Tuesday, October 19, 2010

Interest Expense - Is there really a savings? (YES)

Should you pay off debt or invest your money?  Are these two of the same thing?

Once again, I struggle with the conundrum of paying off debt.  So many financial "experts" say that having debt is good - or at least is not all that bad.  And then they blather on about "opportunity cost" of money, which as we discussed before is only a concept that applies to corporations that need capital to invest in equipment and things that create wealth.

There is no "opportunity cost" lost for the individual, when they forgo the opportunity to spend money on depreciating personal assets.  In fact, failing to do so is an opportunity gain.  The less you spend on "things" the wealthier you are.

And the idea that you can invest money and get a greater rate of return than you are paying in interest on your debt is problematic.  When you pay down debt, it is a 100% "safe" investment.  But when you invest, you can lose all your money and then still have that debt to pay off.  Before you put money into speculative investments, make sure you are paying down debt as well.

Our mortgage is presently an astounding (to me) $340,000.  The annual interest on this loan is about $18,000 or more (last year, close to $19,000).  In terms of a "rate of return" on your investment, this works out to be about 5.3% which is close to our mortgage interest rate.

Again, go down to your bank, and ask them for a $340,000 1-year CD that is totally guaranteed by the FDIC and has a 5.3% interest rate.  They will boot you out the door.

The best CD rates in the country at this time are only a little more than 1% perhaps 1.5% tops, and the FDIC insures deposits only for $250,000.

Even taking into account the vaunted "mortgage interest deduction" you still come out ahead being debt-free.  While the mortgage deduction might drop $18,000 from my income, this results in a tax savings of, at best, $6000, or about 1/3 the total amount.  This still works out to an effective "savings" rate of 3.5% - about triple what the banks are paying for a similar "safe" investment.

Could I do better in the "market"?  Perhaps.  If I took that money and invested it, I might get a higher rate of return - or perhaps a negative rate of return.  The risk is very high, compared to no-risk.

And as for the tax deduction of an IRA or 401(k)?  Well, I already pretty much max these out as it is.  I could not drop $340,000 into my IRA and get a deduction.  However, if I had $2000 a month I don't have to spend on a mortgage payment, it does make it easier to fund my 401(k).

But even assuming this money could be put into an IRA, the savings would be hard to quantify.  According to my old tax-law professor, (after doing a convoluted calculation on the board for an hour) the simple rule is, the savings in putting money in your 401(k) or other tax-deferred investment is about equal to the marginal tax bracket rate you are in.

Right off the bat, here is a little conundrum:  If you are like a lot of middle-class Americans, the mortgage interest deduction often bumps you into a lower tax bracket, (e.g., from 25% to 15%) so the savings amount in the 401(k) may be diminished by your mortgage interest tax deduction - or at least it is for me.  For the wealthier, who make a million dollars a year, they get full advantage of both deductions, getting 38% (the highest marginal rate) back on their mortgage interest payments, and on their IRA or 401(k) contributions.  For us lesser folks, the savings are not quite as good.

So yes, in theory, I would get a 15% boost over time from my IRA/401(k) contribution if I put money into that as opposed to paying off debt.  But of course, for my situation, without the mortgage interest deduction, I will probably end up in the 25% bracket now, which means my 401(k) contributions will result in an increased amount of deduction for me.

Wow, another one of those "its pretty much a wash" kind of deals.

Overall, I will save about another $3000 in interest payments on credit cards by paying them off (ouch!) and I have no car payments, not having had a car loan for a decade or more.  So the net "raise" I get by not paying interest is about $21,000 a year, conservatively.

Oh, but wait.  As I have noted in other blogs, when you save money, while it is like getting a raise in pay, it is not taxable income.  A dollar not spent is not a dollar earned, but more.

To get the equivalent of a $21,000 take-home-pay raise, I would have to earn at least 1/3 to 1/2 more to cover State and Federal income taxes plus Social Security and Medicare payments (and the dreaded self-employment tax).   That means in actual terms, this is like getting a $30,000 to $40,000 a year raise.

Um, that works out to better than a 10% return on "investment" of $340,000.  Wait a minute here.  10% rate of return on a totally safe investment?

I must have slipped a digit or something.  No wait, I didn't.

As I noted in the Pay Off Your Mortgage posting, the idea of owning a home free and clear is alien to most Americans today.  And one reason this is, is because investment gurus need to sell some unorthodox or odd advice that people will say "Gee, I never thought of that!"  Because ordinary common-sense advice is not something that people will pay money for.  "Gee, I could have told you that!  What a ripoff, paying $20 for an investment book that tells me to pay off my debts!"

That, and well-meaning tax advisers, looking for that next deduction, encourage people to do things according to the tax code in order to reduce their tax burden.  And in some cases, it may make "sense" to take on a mortgage.  For example, if you are a young person starting out at a high-paying job ($100,000 a year, poor you!) and you are paying $3000 a month to rent a luxury condo, it may make more sense to pay $3000 a month on a mortgage and get a tax deduction.

But it makes more sense to pay down the mortgage rather than have perpetual debt.  If you are making $100,000 a year, you could pay off the mortgage on a non-luxury condo in a few years, and own it outright.  But most young people (myself included) are too caught up in the whirlwind of living life on their own for the first time, and the excitement of buying themselves presents.

Each person's situation is unique, of course, and you have to study your situation to determine whether you should be paying down debt faster, or putting money into savings more.  The bottom line, of course, being, for any individual's situation, spending less on "things" and paying more toward debt reduction and savings is the best idea around.

Whether your bias should be toward debt reduction or savings may depend on a number of factors:
1.  Your Age:  When you are young, you can afford to take more risk, and you have more time to take advantage of compound interest.  Save all you can, and try to minimize debt.  When you are older, you cannot afford to take risks on speculative investments, and you can't afford a high debt-load as you approach retirement.  So paying off debt may be more important than adding another dollar to your 401(k).  You should do both, of course, but the bias may be more toward debt.

2.  Your Marginal Rate:  If you are in the 38.5% bracket, you need to take all the deductions you can - and you are earning enough money to afford to pay for them.  Putting as much as possible in tax-deferred savings may make more sense than paying down debt.  But if you drop down to a lower rate - 25% or even 15%, the savings diminish accordingly.  Paying down debt may be more profitable at this point, as the tax savings are less.

3.  Your Cash Flow Requirements:  If you have a heavily mortgaged mini-mansion that is nearly upside down in debt, and a 401(k) portfolio all in high-yield, high-risk stocks, you could be in a lot of trouble in short order if the market goes down and housing prices drop.  Throw in the chance of unemployment, and it is a trifecta of bad news.  And this is exactly what happened (and is happening) to a lot of people in this country.  If you require a lot of money every month just to pay debts and fund savings, bad things can happen in a hurry if you lose a job.  The first thing to go is funding savings, then you dip into the savings, and then you lose the heavily mortgage house.  On the other hand, if you have a house that is "paid for" and you lose your job, you at least have some time and flexibility - as well as equity in your home - that you can use.
It is unfortunate, but most of the investment "gurus" out there are either hyping stock picks or hyping consumer spending, as we shall see in the next post.  Real hard advice on personal finances seems hard to come by, for the most part.

UPDATE 2021: Since I wrote this, I am debt-free and realized another aspect of being out of debt - taxes.  While you might get a tax deduction for some debts, when you are retired and living off an IRA, your taxes are determined by how much you cash-out every year.  If you have to cash out an additional $30,000 to service debts, well, that knocks you into a higher tax bracket and decreases any Obamacare subsidy you might get.

Turns out, retiring debt-free isn't some fancy option, it is a necessity, for the 401(k) generation.  Unless you have a defined pension from a government agency, that is.... and so few do these days.