Long-term Interest Rate

Posted by  on Apr 16, 2009
With the significant decline in long-term interest rates during the last several years, mortgage loans with shorter terms have grown in popularity. Assuming a person can afford the higher payments associated with a short-term mortgage, he or she needs to decide which loan term is more advantageous. The deductibility of home mortgage interest, however, is one of the last great tax breaks available to taxpayers of all income brackets.

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.


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