Taking a New Stand About Mortgages
Question: As a result of divorce, I received a large cash settlement that would enable me to buy a home without a mortgage. Many of my wealthy friends tell me I’m crazy not to take out a mortgage because I could invest my cash and come out ahead. I could never understand this, because the interest I would have to pay on a mortgage exceeds what I could reasonably earn from a conservative investment like a municipal or GNMA (Government National Mortgage Assn.) bond. My deductions do not exceed the standard deduction. I am a wage earner in approximately the 40% bracket with a substantial part of my income already coming from municipal bonds. What is the best investment strategy for me? Incidentally, I currently share an apartment in which I am very content for $350 a month.--T.H.G.
Answer: I hope you understand that this reluctance to go into debt strikes at the very core of America’s moral fiber. Where would the country be if everyone paid cash for everything?
The attitude of your wealthy friends is, admittedly, the current conventional wisdom--mortgage interest and property taxes are deductible (and, in spite of tax- reform rumbling, seem destined to stay in place), and the tax deduction, as we all know, is the cornucopia from which all blessings flow.
“Conventional wisdom,” however, has been undergoing some significant changes recently, part of it as a result of basic changes in the economy and part of it--real estate experts say--because today’s buyers are getting smarter.
The key “basic change” that we mentioned has to do with the erosion of inflation as a major consideration in our planning. A few years ago, with inflation running at, say, 13%, taking on as large a mortgage as possible costing you 12% a year made sense because, in effect, you were “making” 1% a year simply by being in debt.
And, for those holding older mortgages carrying interest rates of 8% or 9%, it, again, made sense not to accelerate your mortgage payments when you could invest this money at 10% or 12%.
But times have changed, and inflation is running at a tad under 4% a year, mortgage interest rates (although dropping) are still relatively high (at about 12%), which makes the “real” interest rate about 8%. At the same time, most money-market rates are in the 7% to 8% range, so there’s not much, if any, advantage in taking the money you would otherwise use to pay off your mortgage and investing it in something with a higher yield.
All of these things combine to make the idea of outright ownership of your home a lot more reasonable than it might have been regarded three or four years ago, and it’s a far less lonely position you occupy too. About one out of every seven mortgages written today, in fact, is for 15 years--a dramatic shift away from the traditional 30-year mortgage and is clear-cut evidence that a lot of people are sharing your views about the desirability of owning your place free and clear--and the sooner, the better.
As far as having a mortgage is concerned, it’s a little bit like looking at a doughnut and seeing either the hole or the dough surrounding it--what the mortgage is really costing you on the one hand, or the high percentage of that cost that is deductible on the other hand.
I don’t know, of course, how “large” a divorce settlement this was, but if it is sufficient to buy a home outright, we’re looking at pretty big bucks in Southern California--the land of the $135,000 “fixer-upper.”
Let’s take a “for instance” and talk in terms of a $100,000 settlement--with which you could buy a pretty fair home if you go out far enough, or a pretty nice town house or condo closer in.
If you bought it conventionally you’d pay $20,000 down and take on a mortgage of $80,000 at, we’ll say, 12% for 30 years. Monthly payments for principal and interest: $823. Total cost over 30 years: $296,280. Interest cost alone: $216,280--a very chilling thought, indeed.
The other way of looking at this “doughnut” is to consider the fact that--of the first year’s payments totaling $9,876--about $9,659 of it is deductible. That’s right. During that first year only about $217 of that $9,876 is going toward the reduction of principal. That’s how fast your real equity in the home is building up. That’s a little chilling too, unless you are thinking entirely in terms of your tax situation.
But, bit by bit, a little more of each monthly payment is going toward the reduction of principal and, sure enough, you finally reach the point where a full half of that monthly $823 payment is going to interest and the other half is going to the reduction of principal.
Unfortunately, it takes the first 24 or 25 years of that 30-year mortgage before this 50/50 split comes about.
With all of this money going to the lender in the form of interest, the deductibility of it is naturally going to impact your tax situation, but to what extent can be determined only by your accountant. You are currently in the “40% bracket,” which, as a single taxpayer, puts your income at about $40,000 a year, and the standard deduction you claim is now pegged at $2,390. Yes, there would definitely be a change in your tax status but, perhaps, not as much as it would look like on the surface because “a substantial part” or your income is already coming from tax-exempt municipal bonds.
So, what are the consequences if you buy this $100,000 home outright?
First, there is the $216,280 in overall interest that is saved by not financing it over 30 years, although this hardly classifies as spendable income. Where your immediate, out-of-pocket saving will come is in the saving in rent--although this will be reduced by taxes and maintenance. But let’s say that by owning your home free and clear you’ll net, each month, $200 of your present rent for investment purposes.
Currently, long term tax-exempt bonds are selling to yield about 8 1/2% and GNMA bonds are yielding about 10%. But let’s split the difference and say that for the foreseeable future you should be able to invest that $200 a month in tax-exempts averaging 9% a year.
If you simply let this pile up, quietly compounding every quarter, you’ll have a tax-free nest egg of $15,170 in five years, $38,848 in 10 years, $75,800 in 15 years, $133,454 in 20 years and $363,838 in 30 years.
And all the time, of course, you’ll be living in a house that--under a conventional, 30-year, mortgage--would be costing you $823 a month.
Although your accountant, looking at your tax situation, might argue otherwise, Joel Singer, the California Assn. of Realtors’ research man in Sacramento had a point recently when he said: “Today, it’s a lot less painful and makes more economic sense to own, rather than be in debt--the last five or six years have seen a really fundamental change.”
Q: As a good computer scientist I cannot allow the slur against computers in your Nov. 14 column to go unremarked. You stated that the computer program had erred, and should only have computed interest on the $2 balance, not the $3,000 of new charges. If the credit card company in question is like mine, the client will have received one of those famous “Change in Terms of Credit” notices in his/her bill. In reading the fine print, if the previous balance is paid in full, there is no finance charge (as was previously the case). However, the banks, not liking to make free loans if they can help it, if there is any outstanding balance (such as the $2), then all new charges accrue interest from the date of posting, with no grace period, until such time as the account is paid in full.
Thus, the poor maligned computer was doing exactly what it was supposed to (whether the banks want you to know, or not) in computing immediate interest on the new purchases. This little hidden addition to the finance charge is no doubt affecting many people, to the profit of the banks (as was their intent).--L.A.
A: Yes, you were one of about a half-dozen computer buffs who took me to task for suggesting that the computer in this rip-off (rectified by the credit-card company, however) fouled up the job assigned to it.
As you have correctly pointed out, computers can do only what they have been told to do--the old GI/GO (“Garbage In/Garbage Out”) syndrome. The “error,” if that’s what it was, was the programmer’s.
Right. Duly noted. There is, however, one home computer of my acquaintance that remains suspect. This certain computer not only has severe grammar and spelling learning disabilities, but, on at least one occasion, has been known to sneak out of the house at night, make unauthorized use of the family car, stick up a convenience store on Sepulveda Boulevard and stagger home at dawn reeking suspiciously of lighter fluid. Or, at least, of something else with a high alcohol content.
Don G. Campbell cannot answer mail personally but will respond in this column to consumer questions of general interest. Write to Consumer VIEWS, You section, The Times, Times Mirror Square, Los Angeles 90053.
