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Pay Off Your Mortgage

Jimmy and Rosalynn Carder are both 50, live in Planes, Georgia, and earn a combined $75,000. Thanks to the untimely death of Jimmy’s rich brother, Bilous, they also have $500,000 in financial assets. Jimmy and Rosalynn want to buy their dream house. It’s on the market for $437,500. But they don’t know whether to use their inheritance to buy it outright or use just 20 percent of their inheritance as a downpayment for a mortgage and save the rest. At the prevailing 7 percent rate for a fixed-rate, 30-year mortgage, they’ll pay $2,329 per month if they take out a mortgage.

The Carders have received plenty of conflicting advice, including:

  • Buy the house for cash and enjoy owing your home free and clear.
  • Take out a mortgage, deduct the interest payments, and invest your assets in the market.

Which choice makes the most economic sense?

Well, here’s what we know. Were the Carders to take out a mortgage and invest in long-term U.S. Treasury bonds the money they have left after making the downpayment, they’d earn less than 5 percent given prevailing interest rates. Meanwhile, they’d have to pay interest on their mortgage at 7 percent. Yes, the Carders could invest in the stock market, but to make an apples-to-apples comparison, we need to leave risky investments out of the story.

If the Carders finance their house, their mortgage payments may or may not be deductible depending on whether they qualify for the standard deduction. But one thing is sure, the interest the Carders will earn by investing in long-term Treasuries is subject to taxation. So, at best, it’s seems like a wash—that there’s no tax advantage to financing. At worst—taking the standard deduction and not deducting mortgage interest—there’s a tax disadvantage. These alternatives however, ignore the Alternative Minimum Tax (AMT). Having high mortgage interest deductions can prevent one from paying the AMT. So the answer to whether or not the Carders should finance their house depends, in part, on whether their income is high enough that they’d otherwise have to pay the AMT.

Another issue to mention is retirement accounts. Were the Carders not already maxing out on their retirement account contributions, they could put some of their inheritance in those accounts.

A third consideration is liquidity. By retaining their assets and taking out the mortgage, the Carders will have lots of assets available in case of any emergency. On the other hand, were they to use these assets to buy the house, they could always take out a mortgage or a home equity loan if they needed ready cash.

Setting this last issue aside, which option—buy the house outright or take out a mortgage—generates the highest living standard for the Carders given all the federal and state tax issues? ESPlanner can figure this out in seconds taking into account all current and future taxes, including those arising from the AMT.

Here’s the answer according to ESPlanner:

Buy the house outright.

If the Carders do this, they will enjoy a living standard of $21,722 per person. This living standard is 3.76 percent higher every year for the rest of their lives than the living standard they’d experience were they to take out the mortgage and invest their remaining assets in Treasuries.

This 3.76 percent represents a meaningful hike in their living standard. Jimmy and Rosalynn would each have to work almost an extra year (retire one year later) to achieve the same permanent living standard increase.

Unfortunately, thanks to the AMT we can’t claim that what’s best for the Carders is necessarily best for the Clindons, the Carders’ friends from Hops, Arkansas. The Clindons make a lot more money giving lectures around the country entitled “The Power of Power.” Jimmy Carder has decided to get in on this gig with lectures entitled “The Power of Economics.”

Buying the house outright is equivalent to having the Carders take out the mortgage and immediately pay it off. ESPlanner can also be used to consider gradually paying off your mortgage, but doing so more rapidly than originally scheduled. Go to click How Do I? and you’ll see an easy way to consider this option using ESPlanner.