|Gary Foreman is a former Certified Financial Planner (CFP) who currently writes
about family finances and edits
The Dollar Stretcher website
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We have very nearly paid off our mortgage! We put a lot of spare
money into it because the mortgage had a higher interest rate than
any safe investment we could find. But for some personal reasons we
would like to have a different house, probably one that is nicer
than our current one. My husband says that since interest is
tax-deductible, getting a new house makes financial sense especially
with today's fairly low interest rates. So he's all for it. To me,
as much as I'd like to have a new house, it feels as if we have
finally "caught up with our tails" only to begin chasing
them again. Can you give us some perspective?
Congratulations, Rebecca! It sure
does feel good to own a home without a mortgage. Financial life is
much easier without a mortgage payment.
On the other hand, she and her
husband have a lot of company in wanting a bigger and better home.
According the National Association of Home Builders the average home
has increased in size from 1,500 square feet in 1970 to 2,265 square
feet in 2000. That's a 50% increase in just 30 years.
Rebecca's husband isn't the only one
to think that the deductibility of mortgage interest makes a more
expensive home a good deal financially. But sometimes the
'conventional wisdom' isn't really wise. So let's pull out our
calculators and take a look at mortgages, taxes and housing prices.
We'll assume that Rebecca is in the
highest tax bracket. That would mean she gets the biggest possible
benefit from the deductibility of mortgage interest. In 2002 the top
bracket is 38.6%. So for every dollar of interest that Rebecca pays
the mortgage company her tax bill would be reduced by 38.6 cents.
Not such a good deal. In fact she could cut out the middle man and
just give a buck to a friend. I'm sure that the friend would be
willing to give her 40 cents in return!
Is it really that simple? Probably
not. There are other factors to consider. Some people would argue
that it's still a good deal because of the benefits of using OPM
(other people's money). That's an old idea. And one that does indeed
work well when prices are increasing.
Let's see how it works. Suppose
Rebecca buys a house and she's paying a mortgage at 8% per year. But
with the tax deduction the true cost of the mortgage is really 4.9%.
There are plenty of free
online tax calculators available that can take the guesswork out
How did we get the 4.9% figure? To
calculate the true cost of your mortgage, first you'll need to know
how much your deduction will be worth. To get that multiply the
interest rate on the mortgage (in this case 8%) by your tax bracket
(38.6%). That works out to 3.1%. Next you'll subtract the deduction
rate from the mortgage interest rate to get your true cost to borrow
(8.0% minus 3.1% = 4.9%).
Now back to OPM. For Rebecca to
benefit from the money she borrowed the house would need to
appreciate by more than 4.9%. Is that possible?
The Office of Federal Housing
Enterprise Oversight publishes an index that compares housing prices
going back to 1980. For the first quarter of 2002 housing prices
across the U.S. had increased by 171% compared to 1980. That works
out to about a 4.4% annual increase in price. So it would be close
There were some regional differences.
Some areas did quite well for awhile. But others did not. For
instance, in the Northeast prices dropped after 1989. Prices didn't
return to 1989 levels until 1998. So all housing markets aren't
created equal. Even though you can't predict the future, studying
the history of your community should give you an idea of how lively
the housing market is.
As Rebecca has pointed out there are
also personal reasons to want a nicer home. And only she can put a
value on what a nicer home would mean to her family.
Should Rebecca go ahead and buy the
bigger house? That's up to her. But if they are going to do it, her
husband is right. Low mortgage rates does make it easier. Whatever
they decide I hope that they enjoy their home and it's never a
financial burden to them.