Thursday, September 9, 2010

Wealth effect vs. wealth illusion

With all the talk about renting vs. buying a house, I thought it might be worthwhile to examine borrowing to own vs. owning outright or paying down principal on a mortgage.

I’ve been trying to convince my brother of the wisdom of paying down his mortgage with the piles of cash he likes to sit on.

Married filing joint the interest deduction doesn’t really kick in until one’s total deductions exceed the standard deduction, which is about $11,000.  Assume a marginal tax rate of 25 percent, which covers a household income of about $68,000 to $137,000.

If the only deductions you have are your mortgage, at a rate of 6 percent you’d have to have a principal outstanding of about $183,000 before you got the first dollar of deductibility (=11,000/.06).  If you make charitable contributions or have other deductions, you will achieve deductibility with a lower principal balance.

Now that 6 percent is paid out of after-tax dollars.  The equivalent before-tax return required to match that as an “investment” would be 6/(1-.25) = 8 percent with certainty.

You can’t get 8 percent with high risk nowadays, let alone with certainty.

So if you own a home and your deductions are below the standard deduction, paying down your mortgage is probably the best financial investment you can make.  It’s also an investment in peace of mind.  After all, your property taxes should be going down, too, so your cost of home ownership should be taking a double dip.

So when my brother tells me he has some huge amount (speaking five figures here) of cash piled up and that he’d feel poor if he paid down some of the balance on his mortgage, a balance still many times his cash balance, I tell him—

“It’s an illusion.  You don’t really have that money.”

With this arithmetic and the mortgage debt of the American people—not to mention the volatility of the stock market the past couple of years—is it any wonder that funds are flowing out of retail mutual funds?


  1. Can't he add up? I guess he wouldn't be alone if he couldn't ...

    At least he has sizeable `savings' - think of how many people are in the same boat with nothing extra to fall back on.

    Put all my money into my first loan and lived like a pauper (down to 2nd hand cooking utensils, all but broken tv etc) - and haven't needed another loan since (if i want a 50" tv, or a new shed, i just pay cash). Feels pretty good knowing i'm not giving the bank a pile of free money whilst their profits reach new records every year.

    I might pay a bit more tax than I need to, but i'd rather it went to support the country that gave me a safe and comfortable life than some overweight banker who doesn't need another beamer.

  2. basically, i agree with you; i paid off my house in 12 years...but once that is done, he has no further options for that cash...there is an advantage to liquidity that you havent taken into account...

  3. That's what a home equity line of credit is for--emergencies.