Pay-off or keep mortgage with 2018 interest deduction changes?

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Nowizard
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Pay-off or keep mortgage with 2018 interest deduction changes?

Post by Nowizard » Wed Sep 19, 2018 6:48 am

We have an outstanding mortgage of approximately $325,000 at 3.5% by choice. Our marginal tax bracket is 24% which has reduced the effective interest rate of the mortgage to approximately 2.66%. Our finances are stable, and we could pay off the mortgage but have chosen to invest the "extra" $325,000 with the belief that we can obtain a greater return than 2.66% plus 24% of investment returns. We will be below $24,000 in deductible expenses for 2018 and no longer eligible for itemization. Future income levels will rise due to MRD's.
Options include: 1. Paying off the mortgage but assets would come from retirement accounts, triggering substantial tax increases; 2. Continue with the current loan balance and payments with the expectation that return on investments would exceed 3.5% plus taxes on gains; 3. Increase charitable deductions to exceed the standard deduction level (Estimated increase of 3-5K to reach the threshold); 4. Pay down the mortgage over time with income from SS, pension and RMD's that exceeds spending; 5. Other possibilities not yet considered. Any changes would be made due to tax issues and to eventually simplify our estate for heirs. We are not uncomfortable psychologically with continuing the mortgage if that is the best option.
Any comments will be appreciated.

Tim

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JoeRetire
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by JoeRetire » Wed Sep 19, 2018 6:50 am

Nowizard wrote:
Wed Sep 19, 2018 6:48 am
We have an outstanding mortgage of approximately $325,000 at 3.5% by choice.

we could pay off the mortgage but have chosen to invest the "extra" $325,000 with the belief that we can obtain a greater return than 2.66%
So do you believe that you can obtain a greater return than 3.5% ?

If so, then nothing has changed, right?
Very Stable Genius

bradpevans
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by bradpevans » Wed Sep 19, 2018 6:56 am

keep investing is my vote

Gill
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by Gill » Wed Sep 19, 2018 7:27 am

JoeRetire wrote:
Wed Sep 19, 2018 6:50 am
Nowizard wrote:
Wed Sep 19, 2018 6:48 am
We have an outstanding mortgage of approximately $325,000 at 3.5% by choice.

we could pay off the mortgage but have chosen to invest the "extra" $325,000 with the belief that we can obtain a greater return than 2.66%
So do you believe that you can obtain a greater return than 3.5% ?

If so, then nothing has changed, right?
Of course, that’s 3.5% after tax.
Gill
Cost basis is redundant. One has a basis in an investment | One advises and gives advice | One should follow the principle of investing one's principal

GeoffD
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by GeoffD » Wed Sep 19, 2018 7:44 am

Nowizard wrote:
Wed Sep 19, 2018 6:48 am
4. Pay down the mortgage over time with income from SS, pension and RMD's that exceeds spending;
I think it depends on the mix of these three income sources. If you can live comfortably on your SS and pension income making a mortgage payment and that would continue if you're married and have a death of spouse event, I'd just use the RMDs as mad money. You can't take it with you. Inflation is your friend when you have long term debt locked in at low interest rates.

Personally, those aren't my circumstances. I won't have a pension coming. As I've aged, I've started encountering job stability and age discrimination issues. It helps me sleep at night knowing I'll have a roof over my head no matter what happens. A paid for house with low ownership costs is valuable to my mental health even though it in no way maximized my wealth creation.

stan1
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by stan1 » Wed Sep 19, 2018 7:53 am

Sounds like you are over 70.5. I wouldn't necessarily increase my charitable giving unless I made a deliberate decision to do so but I would shift to qualified charitable distributions so that charitable giving drew from the RMD. Assuming after that you still had part of the RMD exceeding your living expenses your choice would be to invest that money in a taxable account or pay down the mortgage. That's a personal decision that balances your willingness, ability, and need to take risk. If you are contemplating this decision the dominant factor of the three is most likely willingness to take risk. If most of your retirement assets are in retirement accounts I'd probably tend towards keeping that money in a taxable account rather than paying down the mortgage so that you have liquidity. If you plan on selling the house and moving at some point you'll value liquidity.

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jabberwockOG
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by jabberwockOG » Wed Sep 19, 2018 7:56 am

I'd personally I'd sell of a few investments from my portfolio to pay the home loan off. Equity prices are at historic highs so not a bad time to convert to guaranteed long term return by paying off the loan.

euroswiss
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by euroswiss » Wed Sep 19, 2018 8:29 am

jabberwockOG wrote:
Wed Sep 19, 2018 7:56 am
I'd personally I'd sell of a few investments from my portfolio to pay the home loan off. Equity prices are at historic highs so not a bad time to convert to guaranteed long term return by paying off the loan.
That’s my inclination too - lock in the gains.

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Nowizard
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by Nowizard » Wed Sep 19, 2018 8:57 am

Thanks for the comments so far. Here is my more detailed assessment:
Mortgage of $330,000. Interest payments approximately $11,000 annually with 24% "returned" as IRS deduction in the past. Total cost of mortgage: $11,000 - 24% (2,640) = $8,360. Assume the $330,000 is invested at a rate of return averaging 5% or asset gain of $16,500, an amount reduced by 24% (Short term gain) or $3,960 based on IRS deduction in prior years. This produces a net of $16,500 - $12,320 = $4,180 annually from this approach in the past. In 2018 the net gain with no mortgage deduction is $16,500 - (11,000 + 3,960) = $1,540 annually. There are other factors such as a higher or lower rate of investment return and decreasing mortgage principal of approximately $700 monthly.
This does not seem to be a worthwhile return, and higher returns are not to be reasonably expected. However, assume that we withdrew $330,000 from retirement and pay the mortgage (gulp!). Based on our 2017 taxable income, our taxes for 2018 would increase by $42,560 if the $330,000 were withdrawn in a lump sum. There will also be a taxable income increase from RMD's.
This makes it seem like the best approach is to take our MRD's as required, add that to SS and pension income and pay down the mortgage over time with any excess.

Tim

ShowMeTheER
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by ShowMeTheER » Wed Sep 19, 2018 9:20 am

I am in a similar position as you in regards to mortgage balance, mortgage interest rate and tax bracket... although not in retirement/MRD years so money would be coming from after-tax funds.

I am going to split the baby and pay it down by about 1/3 and then let the rest ride at the 3.49% mortgage interest rate for the remainder of the loan... or until the next material change in safe rates of return is upon us.

Tax reform certainly altered the impact of mortgage balance, and in my case significant property taxes too. But, all in all it was a financial win so nothing much to complain about.

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Nate79
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by Nate79 » Wed Sep 19, 2018 9:42 am

Any prepayment of the mortgage, whether paying it off or just putting one extra dollar gets you a guaranteed 3.5% after tax return. So the question that was already mentioned is do you think that if you instead put the money in the market however you have it invested it will beat a 3.5% after tax return over the remaining period of the loan?

mortfree
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by mortfree » Wed Sep 19, 2018 9:59 am

This is how I would look at it (and I’m probably wrong).

You are retired. You can pull 350k or so to pay the mortgage off.

Which means you have 350k plus x. Call x 650k for round numbers.

So you have 1 million working for you and 325k working against you.

If you payoff the mortgage you realize the interest savings but now you only have 650k working for you.

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Watty
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by Watty » Wed Sep 19, 2018 10:30 am

Nowizard wrote:
Wed Sep 19, 2018 6:48 am
.....we could pay off the mortgage but have chosen to invest the "extra" $325,000 with the belief that we can obtain a greater return than 2.66% plus 24% of investment returns.
Investing the money and earning a higher return is harder than it sounds because you have a sequence of return risk. Here is a simplistic example that I have posted before.
 If you do not pay it off then you will have more sequence of returns risk. For example in rough numbers if you just kept a $100K mortgage and also put $100K into a separate investing account which you also pay a $500 a month mortgage out of then;

a) If you get unlucky and get a modest 10% decline in the portfolio the first year then it would be down to $90K
b) You would also need to pay the $500 a month mortgage($6,000) so your portfolio would be down to $84K
c) To break even the next year you would need to gain back the $16K and another $6,000 for the next years mortgage payments which is $22K. That would take a 25.6% return on the remaining $84K just to break even.
In addition when you use the mortgage like that it is essentially a negative bond and if you subtract that out of your asset allocation calculation you may have a much riskier asset allocation then you were planning on.

For example if you have a million dollar portfolio and you want a 70% stocks and 30% bonds you would have $700K in stock and $300K in bonds. If you get $325K mortgage and buy stocks with that money you then have net holding of $1,025,000 stocks and -$25K bonds which give you an asset allocation of over 100% stocks because of the leverage you are using.

Topic Author
Nowizard
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by Nowizard » Wed Sep 19, 2018 12:09 pm

Yes, I do think that over time there would likely be a greater than 3.5% net return, but it would be small enough to not take the risk. The tax hit for a lump sum withdrawal is more than I choose to take at the moment due to having other expenses this year such as an automobile purchase and some others that add up. Seems to me that the best approach is to not take the risks Watty and others have mentioned and pay down the mortgage with any excess available over time. Thank you, everyone, for your responses. It leads to either confirming old thoughts or considering new ones, and a decision that might be made differently by others depending on their circumstances. Ours are, fortunately, such that this is a first-world problem.

Tim

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grabiner
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by grabiner » Thu Sep 20, 2018 9:42 pm

Nowizard wrote:
Wed Sep 19, 2018 6:48 am
Options include:
1. Paying off the mortgage but assets would come from retirement accounts, triggering substantial tax increases;
2. Continue with the current loan balance and payments with the expectation that return on investments would exceed 3.5% plus taxes on gains;
3. Increase charitable deductions to exceed the standard deduction level (Estimated increase of 3-5K to reach the threshold); 4. Pay down the mortgage over time with income from SS, pension and RMD's that exceeds spending
I like idea #1, but you might spread the payoff over multiple years. If you withdraw $325K all this year, you will pay 32% and 35% tax on much of that money. It's probably better to withdraw up to the top of the 24% bracket every year, which will clear the mortgage in a few years.

I don't like idea #2 because the return on paying down the mortgage is risk-free. You can take bonds earning less than 3.5% out of your IRA to pay down the mortgage, without increasing your risk.

For #3, given that you have RMDs, if you want to donate more to charity, it's probably better to make your charitable donations with qualified charitable distributions. These are fully deductible even if you don't itemize, and they don't count as income for other purposes such as the income-related Medicare premium adjustments.
Wiki David Grabiner

Startled Cat
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by Startled Cat » Fri Sep 21, 2018 12:07 am

Watty wrote:
Wed Sep 19, 2018 10:30 am
If you do not pay it off then you will have more sequence of returns risk. For example in rough numbers if you just kept a $100K mortgage and also put $100K into a separate investing account which you also pay a $500 a month mortgage out of then;

a) If you get unlucky and get a modest 10% decline in the portfolio the first year then it would be down to $90K
b) You would also need to pay the $500 a month mortgage($6,000) so your portfolio would be down to $84K
c) To break even the next year you would need to gain back the $16K and another $6,000 for the next years mortgage payments which is $22K. That would take a 25.6% return on the remaining $84K just to break even.
I understand the point you are making, but I don't think this is a fair analysis because it doesn't account for the mortgage payments decreasing your outstanding debt. Using similar logic, you could say that liquidating the $100k portfolio to fully pay off the mortgage is like losing $100k, and no amount of growth is enough to "break even".

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Watty
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by Watty » Fri Sep 21, 2018 4:39 am

Startled Cat wrote:
Fri Sep 21, 2018 12:07 am
Watty wrote:
Wed Sep 19, 2018 10:30 am
If you do not pay it off then you will have more sequence of returns risk. For example in rough numbers if you just kept a $100K mortgage and also put $100K into a separate investing account which you also pay a $500 a month mortgage out of then;

a) If you get unlucky and get a modest 10% decline in the portfolio the first year then it would be down to $90K
b) You would also need to pay the $500 a month mortgage($6,000) so your portfolio would be down to $84K
c) To break even the next year you would need to gain back the $16K and another $6,000 for the next years mortgage payments which is $22K. That would take a 25.6% return on the remaining $84K just to break even.
I understand the point you are making, but I don't think this is a fair analysis because it doesn't account for the mortgage payments decreasing your outstanding debt. Using similar logic, you could say that liquidating the $100k portfolio to fully pay off the mortgage is like losing $100k, and no amount of growth is enough to "break even".
I agree that this is very rough and simplistic.

If the mortgage was at 4% then there would only have been about $4,000 in interest and about $2000 of principal would have been paid off. Which would make breaking even a bit easier.

There would be a tax impact in the second year when they needed to earn $22,000 after taxes and I did not account for the taxes which would make it much more difficult to break even since they might need to earn $25,000 if they had to pay $3000 in taxes on the earnings.

There could also be some tax deductions for the mortgage interest they paid. Inflation should also be factored in. There are probably other factors too.

It would take a complex spreadsheet to model all the factors to come up with accurate numbers but I was just trying to give an easy to understand example of the concept.

bradpevans
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Re: Pay-off or keep mortgage with 2018 interest deduction changes?

Post by bradpevans » Fri Sep 21, 2018 5:39 am

Gill wrote:
Wed Sep 19, 2018 7:27 am
JoeRetire wrote:
Wed Sep 19, 2018 6:50 am
Nowizard wrote:
Wed Sep 19, 2018 6:48 am
We have an outstanding mortgage of approximately $325,000 at 3.5% by choice.

we could pay off the mortgage but have chosen to invest the "extra" $325,000 with the belief that we can obtain a greater return than 2.66%
So do you believe that you can obtain a greater return than 3.5% ?

If so, then nothing has changed, right?
Of course, that’s 3.5% after tax.
Gill
I can't fathom *long term* not beating 3.5%. Some years maybe not, but long term yes.
I also like the idea that the money is in the market sooner when you don't pay down the mortgage.
The sooner its invested, the sooner it doubles, the sooner it doubles again....

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