The Truth About Mortgages

Conventional wisdom holds that a mortgage on the house you live in is a special kind of debt, one that, mostly because of favorable tax treatment, is so cheap that you should be in no particular hurry to pay it off.VA_house

But there is a popular heresy that opposes this firmly established orthodoxy. It holds that all debt is a bad idea, and paying 3X to the bank so you can save X on your taxes is loopy. Free Money Finance made this case recently. And Dave Ramsey is probably the high priest of this particular sect.

I have an instinctive contempt for orthodoxy and a sympathy for heresies of all kinds. But, alas, this is one of those cases where the conventional wisdom is spot on. Sad and boring, but true.

Mortgages are easily the cheapest way a consumer can borrow money. Even setting aside the tax effects, the raw interest rates paid on mortgages are the best deal going for most people. And once taxes are factored in, for many of us mortgages are so cheap we would be very foolish to pay them off.

To illustrate, I will do something I generally try to avoid doing, use myself as an example. Two weeks ago, after three months of hassle and bureaucratic wrangling, I succeeded in refinancing the old homestead. (The appraisal was the biggest challenge. I live in a small and eclectic neighborhood where comps are hard to find and appraisers are understandably very conservative these days.)

The reward for my efforts was a 5/1 ARM at 3.875%, no points. Thinking about that rate still makes me smirk. It is probably even money that inflation over the next five years will average more than 3.875%, meaning that the expected real cost of the loan is zero. The interest I pay will be counterbalanced by the erosion in the value of the principal.

And then there are taxes. Whether or not mortgage interest will have an impact on your tax bill is not as simple a question as you might think, or as it should be. There is the issue of the standard deduction: if your itemized deductions aren’t safely bigger than the standard deduction then the net effect of mortgage interest on your taxes could be small to zero. And at the higher end of the income spectrum all deductions "phase out."

But for me, as for many people, mortgage interest works out to be a straight-up reduction in taxable income. Best I can figure, our marginal federal income tax rate for 2011, the first full year of the new mortgage, will be 36%. So for every dollar I spend in mortgage interest, the tax bill will go down by 36 cents. Put another way, on an after-tax basis that 3.875% rate is just 2.48%.

I’ll borrow at 2.48% all day long. Seriously, I am willing to borrow as much money as is offered at that rate. I’ll take a thousand, a million, a billion, whatever. I may not be as good an investor as I think (few of us are) but I am quite certain I can get a return north of 2.48%.

And just to be clear, for me, investing the money is explicitly the point of the mortgage. I have the liquid assets to pay it off at short notice if that ever became necessary. For example, it is more than conceivable that at some future date interest rates will be much higher and the positive effect on my tax bill will be lower. In the meantime, I am quite happy to borrow this cheap money and to accept the government subsidy that makes it even cheaper.

It is important to remember that the tax deductibility of mortgage interest is a discount on something of value rather than a goal itself.  The heretics argue that paying a dollar to get 36 cents back from Uncle Sam doesn’t make sense. If that was what was going on, it wouldn’t. In fact, I’m paying the $1 as a year’s rent on about $26. I think I can put $26 to profitable use. The 36 cents is a discount, meaning I am really paying only 64 cents to rent $26. That’s a great deal, even if it is boring and conventional.

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