Tuesday, January 17, 2017

Pay Down Your Mortgage?

Should you pay down your mortgage?   

I hear from a lot of people who want to be aggressively frugal, and one thing they mention is getting debt-free by making advance payments on their mortgage, or by going to a shorter-term 15-year mortgage.  I have had friends try this, with mixed results.   Of course, you can make additional payments on your 30-year mortgage and effectively turn it into a 15-year mortgage, but of course, the interest rates would be higher.  Not only that, relying on "self-control" to accelerate payments.... well, we know how that works out.  At least I know how it works out for me.   A 15-year mortgage is a forced savings program, provided you plan on living in a house for 15 years.

If you move within five years or so, well, it probably will save very little if not in fact be more expensive.  Since the monthly payments are higher, you are effectively cash-poor in the interim, and you pay down little of the balance to justify the added expense.   And like the "over-saver" who decides to put 15% of their income into their 401(k) without making a corresponding 15% cut in their expenses, you can end up behind the eight-ball, running up credit card debt as you live beyond your means.   If you decide to go this route, make sure you can make that payment.   Cut something from the budget first - a new car, or cable TV, for example.

It doesn't take a mathematician to figure out the savings in mortgage interest in going to a 15-year loan.  There are plenty of calculators out there to figure out that for you.   You will pay far less interest, but of course, your tax deduction for the interest will be less.   You cannot deduct your way to wealth, however, and even if your deductions are less, you will likely come out ahead by paying less interest than more.   Think about it for a second - would you willingly sign up for a 15% interest mortgage loan just because you'd get a bigger deduction?  Of course not.  Deductions are fine and all, but they merely ameliorate a loss - they do not turn it into profit.

In an earlier posting, we compared paying cash for a car to taking out a car loan.   And a number of things came to light.   If we assume the interest rate on savings is the same as the loan rate then there is a slight advantage to paying cash.    If we assume the interest rate on savings is comparable to a government bond (which is a more apt comparison), then the savings in paying cash (or paying off a loan early) are even better.   The car salesman, of course, would compare your loan rate to the returns available on risky stocks - which shows an advantage to borrowing, of course, but places your investments at risk, and thus is not an "apples to apples" comparison.

Mortgages get a little trickier because Congress decided to make mortgage interest tax-deductible, in an effort to spur home sales.   And like any government subsidy, be it soybean price supports or tax credits for electric cars, these sort of things end up doing little more than distorting the market.   Moreover, they are like a very addictive drug - people become dependent on tax subsidies and structure their lives around them, and as a result, the subsidies cannot be repealed without hurting a lot of people.   At the very least, we can't go "cold turkey" by suddenly withdrawing subsidies, as it would cause a lot of people and businesses to go bankrupt.

The weird thing about tax deductions (as opposed to credits) is that they tend to favor the upper-middle-class and rich, who are in the higher tax brackets.   If I am in the 25% bracket, a tax deduction is worth 10% more to me than some schmuck in the 15% bracket.   Thus, mortgage interest deductions and 401(k) and IRA deductions tend to favor wealthier people.   For the latter reason, there is an "investment tax credit" given to the lower classes, if they contribute to their IRAs, to try to sort of balance out the inequality.

Another "unintended consequence" of tax laws is that having debt in retirement, if you are living off your 401(k) or IRA, can be problematic.   If you have a mortgage totaling $24,000 a year in payments, that is $24,000 a year more you have to withdraw from your IRA.  This, in turn, forces you into a higher tax bracket, so you end up paying a higher tax rate - negating the stated benefit of the IRA, which was to allow you to be taxed at a lower rate in retirement.   In other words, the goal in retirement is to stick to that 15% bracket, if you can, and avoid paying higher taxes.   Having debt in retirement forces you to withdraw more, pushing you into a higher bracket.

So, for the 401(k) generation, paying off your mortgage before you retire is probably a smart move.  You won't have to worry about making mortgage payments, and you can leave money in your IRA and avoid paying more taxes than you have to.

Let's assume you own a house with a $250,000 mortgage, because like me, you refinanced it a number of times and took out cash to pay for a car or your credit cards.   Or like a lot of other people.   So here you are, facing retirement with debt.

But you have over a million dollars in your 401(k) and IRA plans, so it is no big deal, right?  (NOTE:  It may be tempting to take out $250,000 from your IRA and pay off the mortgage, but that just makes the tax consequences horrific!).

Well, yes and no.   That amount of money will generate $50,000 a year in retirement using the 5% rule, and you might expect another $3000 a month or so in Social Security (Trump willing) to supplement that income.  Gee, that's 86 grand a year in retirement income!  Sweet!

Or is it?   You'd be looking at about $1250 a month in mortgage payments or $15,000 a year.  Since, as a 401(k)/IRA retiree, your income is flexible - based on how much you decide to withdraw every year, you can make a conscious choice which tax bracket you want to be in.   For 2017, the brackets are as follows:

Table 2. Married Filing Joint Taxable Income Brackets and Rates, 2017

Rate Taxable Income Bracket Tax Owed
$0 to $18,650 10% of taxable income
$18,650 to $75,900 $1,865 plus 15% of the excess over $18,650
$75,900 to $153,100 $10,452.50 plus 25% of the excess over $75,900
$153,100 to $233,350 $29,752.50 plus 28% of the excess over $153,100
$233,350 to $416,700 $52,222.50 plus 33% of the excess over $233,350
$416,700 to $470,700 $112,728 plus 35% of the excess over $416,700
$470,700+ $131,628 plus 39.6% of the excess over $470,700

You can ignore the higher brackets - we are all middle-class people here.  The big break is right smack dab in the middle of the middle-class - the 15% to 25% jump that occurs at the $75,900 limit for married couples.  As you can see, when you go over that limit, your taxable rate jumps from 15% to 25%.

And at this point in your life, after paying a mortgage for many years, you are paying mostly principal and little interest, so the mortgage interest deduction is pretty small, if not in fact, non-existent.   You may be better off with the standard deduction at this point.

If your house was "paid for" you could withdraw less money from your IRA and bring your taxable income down by $15,000 - to the $75,900 limit, which means you pay 15% tax basically, on the excess over $18,650.

That extra $15,000 in mortgage payments would require you to pay 25% in taxes on that money, or $3750 more a year, which means you'd have to withdraw $3750 more a year to pay those taxes.   And there would be tax on that money as well - so you'd better make it an even $5000 more in taxes - just to pay a $15,000 mortgage payment.

Crazy as it sounds, refinancing at this point makes perverse sense, as the mortgage payment becomes all-interest and is tax deductible.  Of course, you pay thousands in refinancing fees, and you end up paying off the balance years later when you finally are forced to sell the home, or your widow does, or your children do.

The other alternative is to pay down the mortgage before retirement and live debt-free.   With this scenario, you can structure your finances such that you stay in that 15% bracket and give Uncle Sam the middle finger.   But wait, it gets better.

Since you are taking $20,000 less per year from your retirement account, your retirement monies will last longer and you have less to worry about.  It is a more comfortable and stress-free way to live in your "golden years" to be sure.

But, the opportunity cost people will chime in here.   First, they will argue, "Well, that's all very well and fine, but to pay down that mortgage may mean missed opportunities to invest, such as in the 401(k)!"   And this is an argument worth addressing.  To begin with, you could pay down your mortgage before retirement simply by spending less and living within your means.   I can say firsthand that I ended up owing $300,000 on a $189,000 house by refinancing to pay off other debts and to live large.   We could have chosen differently.

Second, as the example illustrates, you need less money to live when you have a paid-for house.  So if you did in fact fund your 401(k) less, it may be somewhat of a wash, as you will need less income in retirement as a result.

Again, using the 5% rule, which is generous, the $20K less you need in your retirement income cash-flow equates to a staggering $400,000 in your IRA or 401(k).   In other words, you can save up 400 grand in retirement savings in order to service a $250,000 debt or just pay off the damn debt in the first place.

The second argument that the "opportunity cost" types will make is that "you could have invested that money and kept the house mortgaged and made more in the long run!"   That is a slick argument, but flawed on a number of levels.

First, it assumes you are keeping the house mortgaged on purpose so you can "invest" the income stream, and are not in fact merely living beyond your means like about half of America is.   Yes, it is a nice fantasy to say we will "invest" the difference, but we all know we are going to spend it on stupid stuff instead.

Second, as I noted time and again, it is a classic apples-and-oranges comparison.   Assuming you have the willpower to invest the money you are "saving" (and these savings are dubious at best), in order to achieve a rate or return higher than your mortgage interest rate you would have to invest in risky securities which may drop in value on occasion, which if that occasion is your retirement, really, really sucks.

As you approach retirement, you should put more and more of your investments into safe harbors - low-yield risk-free investments that may not grow much, but will not go away either.   The two safest investments we have in the USA are government guaranteed bonds and bank accounts, and debt that is paid off.   Of the two, the latter is more secure.   The government could theoretically default on its debts.   Your debt paid off is paid off for good, never to come back - even if the government goes South.

So yes, you could "invest" in your 401(k) and come up with more than the $400,000 needed to service your $250,000 mortgage in retirement, but it would require you invest in high-yield risky investments.

Or, you could pay off the $250,000 debt and be 100% assured you would need $20,000 less in retirement income - meaning $400,000 less you have to save.

Working people simply don't get this math!   I was talking to a bank manager the other day, and she could not understand how the widows on the island here live on so little money every month.  After all, she has a six-figure income and that seems to barely pay for her $3000 a month mortgage payment, her car payments, the cable bill, and the other costs of living. How can someone live in a more expensive home that she has - for such a pittance a month?

And the answer is, simply, the home is paid-for.   It costs about $850 a month to live here on retirement island, provided your home is paid-for.   That is what a small apartment rents for in a not-so-desirable  neighborhood in our nearby town.   Since you don't commute in retirement, your variable car costs drop, and of course, you spend a lot less on things like lunch at work, dry cleaning bills on your suits, and so forth.  Also, you are not setting aside 10-15% of your pre-tax income into a 401(k) but are spending it instead.  It is a different way of life.

Other retirees take a different approach.  Heavily in debt, they spend a lot of money - and pay a lot of taxes - to service this debt.  If they have a pension plan (husband and wife) and social security, maybe this makes a perverse form of  "sense".  But in terms of security, they are reliant on these companies they worked for not going bust during their golden years.

Retirement calculators often state that in retirement, your income requirements are only 60-80% of that when working.   But in reality, living expenses can be far, far less, if you retire with no debt.

The advantages go far beyond that, of course.  You have more flexibility in retirement, more security, and of course, a "nest egg" you can cash in when you decide to downsize.   It really works out better from every angle.

The secret is, of course, to figure out how to retire with no debt.   For me it was deciding to have less "things" and more security.  Vacation homes and fancy cars are fine and all, but not at the expense of perpetual debt.