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.

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.

Housing, Taxes | Frank Curmudgeon | March 2, 2010 12:59 pm

256 Comments

By Ron, March 2, 2010 @ 1:14 pm

Dang it, there you go again being all logical and stuff.

The simple fact is, there are very few simple facts. Each person’s financial position is unique and requires much more than just a “rule of thumb.”
By Steve, March 2, 2010 @ 2:07 pm

Mortgage interest deduction is not a government subsidy, it is an attempt at balancing the costs of owning and renting. If a landlord owned the house and rented it to you, her mortgage interest would be deductible as a business expense. So to keep renting from being excessively cheaper than owning (well, in theory) it has to be deductible for a direct owner.
By Chuck, March 2, 2010 @ 2:32 pm

It is indeed different for everybody. Since my state income tax and property tax entirely soak up my standard deduction, my mortgage interest is fully deductible. While I’m envious of your rate, I have 4.375% on a 30-year fixed, which in my 37% effective bracket, is about 2.76%. I’ll take that for 30 years in a heartbeat. (Too bad I have a modest house.)

Other folks are borrowing at 6% and using the standard deduction. Those people need to get out if at all possible. (Though, these are the folks that can’t. Thus my rule of credit: The best credit comes to those who don’t need it.) You’re right that this is why rules of thumb don’t work.
By Chuck, March 2, 2010 @ 2:37 pm

Also, the Free Money Finance article has this gem: “Plus, having no mortgage has given us a tremendous cash flow that has propelled our net worth to all-time highs.”

It has done no such thing. What an asinine statement. If you are using your free cash flow to make huge principal payments on your mortgage, this is increasing your net worth at exactly the same rate. Your net worth is increasing in both cases BECAUSE YOU’RE NOT SPENDING THE MONEY.
By Kathy F, March 2, 2010 @ 3:34 pm

If I were making extra mortgage payments, then I might not be able to fully max out my Govt Thift Savings Plan TSP (401k like plan for fed employees)or max out my Roth IRA contributions. Every dollar I contribute to TSP lowers my adjusted gross income and my taxable income. If I did not max-out the TSP, I would exceed the AGI limits for contributing to Roth IRA. Plus my mortgage interst rate is only 4.75% Plus why have my money tied up in illiquid assets like a home.
By Mr. ToughMoneyLove, March 2, 2010 @ 6:15 pm

All very logical except I need to quibble with the “the money is free because of inflation” argument. I read that a lot. Inflation is helpful to a debtor IF the debtor’s income keeps pace with real inflation. Otherwise, the fixed rate debt payments end up taking an increasing percentage of the debtor’s spending power. There are millions of Americans with incomes that do not or will not keep pace with real inflation, particularly if you consider breaks in employment.
By Mike, March 2, 2010 @ 7:28 pm

As always Mr. Curmudgeon, I very much enjoy your logical discussion of an overly blogged-about topic.

One item that I always feel is underdiscussed in all the banter is the “where the money is invested” discussion. If people are following some of the usual advice and putting a high fraction of their investments into bonds (DIVERSIFY! the experts refrain) then I think people may be misguided.

Specifically, I call this the right-pocket/left pocket problem. The right pocket is borrowing money at the 30 year rate (the mortgage) and feeling great about such a low rate. Meanwhile, the left pocket is loaning money at a market rate (via owning bonds) that may very well be lower than the prevailing mortgage rates. With the financial friction of the transactions, I’d question if there is any money to be made.

Back to our host, our favorite Curmudgeon, I ask that you reflect on this sentance….”I have the liquid assets to pay it off at short notice if that ever became necessary.” If indeed “liquid” means the money were under the mattress or in a CD I’d suggest that you may not be performing the best interest rate arbitrage possible.
By Neil, March 2, 2010 @ 8:00 pm

“Mortgage interest deduction is not a government subsidy, it is an attempt at balancing the costs of owning and renting.”
Not true. The mortgage tax deduction increases the cost of home ownership (usually through higher purchase prices) so that owning and renting even themselves out. Take away the mortgage deduction and house prices go down because renting becomes cheaper than owning.

In my country, I can’t deduct my mortgage expenses, but my math shows me that over the long term home ownership is still a good deal. And yes, I factored in a maintenance estimate. However, a comparison of my city to US markets with similar rents shows that housing prices are lower here.

“If indeed “liquid” means the money were under the mattress or in a CD I’d suggest that you may not be performing the best interest rate arbitrage possible.”
Why would liquid mean cash under the mattress or in a CD? Liquid just means that the assets can be readily sold with minimal transaction cost. Large cap stocks are probably the next most liquid things to cash in the bank, and certainly more liquid than a fixed-term CD. They may not always be the best investment, but that does not reduce their liquidity.
By Hibryd, March 2, 2010 @ 9:36 pm

We’re paying extra on the mortgage, despite having a good rate, for several reasons:

1) We’re already investing in the stock market through our retirement plans and other accounts.

2) We just took out a mortgage, so paying extra money now has the most impact it will ever have over the life of the loan.

3) The money we’re throwing at the mortgage is “safe” money, money we would *normally* put into a stable savings account or CD. But since savings accounts and CDs are returning 1% right now, we’d rather “make” 5% with it instead. When interest rates become reasonable again, we’ll put money there instead.

4) Not having a payments is nice in the case of an emergency, or if you suddenly have another expense fall in your lap.

I know how the math works out, I know that if past performance is indicative of future results, we should be throwing every dime we can into index funds, but honestly, thanks to some deep-seated personal reasons I sleep better not having a lot of debt hanging over my head.
By Hibryd, March 2, 2010 @ 9:38 pm

I should add that if anyone has a better idea of what we should be doing with the extra cash that isn’t a gamble (or if there’s something we should be investing in besides stocks), by all means, I’m glad to hear it.
By rezkiy, March 3, 2010 @ 4:40 am

being in 36% federal tax bracket, you are probably in 90th or so income percentile. Your readers’ mileage may vary.
By JFP, March 3, 2010 @ 9:00 am

Sorry, but despite having thrown around a lot of numbers, there’s one big number you missed: the probability that the homeowners will lose their jobs and thus won’t be able to continue making payments. Until you factor that number in, your argument will be unconvincing to lots of people.
By Alexandra, March 3, 2010 @ 11:58 am

JFP – let’s say I do lose my job. How will making extra payments to my mortgage help the fact that every month a new payment is due? You can’t get extra payments back. All you have done is give the bank extra money that you should have been putting aside just in case you lose your job and need to still cover your mortgage payments.
By Rob Bennett, March 3, 2010 @ 12:18 pm

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%.

I’m not so certain of this, Frank.

You have an article here that argues that timing the market is difficult. So I presume that you invest a large percentage of your money in stocks even when they are insanely overpriced (as they were from 1996 through 2008). I have a calculator at my web site (“The Stock Return Predictor”) that shows that the most likely annualized 10-year return on stocks when they were selling at the prices that applied in January 2000 was a negative 1 percent real. You freely chose to invest a good bit of money in an asset class likely to provide a long-term return of far less than 2.48 percent. You did this just recently!

You’re assuming rationality on your part. That’s your mistake. We all possess emotions and our emotions cause us to be drawn to Get Rich Quick schemes (the idea that stocks can provide a good long-term return when purchased at insanely dangerous prices is Get Rich Quick thinking).

The people who elect to pay off their mortgages don’t know all these details. But they sense that the people insisting that they can always get a higher return than 2.48 percent are engaging in a lot of bluff and bluster. They are going for the sure thing.

Paying off your mortgage is not always a good idea. But those who ridicule those making this choice reveal their own lack of confidence in their own choices, in my (controversial!) assessment.

I don’t mean for any criticism expressed here to be directed to you personally, Frank. It is my belief that we all make a practice of kidding ourselves that we are a lot more rational about money decisions than we really are.

Rob
By Naomi, March 3, 2010 @ 12:24 pm

@Neil:

“Liquid just means that the assets can be readily sold with minimal transaction cost. Large cap stocks are probably the next most liquid things to cash in the bank, and certainly more liquid than a fixed-term CD.”

Not true. Liquidity is the ability to quickly convert an investment to cash with little or no loss in value. Stocks are not liquid investments.
By Investor Junkie, March 3, 2010 @ 2:23 pm

I’ve raised this argument many times over. I’m sick of the people that state “debit is evil” mantra. Ugh!

@rezkiy actually it’s less than 3 percentile.

Even if you don’t get the tax deduction (which Congress has been talking may go away. I don’t doubt eventually it will) 3.875% is still pretty easy to beat with investments.

We opted for the 30 year fixed at after tax comes to 3.75% return. You would have to be a fool not to take up on that offer.
By JFP, March 3, 2010 @ 2:28 pm

Alexandra, obviously if you lose your job before you pay off your mortgage, you aren’t going to be helped. But once you do get it paid off, then you can lose your job or suffer some other catastrophe and not worry too much.

We paid off our mortgage in less than ten years. We are very happy we did this, and all our friends who still have mortgages are envious of us.
By Frank Curmudgeon, March 3, 2010 @ 5:23 pm

Okay, a few follow-ups:

1) I’m not saying the mortgage subsidy doesn’t make sense, only that it is a subsidy.

2) Liquid is, to me, a relative term. I am thinking about financial instruments such as stocks and bonds that I could turn to cash in a few days. In the context of paying off a mortgage, that’s quite liquid enough.

3) Finding investments that clear 2.48% isn’t really a big challenge, even today. Granted, if you want perfectly risk free, it’s hardly worth the effort. But with any risk at all, e.g. municipal bonds, you’re ahead of the game. I can’t guarantee that stocks will return more than 2.48% annually over the next five years, but I am happy to bet money that they will.
By rezkiy, March 3, 2010 @ 11:42 pm

@Investor Junkie — do you mean 97th?
By Patrick, March 4, 2010 @ 12:59 am

The part I don’t understand is, if it’s so easy to earn more on your money than the bank is charging, then why doesn’t the bank just invest in that?
By Chuck, March 4, 2010 @ 11:32 am

You can get over 3% on a CD. The arbitrage is easy. The bank is making 3.875% (which is more, duh) and Frank is paying 2.48% (which is less). The government pays the rest. Why is this confusing?
By Neil, March 4, 2010 @ 2:45 pm

@Naomi
“Not true. Liquidity is the ability to quickly convert an investment to cash with little or no loss in value. Stocks are not liquid investments.”

The loss in value in that definition refers to the sale reducing value. Most stocks are liquid because your sale of them is too insignificant to change value. Any loss or gain has already occurred. Stocks where your holdings represent a significant portion of the market cap are significantly less liquid, since selling your entire holdings will push down the price.
By Investor Junkie, March 4, 2010 @ 3:28 pm

@rezkiy Correct. I mean Frank, or his tax rate, 3% of the population make that amount or more. The stats are around the net and the source is the IRS.
By Investor Junkie, March 4, 2010 @ 3:31 pm

Also let me add, I suspect if/whe mortgage rates get into the high single or double digits (anyone remember the early eighties?). The reverse will be true.

You’ll be better off pre-paying your mortgage than taking the cash out for other investments.
By Hibryd, March 4, 2010 @ 9:03 pm

Speaking of Dave Ramsey, this spat of super-low rates is going to trip him up later down the road. In a few years (maybe 3, maybe 10), interest rates will rise again and you WILL be able to get 100% safe CDs that pay more than every fixed-rate mortgage getting issued today. Given that his insistence on paying off the mortgage is based on risk, what will he advocate doing then?
By Craig, March 5, 2010 @ 1:50 pm

Fixed-term, fixed-rate debt is a powerful hedge against inflation. Having just refinanced, I’m fairly confident about what my “rent” payment is going to be twenty years from now. I can’t lock in the price of food, transportation, clothing, medical care, or much else in this world, but I can control the majority of my housing expense.