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Thursday, December 21, 2006

Truth About Interest Rate

I am often asked,

Why should I pay off my low interest rate loan (mortgage or otherwise) when I could make so much more by investing in the market?


John Cummuta says, On a typical monthly mortgage payment, 90% or more of the payment is interest each month. While the loan company made you feel like you were getting a 5% or 6% mortgage, you're actually paying 90%+ of your money toward interest each month. It would only be 5% or 6% if you paid the entire balance off the first year.

The other reason paying off your mortgage is a good idea is that paying off debt gives you a guaranteed return on investment equal to the debt's interest rate, so you must only compare paying off your mortgage loan with investments that would also guarantee their return. What investments guarantee their returns? Growth/equity mutual funds do not guarantee their return. In fact, you can lose money in these funds. It's the same with individual stocks, bonds, real estate, precious metals, and almost all types of securities. The safest investments that do guarantee their return rates are U.S. Treasury instruments, such as bills, notes and bonds. You'll find that long-term bonds generally offer the highest interest rate of the three, but this rate will always be less than current mortgage interest rates. So prepaying your mortgage will always give you a higher return on your money then the best comparable guaranteed-return investment.
Posted by Kevin Surbaugh at 12/21/2006 07:39:00 PM
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8 comments:

  1. I think it's true that you start off paying 90% interest, but I don't think it continues that way. As you get further into the 30-year mortgage you are paying more towards the principle. Towards the end, I believe you get to the point where you are paying 90% principle.

    It is true that mutual funds do not provide a guarentee, but over a 30 year time frame (the same time frame as a mortgage) it's as close to a guarantee that you can get. I'm pretty sure no one has lost money by being properly diversified and in the market for 30 years.

    In my opinion one must decide between a 6% mortgage (which may be more like 5% since many can deduct mortgage interest), and the 8-12% in the market (minus taxes bring it to probably 6.25%-9.5%). Overall the mortgage is 100% certainty at the rate of your mortgage (which I ssumed at 6%, while the mutual fund is around 99.99% certainty (for me at least) at a higher return. That's why I choose the later. To me, that .01 percent of risk is worth 2-3% of gains over the long haul. Especially because over that time, that 2-3% compounds quite a bit.

    As usual, seek a professional (I'm not one) and make up your mind as to what's right for you.
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  2. It is a misleading argument - it leaves out a number of factors: renting costs, inflation, asset appreciation and tax benefits. A much better heuristic is that do not pay more in interest+taxes than what you'd be willing to pay for rent for a comparable lifestyle. Even that heuristic is subject to several factors such as future rent rates, # years in a house, etc. After looking at all those, mortgaging to buy a home is often a very astute thing to do.

    90% of the payments in a year do go towards interest but it is against an asset that generally appreciates over the long term. Even if you assume that houses won't appreciate more than the long term rate of inflation, the real out of pocket would approx 1.5%. A 6% loan translates to about 4.5% after taking into account tax deductions. 3% per annum property valuation growth cuts down the difference to 1.5%. In most cases, even in expensive markets, that is much lower than what you'd pay for rent (assuming if you don't own, you rent) In periods of hypergrowth as the last 10 years, mortgages clearly outperform cash downs or prepayments. As always investments are risky but this is less risky than most.
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  3. Dinesh -
    You bring up deuctions, and show that you like so many Americans are misguided. You can only deduct intrest on home loans, not any other loan or the full loan amount. Second you can't deduct the all the interest. Anotherwards, lets say you are in the 28% tax bracket, then you can only deduct 28 cents of every dollar you pay in interet. I would rather pay off the debt and keep the 72 cents so that I can invest it rather then give it to the bank so that I can get that other 28% back from th government.

    In short, your figures look to be way off.
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  4. The interest is a deduction, Kevin. So my 6% mortgage is more like 5%. Can I invest in CD's for that rate? Nearly so. DON'T YOU LIVE IN AMERICA? DEDUCT YOUR INTEREST AND CONSIDER THIS VALUE WHEN CALCULATING AGAINST OTHER INVESTMENTS. I've said this about twenty times in this blog! I'M GOING FOR TWENTY MORE. DEDUCT IT! Mortgage deduction is one of the four main entitlement programs of the American government budget. So why isn't the deduction in your calculation here???
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  5. Yes I said that, all you can deduct is the interest, however, you can't deduct it all and only if it is a mortgage NOT any other loan like the car, credit cards or whatever other loan that could have been wrapped into the original post.

    For every dollar you spend in intrest (and deduct) the government will only give you back the amount of your tax rate. So as I said earlier, if you are in the 28% tax rate then for every dollar in interest you pay to the bank and then deduct on your taxes, the IRS will only give you back 28 cents that means you are in the hole by 72 cents.
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  6. does the 28% rate even exist? I stay in the 15% rate by saving heavily in my HSA, IRA, and 401(k). Next you'll tell me I should be paying down my mortgage. In my case that's definitely not true because I have a unique property that WILL NOT BE APPRAISED AGAIN without pulling a banker's tooth. But in most cases, at least some of that future savings is more appropriate than paying down the mortgage. I'm facing this issue now. I haven't quite figured out where the mortgage fits in the priorities. i think HSA comes first (because the contrib will put me into the 4% rate, vs. 1%), then perhaps Roth, then perhaps mortgage... but I'm not sure yet. In my case, a "pay-down" would mean keeping CD's in a tax account, due to the appraisal issue. But I suspect I'll fund retirement and medical again in 2007 rather than paying down the mortgage. THE SPREADSHEET WILL DECIDE, as it should.
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  7. 1) Yes you can deduct mortgage interest, but you have to pay yearly taxes on most guaranteed-interest vehicles (excluding say long-term CDs or individual bonds), so the rates are roughly comparable on their face.

    2) The OP is counting compound interest for the mortgage but ignoring it for an alternative investment. Compounding is compounding whether it works for you or the bank. So a 6% guaranteed return WILL leave you financially better off than paying down your 5% mortgage. Whether it is the correct psychological decision is another question.
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  8. There's a misconception here that many of us make: home loans are different from other loans even though they do cost a lot. According to Bankrate.com, a $150,000.00 loan at 6% will cost you about $900.00 per month for 30 years and you will pay interest of 172,000.00 over the lifetime of the loan. Assuming a 28% tax rate, you will get a deduction of 48,000.00. Over the long haul, equities in conservative funds tend to make 8%. Thus, I took the 900.00 per month and put it into equities. Believe it or not, putting the same 900.00 a month to work for the next 30 years at 8% interest compounding will give you 1341323.5 That's over 1 million dollars. Taxes of 28% would be 375,000 give or take a few dollars and thus, you would be left with a bit less than 1 million (assuming you are not putting the money into a tax sheltered account and/or reducing the amount of your income tax with it by using a 401k.) Thus, assuming you were to double up your payment to an additional 900.00 a month, the most you would save is about 130,000.00. If you took that same money and invested it, you would save almost 1 million dollars. It is a no-brainer under those terms.

    Credit card and other debt is different: interest rates are higher, there is no tax deduction and they generally prevent you from achieving financial goals. But a mortgage is actually a useful tool for owning a home and allowing you to save money for retirement at the same time.

    Also, personally, I would rather have the money when i retire in liquid form than just in my house (although I could achieve both goals at the same time). If I don't save, but I double my mortgage payment, I need to sell the house to live. If I save money, I can than live in the house and spend the money I saved.

    Obviously, this is an individual consideration -- I often think that if I got a chunk of money I would pay off my mortgage just because it would be nice not to have it hanging over my head, but having calculated the amount, I don't think I will do that.
    ReplyDelete

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