by David John Marotta | 12-15-2003
Most Americans have a home mortgage. The rich often have two. Only the poor can't take advantage of this "good" debt.
While most debt is bad, a home mortgage can be used to your advantage if you follow all seven of these rules when financing or refinancing your home.
The primary benefit lies in deducting your interest payments each year. If your home mortgage is at 6% and your payments are mostly interest then most of your mortgage is tax deductible. If your marginal tax rate is near one third, the government is paying 2% of your interest, and you are only paying 4% of your interest. For most middle class families that results in a huge tax savings.
Families who could pay off their mortgages do better by not paying them off.
Families who could pay off their mortgages do better by not paying them off. Why pay off your mortgage when each dollar you pay only saves you sixty-six cents and you lose the other thirty-three cents to taxes?
If your investments can earn more than 4%, it is better not to pay off your loan. By keeping your investments and your loan separate you earn more money than by combining them. Paying off the loan only benefits the government by eliminating their subsidy of your mortgage.
The benefits of a mortgage are greater when the majority of your payment is interest, not principle. There is no tax deduction for payment of principle. Therefore, unlike other debt, paying money up front to reduce the interest rate does not save money. That fact results in some unconventional advice.
Since you want as many years of interest payments as possible, 30-year mortgages have much greater savings than 15-year mortgages. The tax savings on a 15-year mortgage barely pays for the closing costs, but the tax deductions on a 30-year mortgage are much larger.
Also, the first year of a mortgage is mostly interest while the last year is mostly principle. Therefore the tax savings are in the first eight to ten years of a 30-year mortgage and the remaining 20 years offer little benefit. Therefore the best approach financially is to get a 30-year fixed mortgage and pay it off or refinance it every 8 to 10 years.
That may seem like crazy advice. But financially, you should get a 30-year mortgage, and after ten years refinance and get another 30-year mortgage. Then ten years later repeat the process again. It seems like crazy advice! You will never own your home! You will still have a 30-year mortgage when you are 90 years old! But remember, we are trying to keep our loan and our investments separate in order to get the maximum tax subsidy from the government. If it is always in your interest to keep them separate, then you need to refinance sometime before the end of the thirty years. The only information I have given you is that between eight and ten years is the best time financially to refinance.
One way to think about this advice is to ask if you would rather have owned ten rental homes over the past decade, or have owned fifty homes each starting with 20% equity. The way houses in Charlottesville have appreciated your 20% equity might have grown to 50% equity. If leveraging rental property to invest in more rental property makes sense then leveraging your home to add other diverse investments also makes sense.
Another implication of wanting to pay mostly interest is that you should never pay points to buy down the interest rate. Again, this may sound like crazy advice, but paying points to buy down your interest rate is only a good deal if you keep your loan the entire 30-years. But few loans are held for 30 years, and you want to either refinance or pay yours off after just 8-10 years. Therefore interest points are just giving the loan company extra money and reducing your tax benefit.
Another rule when refinancing your house is to keep your loan under 80% of the assessed value of the house. Loans for over 80% of the assessed value are charges higher interest rates on the entire loan amount. This interest can be eliminated entirely and therefore should be avoided.
Keep your mortgage debt under 30% of your net worth including your debt value. This is a good amount to leverage your home into different investments. Imagine two families each with the same total worth. The first family owns their $200,000 home clear and has $80,000 in stable fixed investments and $80,000 in growth stock investments. Their total net worth is $360,000.
Now the second family started in the same situation, but then they took 80% of the equity out of their home by getting a $160,000 mortgage. They split the money between stable fixed investments and growth stock investments. After refinancing their home, their financial picture is more diversified.
The second family is in a much better financial situation even though their net worth is still $360,000. Because they have leveraged their home they have assets totaling $520,000 that can grow and appreciate. Their debt of $160,000 is 30% of their total investments and 80% of the value of their home. As their house and investments appreciate these percentages will decrease.
Also, if the second family losses their job, they have greater resources available for emergencies. The first family would not be eligible for refinancing at the very time they needed it.
To benefit from this technique, the second family must use their mortgage savings to invest. Taking equity out of your home in order to fund a higher lifestyle is money down the drain. One rule of thumb is that you should be investing at least 15% of your disposable income, and at least a third of that should be in a taxable account. Another rule of thumb is that you should be investing about the same amount as your mortgage payment each month.
Wealthy Americans have already learned to benefit from this technique. The average wealthy American is worth $1,400,000. They have $275,000 in debt, nearly all of it in real estate. Because their assets have appreciated, their debt is now less than 20 percent of their net worth.
As 2002 closes, it is liable to be the last change to refinance your home, if you haven't done so already. Interest rates are heading back up and the benefits will shrink when that happens.
In summary, here are the principles to use when handling mortgage debt
1. Have a home mortgage.
2. Borrow a 30-year fixed rate mortgage.
3. Don't buy down the interest rate by paying points.
4. Keep your mortgage debt under 30% of your net worth and under 80% of the value of your home.
5. Invest significantly in taxable investments each month.
6. Diversify your investments between stable fixed investments and growth stock investments.
7. After 8-11 years, pay off your mortgage or refinance depending on interest rates.
Marotta Wealth Mangagement, Inc. of Charlottesville provides fee-only financial planning and asset management. Visit www.emarotta.com for more information. Questions to be answered in the column should be sent to firstname.lastname@example.org or Marotta Wealth Management, Inc., 1000 Ednam Center, Charlottesville, VA 22903-4615.