Wednesday, February 9, 2011

Viewer Mail - Use the Tax Code as an Investment Guide? No!!

This is a copy of the Internal Revenue Code.  It is NOT an Investment Guide!

A viewer asks, "Is there a tax incentive for paying off your mortgage in one lump sum?"

Sigh.  It seems that most Americans just don't "get it" - do they?  People have been trained like seals to only do things for which there is a tax deduction or tax credit, as if whatever the Government says you should do is the best possible thing for you.

Here's a clue:  Uncle Sam doesn't always have your best interests at heart - and in fact rarely does.

No Virginia, there is no tax deduction or tax credit for paying off your mortgage in one lump sum.  In fact, you will be losing the largest middle-class tax deduction possible when you pay off your mortgage.

So, paying off your mortgage is a bad idea, right?

No.  Please pay attention this time.  I'll explain it again.  S-L-O-W-L-Y.

Not having debt is better than having tax-deductible debt.  PERIOD.

Many people make the mistake of thinking that since there is a tax deduction or tax credit for something, then doing that thing is a good idea or a wise fiscal move.  However, this is not always the case - and in fact rarely is.

If you plan on doing something anyway and they offer a tax deduction or credit, then yes, you should look at that benefit in your cost/benefit analysis.  But don't do something simply because there is some positive tax implications.

For example, you can get a $7500 tax credit for buying an electric car, like the Nissan Leaf.  Does this mean you should run out and buy a Nissan Leaf?  No, of course not.  If such a car is suitable for your lifestyle and is something you really want, then you might want to consider one, and the $7500 off the purchase price is certainly something to take into consideration - but they are still expensive cars with limited use - and not surprisingly, the manufacturers raise prices by about....$7500...because of these tax credits.

So no, you are not going to "make money" buying electric cars, just because there is a tax credit.

And tax credits (amounts lopped off your tax bill) are like Crack Cocaine, compared to tax deductions (which are more like weak beer).  A tax deduction merely deducts an item from your income, for tax calculation purposes.  So if you are in the 28% tax bracket and can deduct a dollar expense legally, then you save 28 cents on your tax bill.

For your home mortgage, the interest is deductible, for mortgages up to the purchase price of the home (a so-called purchase-money mortgage, or PMM). 

So, for example, if you have a $100,000 30-year mortgage, at 5% interest, you'll have a monthly payment of $536.82.  Over the life of the loan, you'll pay $93,255.78 in interest charges, which, if you are in the 28% tax bracket, will knock about $26,111.62 off your taxes, over the life of the loan.  Note that the amount you deduct every year will diminish over the life of the loan - to the point where itemizing is no longer a benefit, and the "standard deduction" is greater.  So actually, your tax benefit over the life of the loan will be less.

If you paid cash for the house, or came into some money and paid off the loan, you'd save the entire $93,255.78 in interest payments - a whopping amount of money, and over three times the "tax savings" of having a home mortgage interest deduction.  So there is your big savings, right there - not paying interest.  Screw the tax savings, the interest dwarfs it, and will, every time.

"But!" you say, "my Brother-in-Law said that I could invest that money instead and get a higher rate of return in the stock market!"

This is an interesting argument and is made all the time by financial advisers, who would rather you put $100,000 into their mutual funds, which yields them a 5% commission, than have you pay off your mortgage which yields them nothing.

The argument is specious on many levels.  To being with, a speculative stock investment is not the same as paying off your mortgage.  Paying off debt is the 100% safest investment there is - safer than even government bonds or FDIC insured accounts.  You pay off a debt, it is PAID, no questions about it.  The interest you don't pay is your guaranteed "profit".

And all debts have to be repaid, eventually. 

So comparing stocks (which can yield 10% or more, or lose all their value entirely) to a sure thing is specious.  And by the way, "specious" is a bad thing.

And as many people discovered during the last recession, you can end up losing it all in the stock market and end up "upside-down" on your house - and end up bankrupt.  You might have had $250,000 in your Mutual fund, and a $250,000 mortgage, but when they both go bust, you end up living in a cardboard box.  But if you had paid off your mortgage, you were safe - and everyone, yes everyone, should have some "safe" investments - owning your own home is the best example.

A better comparison would be a safe investment like a bond, CD, or government backed security or FDIC-insure bank account.  But these would yield 2-3% interest at best.  So paying off debt is a better deal.

In addition, by not having an onerous debt load, your options are better.  Lose your job?  (a lot of that going around these days) - you don't have to worry about "losing your house" if it is paid for.

And if you don't have to make those mortgage payments, you can put that $536.82 per month into your IRA or 401(k) and deduct the full amount from your taxes.  This is a better and larger deduction.  So, over 30 years (the term of most mortgages) if you put that $536.82 per month into a 401(k), it would be worth over $193,255.20 in principle alone ($477,412.91 at a modest 5% rate of return).  But more importantly, you'd get a whopping $54,111.46 lopped off your taxes (more than double the mortgage interest deduction!) through the 401(k) or IRA deduction.

So yes, there is a "tax benefit" to paying off your mortgage in one lump sum, if you take that money you were paying on the mortgage and put it in a tax-deferred account.

But all that being said, stop thinking of the IRS code as some sort of investment guide or guide to easy living.  It is a tax code, plain and simple, and while Congress may try to use it to provide incentives for certain behavior, these behaviors are not always preferable to what you would ordinarily do.

The home mortgage interest deduction is a nice perk for the middle class.  But owning your home outright is far better than being in debt and getting a little money thrown at you at tax time.