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July 29, 2008


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I understand the tax advantage in the sense that the interest you pay on a mortgage is deductible, however...If you're in the 28% tax bracket, doesn't that mean for every dollar you put in, you only get 72 cents back come tax-time? If that's the case, wouldn't it make more sense to pay off your home if you could afford to do it?

I think that the current economy is a good reason to pay off your house. Let's say you get laid off of work. If you have a mortgage, you better find a new job quickly in order to pay the bills. Since stocks are down, your investments aren't doing well. You may be facing foreclosure.

Compare this with someone with no mortgage. They lose there job. Since they own the house, the worst case scenario is that the gas an electric get shut off assuming they have no savings. In reality, they could easily get a low paying position to make it through the next few months until they find a better job. Since all they have to pay is their everyday living expenses, it's easily doable while the example of the person investing will have to liquidate funds in an already down market and lose out on the next up in the market.

But this is just about risk assessment. If you don't think you will ever be let go from a company, then you should probably invest. The combination of investing AND the tax deduction is on average greater than the monetary value of paying off your home. But it's a riskier investment.

The peace of mind that you get when not having a mortgage is something that is hard to put a price tag on. I expect to have mine paid off in about 5 years and cannot wait for that day. My father just paid off his house (after a lifetime of mortgages) and the sense of relief to him was something that I will not forget.

Not sure I ever understood the "tax advantage" argument for a mortgage. Sure a 6% mortgage may only really "cost" you 5% because of the deduction, but a 6% gain on an investment may only make you 5% because of the taxes you owe on it, so pretty much a wash as long as you are comparing apples to apples (pre or post-tax rate of return on investments versus pre or post-deduction cost of mortgage. The math can change if paying cash means you won't be able to max out retirement advantaged accounts.

Not sure Less Liquidity is a con. Liquid flows through the fingers of many a little too easily. Its starting to look like home equity may even have been a little to liquid for some.

FMF - I always wondered about the "you can often negotiate a better deal" pro to cash. Are you finding that to be the case in your house hunting? You're obviously in a situation where you can choose to do either (even if maybe it means waiting a year), so I'd appreciate your insight.

Strick --

Hard to say. We've only placed a firm offer on one house and it wasn't with cash -- it was with a pre-approved loan. Didn't phase them. They weren't ready to accept that their home was worth far less than they wanted for it. Since then, they've come down $25k and it's still not selling -- still a ways to go.

I'll let everyone know how it goes if and when we do buy a place.

In my eyes, the tax advantage of a mortgage really only holds water when comparing owning a home to renting one. Since you are getting a slight deduction (and Mark in your example you would only get 28 cents back, not 72) it is more advantageous, all else being equal, to buy rather than rent.

Like Strick said, there is a tax aspect to investing (or whatever the alternative is to paying off the mortgage) as well that is conveniently ignored in this discussion most of the time.

So for every dollar I pay in interest, I'm getting a quarter back.

Now, can the same be said for interest in savings? So for every dollar I make in capital gains, I pay a quarter in taxes?

I know it sounds like a wash but when you think about compound interest working against you, it sounds like it'd make more sense to put more money towards the mortgage. I'd still save some money on the side in investments, sort of like a 75/25 (75% of money I can save going towards paying down mortgage with 25% of money I can save going towards savings/investment accounts.) That way I still can enhance emergency savings, add to savings/investments, and speed the paydown of my mortgage at the same time.

At the rate I'm going at now I can pay my mortgage in 20 years instead of 30, but once my student loans are paid off in the next few years I can add that to the mortgage payment and try and pay it down even faster.

I never understood the whole "peace of mind" aspect. FMF has stated in the past that it's important not to be emotionally attached to one's home. I think the same should be true of one's finances. That is, don't act emotionally, but act logically and rationally. To me, debt is no more than just a number on a spreadsheet. It doesn't matter. I don't see it as cash I don't have. I see it as simply a negative number on my balance sheet. To increase that negative number will cost me 6% a year. To increase the number in the next column over that represents my investments will gain me (on average) 8% a year. Which should I choose? Emotion doesn't play into it. Obviously, I'll pick the 8%. (And yes, the past 10 years have not been good in the stock market, but who can predict the future?)

The only number I'm particularly interested in is my net worth. And that number will increase more by investing than by paying off my house. Therefore, that is what I choose to do.

Do not let emotions get in the way of your finances.

"FMF - I always wondered about the "you can often negotiate a better deal" pro to cash. Are you finding that to be the case in your house hunting? You're obviously in a situation where you can choose to do either (even if maybe it means waiting a year), so I'd appreciate your insight."

I would argue that in normal times, it wouldn't be a big difference to the seller. But we are clearly not in normal times, and I would wager than a LARGE percentage of accepted offers fall through due to financing problems, even for buyers who had a pre-approval letter from a bank dated 45 days prior.

I consider the extra principal I pay each month to be the 'bond allocation' of my investment strategy. I know that's lame, but I like it. :)

Also, I want to address the issue of the tax advantage of mortgages. There is so much ignorance out there, it's crazy. Mark's comment (#1) just goes to show the ignorance that's out there. I will say, if you don't understand the tax consequences of your actions, please consult a qualified financial advisor who can explain it to you. (Ignorance is not a fault. It's simply a lack of valid information. The only stupid question is the one not asked.)

The tax advantage comes into play in several circumstances. First, you have to already be itemizing your deductions to take advantage. If not, the tax advantage of a mortgage will be even less. So to start, let's assume you're already itemizing more than the standard deduction.

Any interest you pay on a mortgage will be tax-deductible. So, if you are paying a credit card at 6%, this is not tax-deductible. If you can transfer your credit card debts to a home equity loan also at 6%, you'll come out ahead. If you're in the 25% margin tax bracket, the tax-free equivalent to the credit card rate is:
6/(1+0.25) = 4.8%.

Thus, any debt that you are paying with after-tax dollars (like credit cards, car loans, etc) should be rolled into a home equity loan at 6%, as long as the original debts were greated than 4.8%. Any debt less than 4.8% should not be rolled into a home equity loan.

As far as investing versus paying off the mortgage, it is true that investing in a taxable account incurs taxes. So you have to compute the taxable-equivalent returns of each choice. The mortgage @ 6% would be 6/(1-0.25) = 8%. So you'd have to earn 8% in a taxable investment account to beat the 6% mortgage. However, if you invested in a tax-free account, such as an IRA or a 401K, then you could directly compare the 6%'s. So you'd only have to earn 6% in a tax-sheltered account to meet or beat the mortgage.

But remember, if you don't already itemize because the standard deduction is higher for you, these numbers will change.

I realize that the tax-equivalent yields can be confusing. That is why, if you don't understand these, you should consult a financial advisor and tax professional.

We plan on paying off our home mortgage early. A key reason for us in wanting to pay off early is financial security. When your house is paid off you don't have to worry about a big mortgage payment hanging over your head. So if you get laid off or otherwise run into problems its a lot easier. For most folks one of biggest problems financially is making the mortgage payment. If you have no mortgage then its a large burden you don't need to deal with.


Mark - capital gains and some dividends are taxed at a lower rate (for now anyway) so those are a little different than ordinary income (wages, bank interest, etc.)

Rick -

To play Devil's advocate here, why would you roll unsecured credit card debt into a home equity loan that could take 15 to 20 years to pay off AND have your house as collateral?

Rick -

I admit I don't know all the details, hence why I participate and ask questions. I think your example though does justify getting a tax/financial advisor involved if someone was looking for the most efficient way to grow their money, but I also think it would involve a lot of work. Also, if that money is invested, there is no guarantee that it would earn that amount above and beyond whatever the interest rate on the mortgage.

I don't put myself in this category, but I also believe it could be risky for some people to invest that money because it is easier for them to get it out if they wanted to. Granted someone could take a loan against their home, but I find that a little more difficult to do than to cash in on an investment.

I think I'm just a believer of paying down debts...IE use the money you were paying on Debt1 and apply that amount to Debt2 and so on and so forth. It's just hard putting your mortgage into a financial calculator and seeing you're paying so much extra in interest (sometimes double or triple the original amount). Even if you get tax breaks, I personally feel better paying that down as soon as I can.

Pay cash for your house if you can. If you want the same tax advantage, take the money you would have given to the bank and give it to a church or the good cause of your choice.

If an offer is "stronger" when it is accompanied by a letter from a lender saying someone is pre-approved for a loan (versus pre-qualified, or no letter at all), how does one prove they have the cash to buy the house outright when submitting an offer?

Julia --

I called my banker, told him how much I wanted to borrow, he checked my credit, and then approved me. He then sent a pre-approved letter to my agent. The whole deal took 15 minutes.

Two issues that helped me: he was willing to lend me a TON more than what I needed/wanted and my credit score was very high, so pre-approval was rather quick.


You are in error in your comparison of taxable returns versus mortgages. You said:

"The mortgage @ 6% would be 6/(1-0.25) = 8%. So you'd have to earn 8% in a taxable investment account to beat the 6% mortgage."

But the mortgage interest is tax deductable so you can compare them apple for apple.

For example. If you borrowed 1000 dollars at 6% (for a mortgage) you would pay $60 in interest and you would deduct that from your taxable income. If you then took that 1000 dollars and invested it and got 8% return you would get $80 in return. This would give you income of 80 with deductions of 60 for a net taxable return of $20. if you got 6% on your investments outside of the mortgage it would wash because the mortgage deduction would wipe out the taxable return and you would be left with 0 taxable gain.


One nice thing about paying cash up front versus paying it off later is almost no closing costs. In an all cash deal the closing costs are usually well under $1000 dollars. In a mortgage deal you can be looking at up to $5000 in closing costs. Thats just free money and a very nice benefit to paying cash and never having a mortgage at all.

Most folks (including those commenting) still oversimplify and misunderstand the tax benefits of home ownership. As for the interest deduction, you are receiving an extra tax benefit only as to the amount by which your total deductions exceed the standard deduction. Assuming that you are a married couple with 10,000 in mortgage interest and $2000 in other deductions, you are getting an extra benefit only for $1600 in interest (the amount by which your deductions exceed the $10,400 standard deduction for a married couple). Second, you don't compute the benefit using your marginal tax rate, but using your effective rate which will be less. Third, the real tax benefit from home ownership is that you are receiving a benefit/imputed income (housing) and not paying taxes on it. If you have a paid-for house that you could rent for $1500/month, you are receiving imputed income of $18,000 year, tax free, because you own it. Finally, many folks argue that a mortgage is good because you are repaying over time with inflated dollars. That's all well and good IF your income increases at a rate that exceeds the inflation rate.


As to itemization, you are correct. It is assumed you are itemizing. If you don't have enough other deductions to reach the max in itemization they you don't get much benefit. But if someone has 10K in mortgage interest they probably have 5K in real estate taxes and state income taxes and charitable contributions. If you have that big of a mortgage you are probably making enough to get to the limit on the standard without the mortgage interest. If not, they you probably have way to big of a house. So for low income small mortgage families, yes there is probably little to no benefit.

You are in error with respect to marginal versus effective rate. You definately use marginal rate. Why would you use effective. If I get 5K of extra deductions and I am well into the 25% bracket all of that 5K is saving me money at the 25% rate, not at my effective rate of 12% or whatever it might be. For example. Assume my marginal rate is 25% and my effective rate is 12%. If the cutoff for the 25% bracket is 65K and I have taxable income of 85K and I get 10K of deductions, how much does the 10K deductions save me? 25% of 10K or 12%? It saves me 25% or 2500 dollars. Because its going to lower my taxable income now to 75K and all of the 10K that I saved comes out of the 25% bracket. So marginal rate is what you need to use not effective. Now if I happened to be right near a bracket change then I have to do some math to find out how much of that deduction came out of the 1 bracket and how much came out of the other one, but it would never be based on the effective tax rate.

Apex is correct. There are many variables to consider in this discussion. I would probably take the lower risk option of paying my mortgage off sooner rather than sticking that money in the market. But, DONT FORGET THAT EMERGENCY FUND!!

I paid my house off last year and have not regretted the decision. I did not think I could beat the rate I got versus the stock market(7%). After watching the market drop this year I feel better about the decision. Of course I max pre-tax contributions, have an emergency fund, and fund my kids 529 to the max. It all comes down to buying a house you can easily afford.

You've said you can often get a better deal if paying with cash versus with a mortgage. Does this work if you are building a house, or just if you are buying a pre-existing home?

Lauren --

I didn't say that -- the author of the article I quote did. I'm not so sure -- as long as you have financing, what's the seller care?

My background includes financial planning and being a tax advisor so I definitely understand everyone's argument. Nonetheless, paying cash for our homes is something both my husband and I desired to do before we ever knew each other. Though we are not emotionally tied to our finances and use logic and rationale in making our decisions, the peace of mind and no debt option is the most appealing to us. Even if we miss a 2-5% or even 10% return on our investments that is not enough to compensate for the most attractive option for us--being debt free. From our humble perspective, we get a certain swagger and confidence knowing we don't owe anyone anything--it's liberating. There are other things to consider, but if you make sure you're buying a solid home in a neighborhood you love, you're not spending more than what you can afford, and you've made yourself aware of the pros and cons of both sides, you should come out okay.

Information and awareness is key!

I rather be rent or mortgage free, I will be in about a week, bought a house with two acres of land. Putting solar power on it so not to have an electric bill. Car paid off, Im doing good.

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