Question: As a result of divorce, I received a large cash settlement that would enable me to buy a home without a mortgage. Many of my wealthy friends tell me I'm crazy not to take out a mortgage because I could invest my cash and come out ahead. I could never understand this, because the interest I would have to pay on a mortgage exceeds what I could reasonably earn from a conservative investment like a municipal or GNMA (Government National Mortgage Assn.) bond. My deductions do not exceed the standard deduction. I am a wage earner in approximately the 40% bracket with a substantial part of my income already coming from municipal bonds. What is the best investment strategy for me? Incidentally, I currently share an apartment in which I am very content for $350 a month.--T.H.G.
Answer: I hope you understand that this reluctance to go into debt strikes at the very core of America's moral fiber. Where would the country be if everyone paid cash for everything?
The attitude of your wealthy friends is, admittedly, the current conventional wisdom--mortgage interest and property taxes are deductible (and, in spite of tax- reform rumbling, seem destined to stay in place), and the tax deduction, as we all know, is the cornucopia from which all blessings flow.
"Conventional wisdom," however, has been undergoing some significant changes recently, part of it as a result of basic changes in the economy and part of it--real estate experts say--because today's buyers are getting smarter.
The key "basic change" that we mentioned has to do with the erosion of inflation as a major consideration in our planning. A few years ago, with inflation running at, say, 13%, taking on as large a mortgage as possible costing you 12% a year made sense because, in effect, you were "making" 1% a year simply by being in debt.
And, for those holding older mortgages carrying interest rates of 8% or 9%, it, again, made sense not to accelerate your mortgage payments when you could invest this money at 10% or 12%.
But times have changed, and inflation is running at a tad under 4% a year, mortgage interest rates (although dropping) are still relatively high (at about 12%), which makes the "real" interest rate about 8%. At the same time, most money-market rates are in the 7% to 8% range, so there's not much, if any, advantage in taking the money you would otherwise use to pay off your mortgage and investing it in something with a higher yield.
All of these things combine to make the idea of outright ownership of your home a lot more reasonable than it might have been regarded three or four years ago, and it's a far less lonely position you occupy too. About one out of every seven mortgages written today, in fact, is for 15 years--a dramatic shift away from the traditional 30-year mortgage and is clear-cut evidence that a lot of people are sharing your views about the desirability of owning your place free and clear--and the sooner, the better.
As far as having a mortgage is concerned, it's a little bit like looking at a doughnut and seeing either the hole or the dough surrounding it--what the mortgage is really costing you on the one hand, or the high percentage of that cost that is deductible on the other hand.
I don't know, of course, how "large" a divorce settlement this was, but if it is sufficient to buy a home outright, we're looking at pretty big bucks in Southern California--the land of the $135,000 "fixer-upper."
Let's take a "for instance" and talk in terms of a $100,000 settlement--with which you could buy a pretty fair home if you go out far enough, or a pretty nice town house or condo closer in.
If you bought it conventionally you'd pay $20,000 down and take on a mortgage of $80,000 at, we'll say, 12% for 30 years. Monthly payments for principal and interest: $823. Total cost over 30 years: $296,280. Interest cost alone: $216,280--a very chilling thought, indeed.
The other way of looking at this "doughnut" is to consider the fact that--of the first year's payments totaling $9,876--about $9,659 of it is deductible. That's right. During that first year only about $217 of that $9,876 is going toward the reduction of principal. That's how fast your real equity in the home is building up. That's a little chilling too, unless you are thinking entirely in terms of your tax situation.
But, bit by bit, a little more of each monthly payment is going toward the reduction of principal and, sure enough, you finally reach the point where a full half of that monthly $823 payment is going to interest and the other half is going to the reduction of principal.
Unfortunately, it takes the first 24 or 25 years of that 30-year mortgage before this 50/50 split comes about.