House Mortgage Vs. Cash

House Mortgage Vs. Cash

A few days ago, I pointed out that because the interest you pay on a car loan is interest on the declining balance, and the interest that you earn on savings is on an accruing balance, it is actually possible to come out ahead getting a car loan, instead of paying cash for a car. (This assumes that you have very good credit, and are willing to lock up your cash in a CD for the duration of the car loan.)

I've been considering another scenario, one that may seem a bit weird to many of my readers, but for those who are over 50, not an absurd one: paying off the mortgage. Does it make sense? Right now I have an ARM which just adjusted down to below 4% APR. I expect that it will probably adjust down again next year--or at least not adjust up much. (I'm expecting bad news from the economy for a couple of years at least.) So I created a spreadsheet that works much like that car loan spreadsheet.

One significant difference is that car loan interest (unless you have it tied one of those funny mortgage loans) is not deductible from your income taxes. House mortgage interest in deductible. So using a five year horizon, with a 5% yield (which is less than I am getting from my Treasury and Fannie Mae bonds), the interest on $240,000 is a bit more than $65,000 in gross interest. Assuming a 33% marginal tax bracket, that nets $43,696.66 over five years.

What about the mortgage? I've plugged in 5.35% APR, which is what my credit union is currently quoting for 30 year fixed mortgages. (I'm paying a bit less than that, so all the better.) Over five years, that means you pay $61,871.78 in interest. Assuming a 33% marginal tax rate, paying this interest reduces your income taxes by about $20,417.69 over those five years.

So what if you liquidate your portfolio (and can do so without getting eaten alive by income taxes on capital gains), and pay off your mortgage? Now, put your $1340.19 a month house payment into savings every month. Assuming that you earn about 3% on it (for the reasons that I discussed with respect to the car loan--little chunks going in every month, so you don't get to open big CDs for five years), at the end of five years, you have earned $6,127.07 gross interest--and paid $2,021.93 in taxes at the 33% marginal tax rate. Your net interest is $4,105.14.

So, you have two choices:

1. Keep your money invested, and make mortgage payments: net interest income of $43,696.66, a $20,417.69 reduction in income taxes paid because of the mortgage interest deduction, and $61,871.78 in total mortgage payments. At the end of five years, you are ahead $2,242.47 (interest income plus tax reduction - mortgage payments).

2. Sell your bonds or what have you, and pay off the mortgage. You forgo $43,696.66 in net interest income, in exchange for $4,105.14 in interest income on the money that otherwise would have gone towards the mortgage. At the end of five years, you are behind $39,591.52.

That mortgage interest deduction makes a world of difference. Now, if you have an adjustable mortgage--and whatever you have your cash invested in is not--this changes the equation a bit. But unless your adjustable rate mortgage goes up to a really ridiculous level relative to your savings, you will almost certainly come out ahead over the next five years by keeping your money invested, and making mortgage payments.

Of course, this assumes that your investments are safe. I have some Ford bonds due in 2011 that have fallen quite substantially in value. (When I have spoken at some length about letting the car companies go into bankruptcy, I'm not speaking as a disinterested party. Quite the opposite. I would benefit quite substantially from the government bailing out Ford. It is still wrong.) Those Ford bonds are still paying more than 6% per year in interest, and unless Ford goes under--and goes under harder than is likely--I can ignore the reduction in their capital value. I'll just hold them until redemption.

The spreadsheet is available here for those who want to use it--and since some of you look these over very carefully, if you find any errors, let me know.

UPDATE: A reader noticed an error in the spreadsheet concerning the decline balance on the mortgage. It changes the results somewhat, but you are still ahead making the payments.