Mortgage rate % when tax deferred should take back seat

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davos8923
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Mortgage rate % when tax deferred should take back seat

Post by davos8923 » Mon Apr 16, 2018 9:38 am

At one point would mortgage rates have to reach for it to no longer be advantageous to instead prioritize tax advantaged investing? Similar questions have been asked a lot I know and I've used the search feature, but had trouble finding a simple scenario such as this --

22% tax bracket, expect to earn less in retirement (maxing out 401(k), tIRA, etc)
Standard deduction (therefore no mortgage interest deduction)

Haven't bought yet, but say I do next year and rates are at 5%. Still max out tax advantaged first? If yes, at point shouldn't I? 7%? 8?% How do you know? I get you should probably pay the loan at anything over 4% when comparing to taxable investing (I think), but tax deferred is a different beast and I'd hate to lose the space but don't know how much interest is too much.

chevca
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Re: Mortgage rate % when tax deferred should take back seat

Post by chevca » Mon Apr 16, 2018 11:36 am

davos8923 wrote:
Mon Apr 16, 2018 9:38 am
but tax deferred is a different beast and I'd hate to lose the space but don't know how much interest is too much.
I'd say you pretty much summed it up right there. I don't think you will find many Bogleheads that would say to ever skip tax advantaged space just to pay down the mortgage.

I don't know if tax advantaged space was even around back when mortgage rates were in the teens. But, just 10 or so years ago mortgage rates were in the 6% or higher range and tax advantage was the way to go.

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UpsetRaptor
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Re: Mortgage rate % when tax deferred should take back seat

Post by UpsetRaptor » Mon Apr 16, 2018 11:40 am

Wouldn't this just be when the mortgage rate approaches your expected rate of return of your tax advantaged investment?

E.G. let's say you have $5,500 after tax money, which you put into a Roth that grows at 7% for 30 years, it's worth $42K, which is $5,500 principal and $36K tax free earnings. Then let's say you have a 30-yr mortgage at 7%, you pay an extra $5500 up front, you get an extra $5,500 equity and save $36K interest over the 30 years. So then it's even, unless I'm thinking of the equity vs principal wrong.

chevca
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Re: Mortgage rate % when tax deferred should take back seat

Post by chevca » Mon Apr 16, 2018 11:50 am

That's the thing though, 30 years is a long time. Just as many now say, mortgage rates can't stay low forever... if mortgage rates were to reach 10% again, they may not stay high forever either. The person that buys a home and takes out a 10% mortgage can refinance if rates go down over the next 30 years. The person that skips tax advantaged space to pay down the 10% mortgage can't go back and fill that space 10 or 20 years later if rates go back low enough to make it worth it.

It's a good question. I wonder what folks would have done back when mortgage rates were 15% or so? It could be real tempting to plow any extra money towards paying off the mortgage.

Another good question along these lines would be, if mortgage rates reach 10% again, how much should one save and put as a down payment then? Is just putting 20% down still recommended then?

jehovasfitness
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Re: Mortgage rate % when tax deferred should take back seat

Post by jehovasfitness » Mon Apr 16, 2018 11:54 am

chevca wrote:
Mon Apr 16, 2018 11:36 am
davos8923 wrote:
Mon Apr 16, 2018 9:38 am
but tax deferred is a different beast and I'd hate to lose the space but don't know how much interest is too much.
I don't know if tax advantaged space was even around back when mortgage rates were in the teens. But, just 10 or so years ago mortgage rates were in the 6% or higher range and tax advantage was the way to go.
To hijack, and put in my own question here.

Say in 22% bracket with mortgage of 4.125%.

But, you have wife 401k, your own 401k, but also ability to contribute to 457 plan and HSA.

That's a ton of tax-advantaged space, but doing so would mean carrying a mortgage 12 years after your planned retirement.

I'm aiming to retire at 55 which would mean if not paying more on mortgage now having one until age 67.

I'm leaning towards maxing out our 401ks and HSA, but no both 401/457 just the 401 I have and putting extra on mortgage to be done by time I retire.

FWIW our tax rate may go from 22% to 12% in 5 yrs after doing 401k/HSA and standard deduction.

chevca
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Re: Mortgage rate % when tax deferred should take back seat

Post by chevca » Mon Apr 16, 2018 12:05 pm

Sure, I can see exceptions like that. I'm thinking simple someone has a 401k and Roth/Trad IRA options. I wouldn't skip those to pay down a mortgage. I know some folks have more options than that and I can see not wanting to fill all of those before paying down the mortgage. That seems reasonable.

I might make use of the 457 in the above example though. If retirement age is going to be 55, having easy access to the 457 money might be nice. Although, if it won't be needed between 55 and 59.5, no biggie.

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FiveK
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Re: Mortgage rate % when tax deferred should take back seat

Post by FiveK » Mon Apr 16, 2018 12:12 pm

UpsetRaptor wrote:
Mon Apr 16, 2018 11:40 am
Wouldn't this just be when the mortgage rate approaches your expected rate of return of your tax advantaged investment?
Yes, and it works for traditional accounts as well.*

E.g., take the situation in Guaranteed 9% annualized return? - Bogleheads.org, except having $4000/mo pre-tax (e.g., a working couple age 50) to put in a 401k or to pay tax on and then pay the mortgage faster.

The answer is the same: if the rate of return within the 401k is identical to the mortgage rate, at the end of the nominal mortgage length you will have the same amount in the 401k (and a paid mortgage) whether you paid the mortgage minimum, paid the mortgage as fast as possible, or anything in between.

With a 22% marginal rate, instead of the $974,367.19 investment balance found in the linked post, the 401k will have $816,743.39.

*But here's the catch: there is no tax drag in a tax-advantaged account, so the after-tax rate of return for the same investment in those accounts may be higher than in a taxable account. If it is a 401k/403b/457b and the fees are atrocious, it may also be lower.

davos8923
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Re: Mortgage rate % when tax deferred should take back seat

Post by davos8923 » Mon Apr 16, 2018 1:05 pm

FiveK wrote:
Mon Apr 16, 2018 12:12 pm
UpsetRaptor wrote:
Mon Apr 16, 2018 11:40 am
Wouldn't this just be when the mortgage rate approaches your expected rate of return of your tax advantaged investment?
Yes, and it works for traditional accounts as well.*

E.g., take the situation in Guaranteed 9% annualized return? - Bogleheads.org, except having $4000/mo pre-tax (e.g., a working couple age 50) to put in a 401k or to pay tax on and then pay the mortgage faster.

The answer is the same: if the rate of return within the 401k is identical to the mortgage rate, at the end of the nominal mortgage length you will have the same amount in the 401k (and a paid mortgage) whether you paid the mortgage minimum, paid the mortgage as fast as possible, or anything in between.

With a 22% marginal rate, instead of the $974,367.19 investment balance found in the linked post, the 401k will have $816,743.39.

*But here's the catch: there is no tax drag in a tax-advantaged account, so the after-tax rate of return for the same investment in those accounts may be higher than in a taxable account. If it is a 401k/403b/457b and the fees are atrocious, it may also be lower.
FiveK,

Thank you. So is there a rule of thumb for when the mortgage rate would likely approach the expected rate of return (say for a simple 3 fund portfolio)? At current ~4% mortgage rates I would expect to earn more in investments. Unsure though if mortgage rates go to 5-6% by the time I buy.

Also -- doesn't the investment being tax advantaged play a role too? As in, wouldn't simply comparing rate of return between mortgage and investment only really apply to taxable? If I could save 22% tax now by going 401k instead of mortgage, even if expecting same rate of return, being able to pay less tax than 22% in retirement would mean investing > paying mortgage, right? Sorry is missing anything or my question doesn't make sense.

jehovasfitness
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Re: Mortgage rate % when tax deferred should take back seat

Post by jehovasfitness » Mon Apr 16, 2018 1:11 pm

chevca wrote:
Mon Apr 16, 2018 12:05 pm
Sure, I can see exceptions like that. I'm thinking simple someone has a 401k and Roth/Trad IRA options. I wouldn't skip those to pay down a mortgage. I know some folks have more options than that and I can see not wanting to fill all of those before paying down the mortgage. That seems reasonable.

I might make use of the 457 in the above example though. If retirement age is going to be 55, having easy access to the 457 money might be nice. Although, if it won't be needed between 55 and 59.5, no biggie.
Yeah, I just started contributing to the 457 last month and it's a higher % than my 401k.

chevca
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Re: Mortgage rate % when tax deferred should take back seat

Post by chevca » Mon Apr 16, 2018 1:35 pm

davos8923 wrote:
Mon Apr 16, 2018 1:05 pm
Also -- doesn't the investment being tax advantaged play a role too? As in, wouldn't simply comparing rate of return between mortgage and investment only really apply to taxable? If I could save 22% tax now by going 401k instead of mortgage, even if expecting same rate of return, being able to pay less tax than 22% in retirement would mean investing > paying mortgage, right? Sorry is missing anything or my question doesn't make sense.
Not really. One almost always pays taxes on interest earned. One doesn't pay any taxes on interest saved (paying mortgage down aggressively). So, paying down the mortgage wins either way if taxation is the factor considered.

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whodidntante
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Re: Mortgage rate % when tax deferred should take back seat

Post by whodidntante » Mon Apr 16, 2018 1:55 pm

The common mistake is thinking in nominal terms. If the best rate available to a good borrower was 15%, and inflation is at 0%, then paying that off is a great investment. I'm not enough of an economic historian to say that setup never happened anywhere, but I can tell you that it is unlikely to happen for you. A much more likely scenario is to have inflation somewhere near the best mortgage rate available, perhaps lagging the best available mortgage rate by 4% or so depending on the steepness of the yield curve. It's that difference that you actually pay in real terms, because you pay the mortgage back with inflated dollars.

In your situation I think you are better off maxing all of your tax deferred accounts before one penny goes to mortgage principal.

runner540
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Re: Mortgage rate % when tax deferred should take back seat

Post by runner540 » Mon Apr 16, 2018 1:59 pm

davos8923 wrote:
Mon Apr 16, 2018 9:38 am
At one point would mortgage rates have to reach for it to no longer be advantageous to instead prioritize tax advantaged investing? Similar questions have been asked a lot I know and I've used the search feature, but had trouble finding a simple scenario such as this --

22% tax bracket, expect to earn less in retirement (maxing out 401(k), tIRA, etc)
Standard deduction (therefore no mortgage interest deduction)

Haven't bought yet, but say I do next year and rates are at 5%. Still max out tax advantaged first? If yes, at point shouldn't I? 7%? 8?% How do you know? I get you should probably pay the loan at anything over 4% when comparing to taxable investing (I think), but tax deferred is a different beast and I'd hate to lose the space but don't know how much interest is too much.
deleted

davos8923
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Re: Mortgage rate % when tax deferred should take back seat

Post by davos8923 » Mon Apr 16, 2018 2:02 pm

whodidntante wrote:
Mon Apr 16, 2018 1:55 pm
The common mistake is thinking in nominal terms. If the best rate available to a good borrower was 15%, and inflation is at 0%, then paying that off is a great investment. I'm not enough of an economic historian to say that setup never happened anywhere, but I can tell you that it is unlikely to happen for you. A much more likely scenario is to have inflation somewhere near the best mortgage rate available, perhaps lagging the best available mortgage rate by 4% or so depending on the steepness of the yield curve. It's that difference that you actually pay in real terms, because you pay the mortgage back with inflated dollars.

In your situation I think you are better off maxing all of your tax deferred accounts before one penny goes to mortgage principal.
Thank you, very helpful.

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FiveK
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Re: Mortgage rate % when tax deferred should take back seat

Post by FiveK » Mon Apr 16, 2018 2:13 pm

chevca wrote:
Mon Apr 16, 2018 1:35 pm
davos8923 wrote:
Mon Apr 16, 2018 1:05 pm
If I could save 22% tax now by going 401k instead of mortgage, even if expecting same rate of return, being able to pay less tax than 22% in retirement would mean investing > paying mortgage, right?
So, paying down the mortgage wins either way if taxation is the factor considered.
Strange as it may seem, neither of those is correct.

A simplified example. Your choice of
- Paying a $1000 loan to your neighborhood loan shark. Interest is 10%/month so you need to pay at least $576.19/mo.
- Investing in ByteCoin (it's 8X better than BitCoin) in your self-directed tIRA. Coincidentally, you expect to make 10%/mo.
- You have $1200/mo pre-tax available, and pay 50% tax

If you pay the minimum on the loan, $1152.38/mo goes to the loan. At the end of the first month, you pay the loan shark $576.19 and invest $47.62 with ByteCoin.
At the end of the second month, have made $4.76 from ByteCoin. Adding your second $47.62 contribution, you have $47.62 + $4.76 + $7.62 = $100 in ByteCoin. You also make your second payment to the loan shark, so your account is paid and your legs remain unbroken.

If you pay as much as you can on the loan, $0 goes to ByteCoin the first month. $1200 * (1 - 50%) = $600 goes to the loan shark, reducing your principal owed to $1000 * (1 + 10%) - $600 = $500.
At the end of the second month, you pay $500 * (1 + 10%) = $550 to the loan shark and again emerge with legs intact. You have $1200 - $550/50% = $100 left over to invest in ByteCoin, the same as if you paid the minimum on the loan.

Either way, you have a paid loan and $100 in your pre-tax investment account. Does that make sense?

Tax-advantaged accounts are preferable when one avoids paying tax one would have to pay in a taxable account. For one who would save the same marginal rate now as would be paid at withdrawal, and not pay tax on earnings and capital gains (e.g., someone in the 12% bracket with only QD and LTCG from investments), traditional = Roth = taxable.

See Traditional versus Roth - Bogleheads and the '401k vs Taxable' tab in the personal finance toolbox spreadsheet for more.

chevca
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Re: Mortgage rate % when tax deferred should take back seat

Post by chevca » Mon Apr 16, 2018 2:24 pm

Thanks for partial quoting both of us, FiveK, and then coming up with your own scenario to make your point. Better off paying back the loan shark either way there so as not to get your knee caps broken. :oops: :wink:

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Meg77
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Re: Mortgage rate % when tax deferred should take back seat

Post by Meg77 » Mon Apr 16, 2018 3:47 pm

When I got my first mortgage in 2006, my rate was 7.25% or so I think. I seem to recall at the time that the standard advice (or my idea anyway) was to contribute a set percentage to retirement accounts - 15% or so - and then put the rest toward debt repayment. I think as interest rates come back up to normal levels, such "normal" advice makes more sense.

Riding out debt for as long as possible - even carrying mortgages into retirement and getting a mortgage when you can afford to pay cash for a home - in order to invest more is a relatively new financial planning strategy. It may have worked during the narrow period where stocks were on a bull run and interest rates were insanely low, but it is a risky strategy in general and certainly won't work out well forever.

Filling up all your tax-deferred retirement space should not necessarily be the goal; after all many folks have way more space than they reasonably need to fund retirement. Imagine that you had unlimited tax deferred space (as some do, effectively). Then how much would you put in a 401k type plan, versus into taxable investments for mid term goals and into debt repayment and savings for short term wants?

Don't let the tail wag the dog! Taxes shouldn't be the primary reason for making a certain investment or for selling an investment.
"An investment in knowledge pays the best interest." - Benjamin Franklin

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UpsetRaptor
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Re: Mortgage rate % when tax deferred should take back seat

Post by UpsetRaptor » Mon Apr 16, 2018 3:57 pm

whodidntante wrote:
Mon Apr 16, 2018 1:55 pm
The common mistake is thinking in nominal terms. If the best rate available to a good borrower was 15%, and inflation is at 0%, then paying that off is a great investment. I'm not enough of an economic historian to say that setup never happened anywhere, but I can tell you that it is unlikely to happen for you. A much more likely scenario is to have inflation somewhere near the best mortgage rate available, perhaps lagging the best available mortgage rate by 4% or so depending on the steepness of the yield curve. It's that difference that you actually pay in real terms, because you pay the mortgage back with inflated dollars.

In your situation I think you are better off maxing all of your tax deferred accounts before one penny goes to mortgage principal.
This is a good point. A mortgage is a nice inflation hedge, which is somewhat lacking in your typical Bogleheads 3 or 4 fund portfolios.

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