The Real Interest Rate on a Mortgage Depends on Your Tax Bracket
In a prior article I went over how it would be better to never pay down your mortgage early because the end result of it would be not as good as if you invested the “extra” money in the broad market instead. The result is actually quite staggering, so much so that in finalizing that article, I immediately changed my entire outlook on investing. Prior to those calculations I had always dreamed of paying off a mortgage. Now I say to myself: why bother?
Here are some of the benefits of NOT paying down your mortgage and instead investing in the stock market besides the bottom line dollar amount:
All that additional invested money stays liquid for you. If you get in a pinch you can always sell a stock and have the $$ in your account within 3 days as opposed to selling a house which could take months. Even in a terrible financial downturn, I would say having the option of either selling stocks at a loss or selling a house at a loss would be good to have. If you put everything into your house and lost your job you would not necessarily be able to last longer than if you had everything in the stock market.
The larger your mortgage is, the better it ends up being for you if you let it ride. Think about it. If you have a 1 Million mortgage and 1 Million in cash, you will make ~3X more money if you don’t pay it off than the comparable scenario with a 300,000$ mortgage and 300,000$ in cash. I realize that this is a strange concept - but it’s true! Leveraging yourself to the max will return the max over your lifetime if you can keep it together.
Peace of mind. When you have a ton of cash or bonds/stocks available, you really do feel more secure. On the other hand you would be worrying about paying down a mortgage faster which is a difficult mindset to maintain.
There are many assumptions being made in order for me to truthfully make the above statements. One is that you have a house, and another is that you have enough money to cover the mortgage payment and then some left over to invest as you choose. This article is not for cringe renters. The paramount assumption is that the broad markets will continue, in a cyclical manner, to move up and to the right with an average return well above that of your mortgage interest rate. Woah, wait a minute here DDave, past performance does not equal future returns, so isn’t this risky? Well, in the short term the answer is a resounding YES. After all, time in the market does beat market timing as many would be investors have discovered over their lifetimes. However, you are stuck with the same dilemma either way:
Which is going to make more money over 30 years:
A “fixed rate bond” which is equivalent to your mortgage balance and has a fixed ROR equal to the mortgage interest rate? Or the broad stock market over the same period? -
In order to find and prove a correct answer, you would need to know both the rates of return over that period. Bad news is that for the stock market, though historically it has had massive average returns of about 10% when not adjusted for inflation, you cannot be certain what the future will hold. So we will use the number 10% as a baseline because, well, whatever. The good news is that for any given mortgage, you will know the rate when you buy the house! And you can buy a fixed mortgage for 30 years which is what this article is assuming you did, so you don’t ever have to guess.
Calculating your effective mortgage rate however, is not as simple as reading the number off the loan’s 1st page. After the deductible given on your taxes for mortgage interest, there will be a reduction in rate due to you paying less taxes while holding the loan, but by how much? The short story is that the mortgage interest rate will be reduced by your tax bracket.
So an effective mortgage rate chart would look like this:
Note that any given rate gap between the lowest and highest tax bracket increases as the rate increases. So somebody in a lower tax bracket would be paying more effective interest on a loan than a person in a higher tax bracket.
The funny thing here is that the reduction in rate is not a good thing if you were a proponent of paying down your mortgage. Because the advantage you would get (over the broad market) is further reduced by this interest deduction.
Again, it seems like paying down your mortgage early is a money losing proposition when compared to building a reasonably balanced stock and bond portfolio. Keep in mind that both of these options can be coined as HUGE winners in the broader sense, if you are considering the alternative of not owning a residence and not investing at all. So if this happens to be a sticking point for you and you would like to aggressively pay down a mortgage, just do it! I am sure you will be fine in the long run if that is the attitude you possess.