QUESTION: Several years ago, we bought a house and took a $125,000 mortgage with a 30-year fixed rate of 10.25%. Over the years, our income has increased and we are now able to pay a larger monthly payment than the mortgage terms require. We plan to sell the house in five years. Would it be smart for us to send in a larger payment each month to reduce the principal amount that we owe?--J. G.
ANSWER: Probably not. In fact, several financial planners we consulted suggested that you should consider taking on even more debt, either by refinancing your house or by stepping up your timetable for buying a new, and more expensive, house. Let’s discuss their reasoning, which is based on the assumption that you and your family are still many years away from retirement age.
To begin with, most financial planners consider the mortgage interest deduction to be the single greatest income tax break available to the average homeowner. So it makes sense to maximize your use of it.
Paying down your mortgage does just the opposite. By reducing the amount of principal that you owe, you reduce the amount of interest you are paying each month--and thus the amount you can deduct on your income tax. And, equally important, you are tying up your cash, money that you could use as a down payment on a more expensive home that will give you the larger mortgage payment you say you can now handle.
“The only alternatives this homeowner should consider are buying a larger house and refinancing his existing house to get a larger mortgage,” says Michael Blue, an Encino financial planner. “Nothing else makes sense.” (A variation on this strategy would be to buy a vacation or other second home if you have the money for the down payment.)
Refinancing has become quite complicated as a result of recent tax law changes. Under the current law, you may increase the amount of your mortgage as much as $100,000 above its level in October, 1987, and still retain the full mortgage interest deduction on your income tax. Use of the refinancing proceeds is not restricted to any particular purpose, such as home repair, health care or education expenses.
So if your existing mortgage was $120,000 last October--and your home has appreciated sufficiently to warrant the additional debt--you could refinance your house for as much as $220,000 and claim the increased mortgage expense as a tax deduction.
It would seem that unless you are ready to retire--and are looking for increased financial security--paying down your mortgage would be an unwise move for you at this time.
Q: I am 63 years old, retired and have just $100,000 to my name. Until recently I had invested the money in two certificates of deposit that were paying 8% to 9% interest. But this income is taxable, and after taxes I can barely cover my expenses. Please let me know what I should do to make this $100,000 work the most effectively for me. I am not familiar with stocks and bonds, and I obviously am in no position to take much risk.--N. K. E.
A: We took your question to several professional financial planners who commiserated with the problems you face. However, they note that the your biggest financial “plus” is your relatively low tax bracket. This allows you to take full advantage of a strategy of generating the maximum possible income from your investments.
Although you want--and need--to generate high current income from your investments, you obviously have an equally great need for safety. The financial planners advise that you stick with your strategy of buying certificates of deposit. However, they suggest that you divide your $100,000 nest egg into four equal parts and invest each part individually, mixing your portfolio with both short-term CDs--such as 90 days--up to one-year notes. This gives you a flexibility to take advantage of the current environment of rising interest rates. When it appears rates are starting to slip, you might want to lock in a higher rate by buying a longer-term certificate.
Another investment possibility for a portion of your funds are utility stocks. You can either pick a single gas and electric company or select a utility mutual fund. Typically, utility companies pay high dividends and are among the least volatile stocks on the market. But consult a trusted adviser or broker before making your move.
The financial planners suggest that you evaluate your tolerance for risk and balance that with your need for immediate cash on which to live. Whatever you decide, they recommend that you divide your nest egg among several investments to diversify your investment.
Q: I recently cashed some U.S. savings bonds dating from 1943 through 1950 and was surprised at how much interest they had accumulated. However, I just retired and was given a healthy severance payment that puts me in a higher-than-normal tax bracket for 1988. Now I realize that my bond proceeds will be subject to heavy taxation. I have heard that I can temporarily reinvest my proceeds in new U.S. savings bonds and defer my tax obligation until I sell the second series. Is this true?--E. P. A. Jr.
A: What you have heard is essentially correct, but it’s not quite as simple as you might think. (Is anything ever simple when you’re dealing with the tax code?)
You are allowed to roll over proceeds from your original Series E bonds into Series HH bonds and defer taxation on your gain. However, you must complete the rollover within 41 years of the date of the bonds’ issuance. Basically, the regulations require that the transfer be made on the maturity date of the bond, which was a 40-year instrument. But the government gives you a one-year grace period after the maturity date to make the switch.
To be absolutely safe and sure that you are eligible for the tax deferral, the Treasury Department recommends that you make the switch as soon as the bonds mature. This is particularly important because your one-year grace period is likely to overlap a tax year, leaving you potentially exposed for taxes on the bonds in the year they matured, even though you intend to purchase Series HH instruments.
In your particular case, you would now be eligible to roll over the proceeds from the bonds purchased in late 1947 and thereafter. The roll-over period for bonds purchased prior to late 1947 has expired. And the clock keeps ticking. So if you want to do this, you’d better act fast.