The key to successful tax planning is learning how to select the best tax-saving strategies to accomplish your specific goals.
My job is easy: pick the right strategies. Your job is tougher: Pick your goals. Goals change due to various events over a lifetime. You get married, have kids, start a business, you get the idea. One event that comes into the life of most successful people is buying a home. Almost every reader of this column who calls me for tax advice has goals that include: “Pay off the mortgage on my home(s).”
Okay, here’s the question: Is it smart to pay off your home mortgage? Or would it be smarter to borrow as much as you can (via a mortgage or home equity loan) using your home as collateral?
Let’s start with a few quotes from an article written by Steven Marshall and Mike Lowe titled, “How the Affluent Manage Home Equity.” “Thousands of financially successful people, who have more than enough money to pay off their mortgage, refuse to do so.”
The article goes on to say, “They go against many of the beliefs of traditional thinking. They put very little money down, they keep their mortgage balance as high as possible,… and most importantly they integrate their mortgage into their overall financial plan to continually increase their wealth. This is how the rich get richer… While paying off the mortgage saves us interest, it denies us the opportunity to earn interest with that money.”
The most thorough and simple explanation of this keep-your-mortgage-high-and-invest-the-extra-funds is in Ric Edelman’s book, The New Rules of Money. It’s a great read. Edelman tells the story of two brothers. Both earn the same amount and buy $200,000 homes. Brother A puts down $40,000 (all of his savings) and gets a 15-year mortgage at 6.38%. He also pays an additional $100 extra each month to his lender to eliminate his mortgage sooner.
Brother B only puts down 5% ($10,000) on his $200,000 home and invests the $30,000 balance (of his $40,000 savings). He secures a 30-year, interest-only mortgage at 7.42%. As a result, his monthly mortgage payment is $428 less than Brother A. So he invests $528 every month (the $428 plus the same extra $100 his brother is paying to his lender). Brother B’s investment account earns 8%.
Next, Edelman does the math, including tax savings. After 30 years, Brother A has $613,858 in savings and investments. Brother B has $1,115,425.
Sweet deal for Brother B. Of course, both brothers now own their homes mortgage-free. So Edelman points out that Brother B can once again mortgage his home and “Start fresh to enjoy the same benefits once again.”
Now for the reason I was motivated to write this: a series of articles in The Ruff Times, a delightful, easy-to-read investment newsletter, written by Howard Ruff.
“I will teach you in the next few issues why it’s a good idea to borrow as much of your costly, non-producing equity [in your home] as you possibly can and put it to work in safe, income-producing investments,” Ruff writes. “Your mortgage-loan interest payments are tax-deductible… It is also simple interest. Your can put the money to work, even at a lower stated rate, as long as it is a safe, secure place… because that will be compound interest.
“For example, in most cases you shouldn’t have an interest-only loan, but in this case maybe you should, because if you are merely paying interest, your monthly cash outlay will be lower, the tax benefits will stay the same. Just make sure you are earning more than you are paying out.
“So borrowing against the property and putting it to work is a sound strategy. Spending the money on ‘things’ is a bad strategy. I am now borrowing against my Northern Utah home…. I am now researching to see where I can get the biggest safe return as I put that mortgage money to work, producing income in excess of the cost of the mortgage.”
Let’s summarize the simple arbitrage strategy: 1) borrow against your home; 2) invest the mortgage proceeds in a safe investment that earns more than the cost of the mortgage and 3) enjoy the tax benefits of a mortgage interest deduction.blog comments powered by Disqus