Long-term Interest Rate
Generally, interest paid to buy, build, or substantially improve a personal residence is deductible, provided the debt is secured by the residence and does not exceed $1 million. In the example above, assuming the mortgage holder were in a combined Federal and state tax bracket of 40 percent, the after-tax interest savings of the 15-year mortgage, while still significant, would be reduced to $69,026. Even after taxes, thethirty-year mortgage ends up costing more in interest over the long term. Keep in mind that one may come out ahead by investing the cash-flow savings associated with the lower monthly mortgage payment.
A person could either pay off a mortgage in fifteen years and then allocate the available cash flows to long-term savings and investments, or service the debt for a longer period at a lower monthly payment but start building or adding to an investment portfolio now. Again using the above example, the monthly payment on the thirty-year mortgage is only $973 compared with $1,307 for the 15-year mortgage, a difference of $334. After considering the tax savings on the interest portion of the payments, however, the after-tax differential for the initial monthly payment would be $346. This amount would continue to increase as the interest portion of the 15-year loan payments declines relative to the interest portion of the 30-year loan payments. Investing the additional cash flows in a diversified portfolio of securities or mutual funds on a regular basis could enable one to accumulate more wealth over the long term, depending on the portfolio's long-term performance.
A thirty-year-and-invest-the-rest strategy assumes that during the first fifteen years, the mortgage holder makes monthly investments equal to the additional cash flows associated with lower payments. However, the fifteen-year loan scenario assumes that once the fifteen-year loan is paid in full, one then invests an amount equal to the remaining after-tax monthly payments on the thirty-year loan. Results are projected over a thirty-year period. The following investment and tax-rate assumptions also apply: pretax yield of two percent annually; combined Federal and state ordinary and long-term capital gains tax rates of 40 and 24 percent, respectively; and a twenty-five percent portfolio turnover rate.
The 30-year-and-invest-the-rest strategy would produce a larger after-tax investment portfolio at the end of the 30-year analysis period as long as the investment portfolio enjoyed a pretax annual growth rate of 4 percent or higher. At higher growth rates, this strategy can generate significantly more wealth over the long term.