.
Personally the best thing my wife and I have done financially was to convert our 30-year mortgage to a 15-year mortgage years ago. We will have no mortgage when we retire. That is huge.
One can accomplish this by making extra payments on a 30 year mortgage. The advantage of doing it this way is that if you ever need/want to not make the extra payment you don't have to. I often skip the extra payment around the holidays and make up the difference when I get my tax return. I like the flexibility of having a lower required payment (30 yr) that I choose when to make extra payments (as if its a 15 yr).
Here's a calculator that help figure out what the extra payment would need to be:
With respect to the value of mortgage interest deductions, @Catch22 made a good point worth reminding folks.
In order to take advantage of the mortgage interest as a deduction, one must itemize their deductions rather than taking a standard deduction. I can imagine that in states where property taxes are high that the combination of just these two itemized costs (mortgage interest and property tax) would enable a tax payer to itemize.
True, or where high state income taxes plus mortgage do the same thing. In those states, Treasuries shine, because they're state tax exempt, so that helps improve their after tax yield.
Personally the best thing my wife and I have done financially was to convert our 30-year mortgage to a 15-year mortgage years ago. We will have no mortgage when we retire. That is huge.
One can accomplish this by making extra payments on a 30 year mortgage. The advantage of doing it this way is that if you ever need/want to not make the extra payment you don't have to. I often skip the extra payment around the holidays and make up the difference when I get my tax return. I like the flexibility of having a lower required payment (30 yr) that I choose when to make extra payments (as if its a 15 yr).
Here's a calculator that help figure out what the extra payment would need to be:
Years ago, I got a cold call from a mortgage broker, trying to convince me to refinance to a 15 year to pay it down faster. I said exactly what you wrote - that I could do that myself. His retort was that 98% of people who say they'll do this don't. I can't comment on the accuracy of his figure, but I'm sure that many people don't have the discipline to do this (not anyone here, of course).
I did ultimately refinance, first to a 15 year, and later to a 15 year adjustable (first 5 years fixed) mortgage, figuring that I'd either refinance after 5 if rates were decent, or pay it off. I lost the flexibility you described, but gained lower rates. Again, no free lunch - I took on higher risk for better returns.
I did note previous in this thread about being able to itemize deductions for federal (which may also positively affect state taxes, too); and that this ability may have value with deducting mortgage interest and/or that mortgage interest may be the trigger for enough money to get into the itemized deduction section.
It has since been noted too about being able to deduct property tax, and other smaller items that would not otherwise be able to be used.
Another itemized dedcution that has become "more" important in the last year is for the medical expenses area. I will guess that this was not the case previously, except with special medical circumstances within a family's expenses.
NOW, with some families finding more extreme montetary expenses from compliance with ACA, I will again guess that more families now also have this area available for itemizing.
From experience with some friends and families, the following may now exist:
---much higher out of pocket costs for medical and dental plans
I played devils advocate with several folks beginning the start period for new ACA rules to help determine previously unused/couldn't use itemized deductions for this area, due to percentage cut off points. Most of these people would not have considered these deductions in prior years.
Some were now able to include medical/dental expenses due to higher policy premiums, more out-of-pocket expenses for items related to medical and dental. There are many items available to include within this itemized area.
Obviously, everything will vary depending upon one's personal monetary circumstance.
However, this is another point of consideration for maintaining a mortgage to allow for this interest deduction that may allow for many other itemized deductions.
Lastly, as a method of testing whether all of this may be of value versus using the standard tax deduction; is to use tax software and create another "user" tax report as if it was going to be the "real thing". From my recall, the two most popular tax software programs let one create up to 6 tax returns. So, one may fill in the blanks to test if medical/dental deductions of all flavors would meet the cut-off percentage to be of value in reducing taxable income.
Sadly, as we know; tax things should not have to be so complex for regular folks, but this is how things are, eh?
Note: many years ago, we did move to a 15 year mortgage at something around 6.75%. As has been noted here, we pretty much doubled up on the monthly payment. The only variable was that we funded retirement investments to the maximum first. The most important factor, as we here know; is that we did not live beyond our means and were and still are very good with money flows revolving around the wants and needs of human nature.
I think I rambled about what was in my mind an hour ago.
A few more details about medical expenses and taxes (to throw into your personal tax mix):
- The tax laws were changed so that medical expenses are deductible only to the extent that they exceed 10% (formerly 7.5%) of your AGI (Form 1040, line 37). That's net expenses, after ACA subsidies.
- There's a two year exception for people over age 65 (lasting through tax year 2016); for these folks, the floor remains at 7.5%.
- If you use a special tax account (e.g. HSA) to pay for some medical expenses, then you can't use those particular expenses in calculating your medical deduction.
- Insurance premiums (other than Medicare, COBRA, and LTC) can not be paid out of an HSA (so the only place they can be used is in calculating medical itemized deductions).
- A person under age 65 may not pay for their spouse's Medicare premiums out of their own HSA. (You must be over 65 to pay for Medicare premiums from your HSA.)
A few more details about medical expenses and taxes (to throw into your personal tax mix):
Also, if you have self employment income equal to or greater than your medical insurance premiums you can reduce self employment income dollar for dollar up to what was spent on medical insurance premium. This is an AGI, not an itemized deduction, so it's not necessary to itemize to take this deduction.
from link:
" If you are self-employed, you can also deduct the cost of your health insurance premiums regardless of how they compare to your adjusted gross income. Deduct the total amount of health insurance premiums paid for the previous year on line 29 of Form 1040. Fill out the "Self-Employed Health Insurance Deduction Worksheet" in the instructions for Form 1040 to calculate your deduction amount."
Comments
The broad analysis here is fine - that keeping cash instead of paying down a mortgage is a losing proposition, but long term investing could be a winner if the mortgage rate is low. But that's not what the headline says, and his arithmetic is off.
He looks at after tax cost of the mortgage: interest rate minus tax savings. Fine.
He compares that with pretax income from a CD. Wrong.
You need to compare aftertax cost of the money with aftertax earnings. (This only strengthens the argument that keeping a mortgage and putting the money in a CD is a loser.)
Alternatively, you can compare pretax cost (i.e. the mortgage rate) with pretax earnings (the CD rate). This isn't as good at telling you your net savings (or loss), but it gives the same yes/no answer, without even having to look up your marginal tax rate.
I have tended to take a different approach when it comes to housing costs. Whether you rent or "own a mortgage", try to get these costs as low as possible and try to keep them fixed for as long as possible.
One pretty big advantage to "not paying off" or "not paying down" your mortgage is the flexibility you maintain with the cash you didn't throw at the loan. Paying off the mortgage is always an option, but by maintaining some cash you provide yourself the opportunity to diversify away from a single asset (your home).
There is always added risk to owning property outright. I like the idea of sharing that risk with a lender who is willing to reasonably "rent me their money" as part of my housing costs. Strictly from a risk/return perspective I believe there are many more reason to diversify away from owning a single large asset (a home).
'Course, everyone's circumstance will vary with this.
Many years ago, with the elimination (payoff) of our mortgage; we no longer had enough other deductions to itemize them on the 1040. But, the mortgage interest was gone and all is well.
Those payments must be made each and every month; one way or another you must come up with the cash. That is a significant demand on cash flow. Get rid of that, and you have much more flexibility (expenses are then mostly discretionary).
If your portfolio does poorly, it's easier to cut back on expenses for awhile. So you're free to invest more in equities; your survival doesn't depend so much on what you've got in cash and fixed income.
We've always had a mortgage or rent payment of some sort. Guess we've grown used to it. The current one at 3% has about 10 years to run. I'll rather miss it when it's paid off. Think of a fixed rate mortgage as an "anti-bond" - or a bet on higher interest rates. It can serve as an inflation hedge by stabilizing housing costs during periods of rising prices.
I'd argue that you have more control over the money if it's in a highly liquid asset like a fund than in home equity. But, will admit that the home is the "safer" of the two investments and apparently (to many) has a greater emotional value.
I agree. When I bought my condo in 2000, I put 40% down from stock options sold from my Dot Com company. Three months later, I cashed out the rest of them and paid off the mortgage.
My rationale? Simple -- I did not want debt ('good' or 'bad') hanging over my head and/or be beholden to someone for the roof over my head. Some thought I was nuts for doing that, but I did it anyway. Peace of mind!!
Looking back at property appreciation and its retained value (even despite '08) it remains the best investment decision I've ever made.
AMEN!!
As far as being beholden to someone else ...
- If your mortgage allows payoff in full at any time you choose, and if your liquid assets far exceed the value of the mortgage, than you're not really "beholden". You can choose if and when to pay off the mortgage in full.
- So the question should be: Which way do you come out ahead financially? Do your investment returns after taxes exceed the interest paid on that mortgage? (Your home is going to appreciate at the same rate whether or not you've got a mortgage on it.)
The "Amen" above highlights that there appears to be a great emotional value in having a paid-off home. Go for it - if that makes you feel so much better. Doesn't do much for me - but I do understand the comfort, peace of mind and emotional appeal it holds for most.
I'm thinking that at some point it may be advantageous to take out a mortgage. With low interest rates AND a fixed rate mortgage AND the offing (I'm guessing in 10 years) might look good.
Think back to the 1960s when people had low interest rates; then in the 70s interest rates rose.
I agree a lot has to do with comfort level (the sleep factor as OJ put it).
We deal with a fine local bank. If anything changed in that regard, we'd pay them off and get out fast. The two "re-fi"s in recent years went to pay for a couple additions on the house. So our equity rose along with the debt. Also, I refuse to go out farther than 15 years on a mortgage no matter how attractive the rate.
Actually, have recently considered paying off all of the mortgage - as it's getting harder and harder to earn 3% in the bond/equity markets without going out there quite a bit on the risk curve. Am only around break-even YTD.
So it goes.
that would be me, I think
and not at all an original thought or phrase either, not even close
I perhaps shoulda made clear that at 68 I am not very much in bonds: cash and equity funds, though some are blended or have a twist.
Oops - thanks for the correction!
No - the term's not original. "Sleep factor" comes up a lot when discussing investments. As it should. So, you really need to look at the mortgage decision in the context of all your investments and liabilities.
Paying off a 3% mortgage seems to me a very conservative/safe move. I'd liken it to buying a Treasury Bond netting holder a guaranteed 3% after taxes. As safe investments go, in an era of minuscule bond & CD rates, that 3% guaranteed return doesn't look bad.
The only fly in the ointment ... that 3% mortgage likely has a "lock". Should interest rates move up to 5-6% during the term of the loan, you'll feel very smart having kept the mortgage. In that case, bragging rights would go to those still holding 3% mortgages.
-
PS: I'm in the group that values home ownership. I like to be able to kick that dirt under my feet. However, many in our society lead perfectly normal happy lives as renters. Some of the upper level "rentals" in NYC @$10,000+ a month don't look too shabby!
The pretax cost of the mortgage is 3%. When you itemize, you get to reduce your taxable income. This results in a tax savings (and so lower net cost of the mortgage). So your aftertax cost of the mortgage is 3% x (1 -r%), where r% is your tax rate.
That's exactly the same equation and net yield on a Treasury with a 3% pretax rate. Same idea - income taxes reduce the magnitude of any figure - the yield of a mortgage or the cost of a mortgage.
The "lock" problem cuts both ways. In order to get a Treasury yielding 3% (pretax), you have to go out 30 years. Odds are, your mortgage has fewer years to go. The only way to get a better return on the cash is to take on more risk. As you suggested, rates might rise to 5-6%. In the meantime, you've put money into a lower yielding, shorter term Treasury, hoping (risk) that rates will rise soon enough and fast enough that you come out ahead. Or you've invested in a more risky vehicle to get a higher return.
TANSTAAFL.
In order to take advantage of the mortgage interest as a deduction, one must itemize their deductions rather than taking a standard deduction. I can imagine that in states where property taxes are high that the combination of just these two itemized costs (mortgage interest and property tax) would enable a tax payer to itemize.
Itemizing decreases taxable income beyond the benefit of just the interest costs, but can only be realized by itemizing. Itemizing opens the door to additional tax deductions that would not be available to a taxpayer using the standard deduction.
Here's a calculator that help figure out what the extra payment would need to be:
what-if-i-pay-more-calculator
I did ultimately refinance, first to a 15 year, and later to a 15 year adjustable (first 5 years fixed) mortgage, figuring that I'd either refinance after 5 if rates were decent, or pay it off. I lost the flexibility you described, but gained lower rates. Again, no free lunch - I took on higher risk for better returns.
I did note previous in this thread about being able to itemize deductions for federal (which may also positively affect state taxes, too); and that this ability may have value with deducting mortgage interest and/or that mortgage interest may be the trigger for enough money to get into the itemized deduction section.
It has since been noted too about being able to deduct property tax, and other smaller items that would not otherwise be able to be used.
Another itemized dedcution that has become "more" important in the last year is for the medical expenses area. I will guess that this was not the case previously, except with special medical circumstances within a family's expenses.
NOW, with some families finding more extreme montetary expenses from compliance with ACA, I will again guess that more families now also have this area available for itemizing.
From experience with some friends and families, the following may now exist:
---much higher out of pocket costs for medical and dental plans
-including policy premiums
-co-pays (medical/dental)
-co-pays (meds)
I played devils advocate with several folks beginning the start period for new ACA rules to help determine previously unused/couldn't use itemized deductions for this area, due to percentage cut off points. Most of these people would not have considered these deductions in prior years.
Some were now able to include medical/dental expenses due to higher policy premiums, more out-of-pocket expenses for items related to medical and dental. There are many items available to include within this itemized area.
Obviously, everything will vary depending upon one's personal monetary circumstance.
However, this is another point of consideration for maintaining a mortgage to allow for this interest deduction that may allow for many other itemized deductions.
Lastly, as a method of testing whether all of this may be of value versus using the standard tax deduction; is to use tax software and create another "user" tax report as if it was going to be the "real thing". From my recall, the two most popular tax software programs let one create up to 6 tax returns. So, one may fill in the blanks to test if medical/dental deductions of all flavors would meet the cut-off percentage to be of value in reducing taxable income.
Sadly, as we know; tax things should not have to be so complex for regular folks, but this is how things are, eh?
Note: many years ago, we did move to a 15 year mortgage at something around 6.75%.
As has been noted here, we pretty much doubled up on the monthly payment. The only variable was that we funded retirement investments to the maximum first. The most important factor, as we here know; is that we did not live beyond our means and were and still are very good with money flows revolving around the wants and needs of human nature.
I think I rambled about what was in my mind an hour ago.
Take care,
Catch
- The tax laws were changed so that medical expenses are deductible only to the extent that they exceed 10% (formerly 7.5%) of your AGI (Form 1040, line 37). That's net expenses, after ACA subsidies.
- There's a two year exception for people over age 65 (lasting through tax year 2016); for these folks, the floor remains at 7.5%.
- If you use a special tax account (e.g. HSA) to pay for some medical expenses, then you can't use those particular expenses in calculating your medical deduction.
- Insurance premiums (other than Medicare, COBRA, and LTC) can not be paid out of an HSA (so the only place they can be used is in calculating medical itemized deductions).
- A person under age 65 may not pay for their spouse's Medicare premiums out of their own HSA. (You must be over 65 to pay for Medicare premiums from your HSA.)
from link:
" If you are self-employed, you can also deduct the cost of your health insurance premiums regardless of how they compare to your adjusted gross income. Deduct the total amount of health insurance premiums paid for the previous year on line 29 of Form 1040. Fill out the "Self-Employed Health Insurance Deduction Worksheet" in the instructions for Form 1040 to calculate your deduction amount."
deduct-medical-expenses-adjusted-gross-income-15960.html