Different (Prepayment) Strokes for Different (Older) Folks
Whether older homeowners should prepay their mortgages depends on circumstances that vary from case to case. These include their total wealth, age and tolerance for risk. The two cases that follow are illustrative:
Question: I am 50 and want to retire in 13 years. I have $30,000 remaining on my 8% mortgage, which has less than five years left, and I also have $10,000 of other loans at 12%. My stock portfolio is several times larger than my debts.
I am considering the following options:
* Liquidate stocks to pay off the mortgage balance, which saves the $1,000 monthly payment. Then use $500 a month to repay the 12% debt and $500 to invest in stocks.
* Liquidate stocks to pay off the 12% loans, saving $500 a month, which would be invested in stocks.
* Don’t prepay any debt and watch the stocks grow at 20% annually.
Answer: The correct answer depends on how much risk you are prepared to take.
If you were certain that your stocks would continue to yield 20%, the correct answer would be your third option. You wouldn’t pay off any of your debt before you had to, and in fact you would refinance your mortgage for the maximum amount you could get and put the cash you take out into stocks.
The sole reason you are contemplating repaying debt that costs substantially less than 20% is that the 20% is not to be depended on. That option is the riskiest course of action.
The next riskiest is to pay off the 12% loan, your second option, which is what I would do. Borrowing at 12% to hold stock is too much of a gamble for my taste. If you were really risk-averse, you would pay off all your mortgage as well.
Your first option, paying off the mortgage alone, makes no sense. If you are going to repay debt, you pay off the higher-cost debt first.
Q: I have a $49,000 mortgage at 8.75% with 28 years to run. At my age (76), is it worth it to me to refinance? I have no debt other than this and have about $170,000 in cash, Treasuries and a money market fund. I need more spending money.
A: Rather than refinance, I would pay off the mortgage in full. Viewed as an investment, repaying a mortgage yields a risk-free return equal to the mortgage interest rate, which in your case is 8.75%.
Since you have $49,000 in liquid assets earning far less than this, it is a no-brainer.
If you were wealthier and had a significant portion of your wealth invested in the stock market earning 12% to 18%, I would probably counsel you to refinance the 8.75% loan. But you have limited wealth and have elected to invest it conservatively, which for someone of your age makes sense. Prepaying your mortgage in full is consistent with a conservative investment policy.
Insurance Deductions: Two Sides of the Story
Q: My tax advisor said that I should deduct my mortgage insurance premiums from my taxable income, but others have warned me that the premiums are not deductible. Who is right?
A: In some sense, they are both right. If one assumes that Internal Revenue Service must be consistent in establishing deductibility, then mortgage insurance premiums are deductible. The IRS, however, says they are not deductible. If you deduct them and are audited, IRS is sure to challenge you.
Consistency in the rules regarding deductibility means that if an expense X is deductible, and if expense Y is functionally identical to X, then Y should also be deductible.
Interest payments on home mortgages are deductible, and no distinction is made by IRS between the portion of the interest payment that represents compensation for the time value of money and the portion that represents compensation for risk.
If a low-risk borrower pays 7%, for example, while a high-risk borrower pays 9%, the entire interest payment of the high-risk borrower is deductible.
However, if the lender charges both borrowers 7% but requires that the high-risk borrower purchase mortgage insurance, with the mortgage insurer collecting the 2% or its equivalent, IRS will not allow the 2% to be deducted. That is inconsistent.
The IRS classifies mortgage insurance premiums as payments by borrowers for services provided by the lender, similar to an appraisal fee, and as a general matter such payments are not deductible.
The problem with this position is that the lender is not, in fact, providing any service in connection with mortgage insurance. The mortgage insurance premium is a payment for risk, in exactly the same way that the 2% rate increment charged the high-risk borrower is a payment for risk.
Apart from possible differences in price, the borrower doesn’t care whether the lender receives the payment and takes the risk or the mortgage insurance company receives the payment and takes the risk.
Arbitrary IRS Rules Can Injure Borrowers
Q: Why isn’t title insurance deductible?
A: Title insurance premiums on a policy that protects the lender only should be deductible, but they aren’t.
The same is true of expenses billed to the borrower that are incurred by a lender in connection with a loan, such as a credit check or appraisal.
The IRS says they are not deductible because the borrower receives a service for them, but this is a fiction.
The lender requires these services as condition for granting the loan, and they provide little or nothing of value to the borrower beyond the loan itself. Furthermore, if the lender elects to cover these expenses in the interest rate or points, they are fully deductible.
Because lenders vary widely in the extent to which they bill separately for specific expenses, the IRS rule results in arbitrary differences in the way borrowers are treated.
As an illustration, the borrower who takes a loan from lender A, who charges a 1% origination fee and one point, can deduct only the one point. But the borrower who takes a loan from B, who has no origination fee but charges two points, can deduct two points.
Why would a lender elect to price in a way that raises the tax bill of its customers? Primarily because the prevailing practice in this market is to quote the rate and points, leaving other fees to be disclosed later.
Thus, the pricing of lender A in the example appears to be better than that of B, even though it isn’t. A has made a judgment that the number of customers it attracts from appearing to have better pricing is larger than the number it loses by being duplicitous.
This is a sad commentary on the way this market works, on the failure of the government’s disclosure rules to protect the consumer and on the need for consumers to find other means of protecting themselves.
Jack Guttentag is a syndicated columnist and professor of finance emeritus at the Wharton School of the University of Pennsylvania. Questions or comments can be left at mtgprofessor.com.
Distributed by Inman News Features.
