I recently received mortgage solicitations in the mail from two different companies on the same day. As a player in the mortgage industry I like to see what my competition is doing. As a result I analyze all mortgage related marketing material that comes across my desk. For some reason both mail pieces were super hyper in selling their potential customer on the idea of the mortgage tax deductions. Both mail pieces expounded on the idea that by utilizing your home to finance various goals you will, in effect, reduce your tax bill. Ironically, as I was reading various financial publications I subscribe to, I came across an article written by a financial advisor who was illustrating the benefit of making minimum payments on mortgages while investing all you can in various investment vehicles. This financial consultant reasoned that since interest rates on mortgages were averaging 6 percent and that long-term investment vehicles were averaging 12 percent, you are in effect netting a 6 percent return.
I hold a unique position. I’m one of few financial experts who is versed in multiple financial disciplines. That being said, my views often differ from financial professionals who operate in one zone whether it’s mortgages, insurance, real estate, taxes or investing. I will admit that to some degree the concept of the mortgage tax deduction and the concept of investing versus paying off the mortgage have merit. I will also admit having a plan is better than having no plan at all. However, I wonder whether or not this is the most simple, efficient, risk tolerant way to manage your money.
The truth about your mortgage
interest tax deduction
Millions of consumers are sold on the idea that some large tax deduction exists when you pay interest on your mortgage. While it is true that by paying mortgage interest you reap a tax deduction, the question mark lies in the adjective “large.” It is important to note that no tax incentive will be equal to or greater than the interest expense that is paid. More importantly it should be pointed out that there are two types of deductions that exist—a standard deduction and an itemized deduction. When filing your taxes you have to choose one or the other. Naturally, you would want to choose the deduction type that yields a greater benefit. The standard deduction is a specified amount, indexed annually for inflation that may be claimed by taxpayers that do not itemize their deductions. The only time you will claim itemized deductions is if your itemized deductions exceed your standard deduction. The amount of the taxpayer’s deduction is based on filing status. For a married filing jointly taxpayer, the standard deduction in 2010 is $11,400. Given the fact that most deductions have to have a profit motive associated with them such as deductions available for investments or businesses. Deductions available for homeowners including property taxes and mortgage interest are the primary deductions available for the average person. For the sake of simplicity, let’s assume you’re married filing jointly and that other than mortgage interest, you have no other itemized deductions. Let’s further assume that you are in the 25 percent marginal tax bracket. Given this scenario, you will have to pay interest over and above $11,400 (amount needed to exceed standard deduction) before the itemized deduction will began to benefit you. Assuming you paid $12,000 in interest for the year, you may reason that you reaped a $3,000 tax deduction ($12,000 x 25 percent tax rate = $3,000). The reality in this scenario is you would have gotten a $11,400 deduction whether or not you paid interest. Therefore, the benefit should be calculated on $12,000-11,400 which is $600. The actual tax saving in this example paying $12,000 in interest is a whopping $150 ($600 x 25 percent tax rate = $150). If I lost you in the financial jargon, simply ask yourself does it make sense to pay $12,000 in interest to get a $150 tax savings? I hear a resounding NO!
You can earn a greater return paying off debt than you can earn in the stock market.
If nothing I say following this sentence make sense remember this statement, “No investment is as secure as a paid off debt.” Although the stock market has averaged a 12 percent rate of return over a long-term track record, whenever you’re forecasting stock returns, you’re talking about potential after tax returns. However whenever you’re forecasting paying off debt, you’re talking about a guaranteed tax-free return. In reality, given the fact that the risk elements in paying off debt versus investing are at opposite ends of the spectrum, you really cannot compare the two. So often people rationalize it makes more sense to invest whatever extra money they could come up with and earn a 15 percent return versus paying off a mortgage with a lower interest rate. For comparison sake it’s worth giving mathematical value to a paid off debt. Let’s assume that the Jones family has a household income of $52,740 per year or $4,395 per month. Conventional wisdom suggests that we save and than later invest 10 percent of our income.
Ten percent of $4,395 per month is $440. Instead of investing the $440 per month, the Jones family decided to leverage this money to get completely out of debt. They currently have monthly debt payments of $1,597 per month with a total debt balance of $118,000. By following a systematic debt elimination plan, using the extra $440 to accelerate the payoff process by paying off one debt at a time and using a domino effect to eventually payoff all debts, they can be debt free in seven years. This will save them tens of thousands of dollars in interest expenses—not to mention the immeasurable return on investment called peace of mind. More importantly it will free up their old monthly obligation of $1,597 per month. That’s like having a nest egg of $191,640 earning 10 percent per year. To build a nest egg of $191,640 investing $440 per month over seven years, you will need to yield a rate of return of 43.68 percent per year. I don’t know of many stocks yielding that type of return.
(Damon Carr can be reached at 412-856-1183.)