YNAB You Need A Budget

[mec2mec]

I've been following Jesse's tax video and brought the TaxInsight book. Two of the points made were that the Home mortgage deduction is not as great as some people think and that some Muni bonds have tax free interest. Also, he tells how he saved $20,000 and used that money to pay down his mortgage. All which brings me to my question:

Is it better to pay down a 6% mortgage with a lump sum or invest in a Muni bond earning 6% tax free. Assuming you are willing to live with the default risk it appears to me that the Muni bond is better. Because you do get some of the mortgage payment back so the effective interest is less than 6% but the Muni gives you a full 6% and you don't have to pay tax on it.

What does everyone think?

[Patzer]

I've been following Jesse's tax video and brought the TaxInsight book.

The videos make an entertaining presentation, and introduce a few very important concepts. However, with taxes the devil is in the details. Of necessity, Jesse omits a lot of details that are relevant to making tax and investing decisions.

Is it better to pay down a 6% mortgage with a lump sum or invest in a Muni bond earning 6% tax free.

It depends.

All other things being equal, it would be better to have the 6% Muni bond. But all other things are rarely equal. Let's walk through an example with my marginal tax rates of 25% federal and 6.85% New York:

Assuming the mortgage interest is fully deductible for both federal and NY income taxes, my after-tax cost of the mortgage is:

6% * (1 - 0.25 - 0.0685) = 6% * 0.6815 = 4.089%

Assuming the muni bond is issued by a NY municipality, my after tax yield on the bond is 6%. That beats the mortgage easily.

But NY municipal bonds yielding 6% are very rare, because New Yorkers with 35% marginal federal tax rates and NYC marginal tax rates pushing 10% bid the price down to lower than makes sense for my tax brackets. I probably can't find a NY muni bond yielding 6% without an unacceptable default risk. If I get a 6% muni bond from some other state, its after tax yield is:

6% * (1 - 0.0685) = 6% * 0.9315 = 5.589%

But since there are plenty of investors with 35% marginal federal tax rates, I might not be able to find a 6% muni anywhere. Say I find a corporate bond yielding 6%. My after tax yield for this bond is:

6% * (1 - 0.25 - 0.0685) = 6% * 0.6815 = 4.089%

Notice that this is the same calculation as the after-tax cost of the 6% mortgage interest.

Tax detail lesson 1: A rate for fully deductible interest paid can be directly compared to a rate for fully taxable interest earned.

That's a nice theoretical result. "Fully taxable" is easy to explain. That means I pay both federal and state income taxes on the income. "Fully deductible" is trickier.

Mortgage interest is fully deductible for federal income taxes if you have enough deductible expense to be worth itemizing, even in the absence of the mortgage interest. Say I pay $5000 of mortgage interest. If I have $4000 of other deductible expenses, I have $9000 total itemized deductions. But, as a single taxpayer, my standard deduction for 2009 would be $5700. That means that effectively only $3300 of my mortgage interest is giving me a tax benefit on my federal return. On the state side, maybe $2000 of that other $4000 is from state income taxes, which are not deductible for NY taxes. That knocks my NY deductible expenses down to $7000, which is less than the NY standard deduction of $7500 for single taxpayers. So in this situation, I would get no state tax benefit from the mortgage interest at all. This is not an uncommon situation. I paid mortgage interest for a decade and only beat the state standard deduction one year, and then only be a couple hundred dollars.

Tax detail lesson 2: How much tax benefit you get from the mortgage interest is dependent on the rest of your tax situation. Jesse pointed out that you spend $12 to save $3 in the 25% tax bracket; depending on how the rest of your numbers shake out, the picture could be even worse.

Now, how about that 6% bond? As it happens, there aren't a lot of 6% bonds out there these days. To find a bond with a yield to maturity of 6%, you have to go down the ladder a bit on bond quality. That exposes you to default risk. Granted, it can pay off handsomely if you do the work and Murphy doesn't visit you; but it can be a scary ride. A few years ago I bought some bonds that were going to mature in between 2 and 3 years, and I found a yield to maturity of I think around 8%. Yeah, I went down the quality ladder to get that, but I figured it wasn't all that risky because I didn't go long time frame. And it was a solid company that I thought would be very likely to pay off its bonds, even if the common stock did poorly. It turned out that the bonds did pay off; but it was a nervous ride along the way. You might have heard the name of the bond issuer--a little firm called Daimler Chrysler when I bought the bonds. While I was waiting for maturity, Daimler sold Chrysler, and my bonds went with the sale. Then Chrysler went bankrupt. The value of the bonds wend down quite a bit. They paid off essentially because the US government bailed out the auto industry, and some high powered bond holders stood firm against voluntarily losing capital. In other words, I got lucky. My investment got bailed out by some bad public policy decisions.

This is another consideration in comparing paying down the mortgage to buying bonds. Paying down the mortgage is a sure return. Buying bonds carries a risk of default. The higher the bond yield, the higher the risk. You need to have both the stomach to accept the risk, and the financial resources to survive if the risk comes home to roost.

Investment detail lesson 1: Equal after tax returns don't always carry equal risk. Paying down the mortgage may look better from a risk management perspective, even if the after-tax return on a bond looks better financially.

Another practical consideration is how much money you can invest. It's possible to pay extra principal on a mortgage in very small quantities. Some months, I sent only $50 of extra principal at my mortgage. In stark contrast, I need to put $10,000 into bonds to get favorable bond trading costs. Assuming I can, in practice, invest in $10K chunks, that's no big deal; but it matters a lot if I can't invest in $10K chunks.

Investment detail lesson 2: There are economies of scale in some investments that can significantly affect the answers. The analysis for a million dollar mortgage and a hundred thousand dollar lump sum that might be used for paydown looks very different from an analysis of a hundred thousand dollar mortgage and a few thousand dollar lump sum that might be used for paydown.

All that scrolly stuff so far, and I have yet to talk about liquidity. Liquidity is a very important concept, and it should be pretty easy for YNABers to understand. The buffer is about having liquidity. Rule 3 funds are about having liquidity.

From the mortgage paydown vs. investment standpoint, paying down the mortgage (US mortgage, not Australian) is an illiquid investment. You save that 6% interest on the principal you pay down, but you don't get the money back without either selling the house (presumably covering the debt and giving you some equity back in cash) or totally retiring the mortgage (eliminating the principal and interest portion of your monthly mortgage payment going forward). Depending on what you invest in, your investment has good to fair liquidity. A corporate or muni bond can be sold, though the market will fluctuate. If you go more conservative than a bond, your could put money into CDs, or US savings bonds, or even plain vanilla savings accounts. In any of these choices, the money is there if Murphy decides to visit. Of course, none of these safe, mostly liquid choices are likely to pay 6%; but they are extremely likely to get you return *of* your investment, and you can get that on reasonably short notice. If you hold $10,000 face value of bonds, but you need the money when the bond price is $83.25, you're out $1675 even if the bonds end up paying in full on schedule.

Investment detail lesson 3: Don't put money you might need on short notice into investments that can lose principal.

I'm almost certainly missing some important details, but what I'd really like to get across is that there is no simple answer to whether it's better to pay down the mortgage or invest the same money. The answer depends on a lot of stuff, and I've only given a few examples of the kinds of things I might consider if I were making this kind of decision. You might ask, how do I know about bonds and what decision would I actually make? I buy corporate bonds inside a tax advantaged account. Using the IRA as a vehicle to hold the bonds solves the tax issue. I don't buy munis because the market bids them to an efficient price for higher marginal tax rates than mine. I didn't buy bonds at all before I retired my mortgage. But what I do is not necessarily the best answer for someone else. I'm pretty conservative fiscally. A more aggressive investor might choose to play the bond market in his taxable brokerage account while still carrying a mortgage. An investor with a combined federal and state marginal tax rate of 46% might find municipal bonds much more attractive than I do.

I'd be remiss if I didn't mention the most important tax and investment rule, cited by knowledgeable tax professionals as well as savvy investors:

Don't let the tax tail wag the investment dog. Yes, the tax impact of the investment is part of the analysis; but it isn't the whole analysis. You can sell your investments, pay your taxes, and spend the money . . . preferably after first budgeting the money.

Patzer

[MommaMary]

Another point that you may consider. Risk.

If you pay off a house mortgage (in a house you plan to stay in), you get a guaranteed, no risk return on your money.
At 6% -- you are getting 6% return for 30 (or 15) years. There's certainly investment risk in the house itself (as too
many upside-down people have discovered) if you plan to sell soon. But there is a lot of peace of mind in owning
your house free and clear.

Once the house is paid off -- that regular payment to the mortgage company is done. You are living in a PAID FOR
house (you know the joy of a PAID FOR car? -- this is that times 1000.) No one can take your house from you. Your
cost of living goes down dramatically. Property tax and insurance is a tiny fraction of the cost of the mortgage loan
(and you are paying it either way.) Most people can take a really nice vacation on what one month's mortgage
payment is costing them. And if the US experiences true deflation, the dollars you spend on the mortgage will
become more dear. Some economists are still worried about deflation -- the immediate risk seems small --
but if we have a double dip recession, and banks tighten down credit even further, I'd say all bets are off.
The usual nice thing about a fixed rate mortgage is that as time goes by, you are paying the same amount of
money with cheaper dollars. Our parents' 10% mortgage on that $20K house in 1970 was $175 a month.
Doesn't sound like much, does it? It might have been a full weeks salary back then. A weeks worth of groceries
might have been $10-$15 for a family of 4. Remember when you could buy gumballs for a penny? 5 cent newspapers?
I do. What if the dollar deflates? That $800/month might feel like $1000/month or $1500/month. Some people
are experiencing this already as their labor value deflates through furloughs or pay cuts and their fixed costs stay
the same. Zero dollars is zero dollars no matter what one dollar is worth. OK. Off that little soapbox.

The second piece of investment risk is that there is the (tiny) risk that the city/state will default on its bonds.
Look at California, New York. Do you think the counties and towns in these states are hurting? You bet. If one of
these places goes bust, or one of the states defaults on the obligations either to their bondholders or to their
municipalities, you've got nothing but a worthless piece of paper. California is shifting a lot of its responsibilities
to its local governments and pulling (stealing) moneys earmarked for local areas (read up on the gas tax). This
is going to be a problem for many states nationwide in the next few years if our current trends continue. I'm not
in California or New York myself, but even my little state is struggling, so make sure you know what the bonds
you plan to buy are rated.

Mary