IFI Blog

IFI Mortgage Conversation

Friday, November 8, 2013

The age-old conversation on whether to pay down your mortgage versus hold a mortgage has perhaps the most emotional challenges for most investors. If one looks at the interest saved over 30 years they will always be led to
believe that interest saved, always warrants a shorter 15 yr. loan versus a 30 yr. loan.  This conclusion of course is contingent on the following factors.

1.     Lost opportunity cost on the money
 (Principal invested in an alternative safe, nontaxable, nonvolatile, guaranteed insured account).

2.     Taxes saved if interest is deductible.

3.     Costs one must incur to access ones collateral. (i.e. Home equity)in the future.

4.     The rate of return on the asset supported versus ones actual Capital Invested. (Which is typically enhanced with increased leverage) 

5.     Contingent on the discipline and ability to place the equivalent Capital or cash flow savings in a safe place that possesses a guaranteed Investment that earns a rate of return greater than the cost of debt, considering Taxes.(Such as a fixed account in a retirement account, IRA, 401 K, or Roth IRA’s. Or my favorite mutual participating whole life cash values, plus the contracts unique benefits) 

6.     Loss of control of one’s home-equity to the bank or the market.

7.     Reduced flexibility in payments.

What is important to understand is that there is no one single strategy that works perfectly for everyone.  For Example:

A.     If the interest on the mortgage is so little that one has no ability to itemize deductions. Then their interest cost is higher than the individual that can deduct the interest expense.
B.     If the interest on the mortgage is more than the allowable deductible interest the net cost is also higher.
C.     If the individual opting for the 30 year loan versus the 15 year loan lacks the discipline to take the savings and invested in an equivalent nonvolatile account.
D.    The added inconvenience of writing a monthly check.
E.     The investor must have the ability to put the money in one of two alternative places.

1.     Nonparticipating whole life insurance maximum funded smallest amount of insurance for the least amount of cash.
2.     The ability to pretax money in an equivalent 401(k) or IRA and invest in the stable value fund or fixed insured guaranteed account.
3.     In some cases a Roth IRA may provide benefits however the flexibility is more limited than the benefits are primarily to tax-free earnings.
The Institute for Financial Independence Unique Conversations has three rules of thumb in analyzing a 15year mortgage versus a 30 mortgage.
I.              One must be able to invest the savings in a safe guaranteed or insured account, were your earnings must exceed your cost of debt in one of two ways.

A.     tax-free insurance cash values when one balances insurance costs and benefits to the taxes saved.
B.     Pretax opportunity; For every dollar invested in equity in one's home the individual in a 35% federal and state tax bracket can invest approximately $153 to  $154 pretax in an account and have a tax deductible way to withdraw the funds in the future.
C.     One’s cost to support their debt is less than the properties appreciating used conservative reasonable assumption of growth on real estate of 3% over the period of the loan.

In addition other alternative factors should be considered especially when evaluating investment real estate versus primary residential real estate.  In the following analysis we attempt to highlight the benefits of this decision and provide a baseline for discussions about life circumstances that may arise to support our theory.

Issue I:  Real Estate Rate of Return Analysis
Assume two homeowners both own $1 million home one has a loan of $500,000 the other has no loan.
                                        $1,000,000.00       Home
          The home appreciates by 10% over time and is now valued at

                                        $1,100,000.00 projected value

               What is the rate of return on each persons investment ?

Investor A                                                                      Investor B

$500,000 Mortgage                                                  $ 0      Mortgage
$500,000 Owners Equity                                        $1,000,000   Owners Equity

20%                                                                          10%

Issue 2
One must invest the difference in an account that generates a rate of return greater than the cost of debt. In our experience there's only two places that a client can invest their safe dollars and allow them to work, as well as earn a rate of return greater than the cost of debt.

As the below graph illustrates if the banks charging you 6% of the mortgage due to the spread that the bank will take for the stockholders they would probably only be crediting you roughly 4% went CD invested in that bank. In addition because the interest that you earn on that CD is taxable it makes it virtually impossible on a rate of return greater than your cost of debt if your alternative investment is a bank CD.



The following graph shows how perhaps our parents and grandparents analyzed a 30 a mortgage when it was introduced after the Great Depression.
The first option is an account that our parents had but didn't understand old-fashioned participating whole life insurance where the company doesn’t take a spread because the policyholder or owner is the stockholders.


The second option our parents didn't have pretax retirement accounts such as 401(k)s IRAs and in some instances after tax Roth IRAs may provide similar benefits.