Can someone explain the whole mortgage/savings interest thing to me!

[Free Thinker]

I keep reading on here where you shouldn't make big payments or pay off your mortgage b/c the interest is a tax deduction, and since you could be making $$ on the $$, you should invest it instead. I just cannot seem to work out the numbers, so I am going to give a little scenario, it's not real, I just thought it might hlep me understand.

Okay, say I have a 250,000 mortgage, and I have 100,000 in cash. How will I be ahead financially to invest this money over putting it on the mortgage? Also, say I am in the highest tax bracket (I am in MIssouri, if anyone knows that rate?). Is the interest money just taxed as capital gains? Or does it count as interest? What rate will it be taxed at. HOw much will I get to take off on my tax return (Say I make $150,000 or more)? I am not sure what interest is right now, as we don't currently have a mortgage, but just use the current rate for today, for someone w/ good credit and above income level.

Thanks! I am really hoping someone can explain this to me using numbers!

[p.s]

Here is a very recent thread on this very topic, including my response (last one, thread-killer that I am ): http://www.mothering.com/discussions...d.php?t=508274

I hope this does not offend you, but the parameters you've given are kind of vague, and there is also other information that would be pertinent to figuring out the best tax situation for you. It sounds like you are asking for accounting advice/numbers crunching; I am not an accountant, but given your post with batch of criteria, I would really strongly recommend talking with a good CPA. Sounds like, even the small consultation fee would be more than compensated by the savings from advice.

[Free Thinker]

I'm not offened That was the thread I kept reading! I keep trying to do the number crunching, but I still don't get it! I'd LOVE to understand it, though! We do have a CPA, and he suggests us to not pay off everything so fast (we have a small business) but we always just pay it off ASAP b/c we don't like "oweing" for anything. HOw do you figure out how the interest earned on said 100,000 (say it's 5,000 per year) is counted on your tax return? Is it capital gains (and at what percent is it taxed) or is it included as just "income" and you pay income tax on it, too? How is the tax deduction from interest paid taken off? My DH and I keep talking about this, and I guess we just dn't get it. Say you owe 100,000 at 7%, and have a CD of same amount, 100,000 drawing 5%, so in one year you have:

Paid 7,000 interest on mortgage (okay, so I know this is not exact)
Made 5,000 interest on CD (agian, not exact)

You made 100,000 from working, so you own roughly 36,000 in taxes. You get to deduct the 7,000 in. paid (93,000 income) but you made an extra 5,000 from the CD (98,000 in income) so now you only owe 35,280? Meaning you saved $720?

Or

You made 100,000, so you owe 36,000. You paid 7,000 in interest, so you have an income of 93,000 (making taxes 33,480) and you had a capital gain of 5,000 (which you owe capital gains tax on 13%? I ca't remember $650) making total taxes owed 34,130 (so you saved 1,870).

Am I doing this right? Anyone know?

[velochic]

It's a little complicated, but I'll try to help you out. I'm not a CFP nor an CPA, but I do manage our investments.

First of all, the tax benefit you get from your mortgage is that you can take the mortgage interest paid + property taxes as deductions from you federal income taxes when you itemize on your taxes and do not take the standard deduction.

(BTW - knowing you're in Missouri doesn't help because each county/township has different rates of property taxes.)

So, let's assume you have a mortgage of $250k. That means that you will pay about $15,000 in interest on a 30 year fixed loan of 6% (about the going rate). The standard deduction is $7300, so you've already beat the standard deduction and you should itemize. If you pay an additional $5000 per year in property taxes, then you have a total of $20,000 you can claim as a deduction on your taxes to get you adjusted gross income (AGI) down as low as possible. Your marginal tax bracket is based on how much tax you pay on your last dollar, so this is very important as it can lower your marginal tax bracket. Lower tax bracket = less money paid in income taxes AND how much you pay in short term capital gains.

But let's say you are STILL in the highest marginal tax bracket. That is that you are married, filing jointly and earn > $336,550. You are in the 35% marginal tax bracket.

To make it very, very simplified, by itemizing, you are saving 35% of $12,700 or $4445. If that was the only thing to think about, then it wouldn't be worth it to carry a mortgage just for the deduction. It turns out the deduction is just a small perk because the REAL return comes in investing that money you would pay on your mortgage.

Since its inception, the stock market has earned about 11% annualized. That means that over the long haul - 15, 20, 30 years - you can be relatively sure to gain about 11% on your investments before taxes. After taxes and fees about 8.5% - 9% is a realistic number assuming you chuck all of your money into index funds (a passive investment strategy) that earn what the stock market indicies would earn. Already, if you hold a 6% mortgage, you're gaining 2.5% - 3% per year over that. Moreover, assuming you don't cash out the investments within 12 months of the investment, you will only pay 15% taxes on capital gains... NOT YOUR MARGINAL TAX RATE! You only pay your tax rate if you cash out and take short term capital gains.

Where it gets complicated is that if you invest in equity mutual funds, that fund manager is buying and selling stocks within that fund (this is called "turnover") and the higher the turnover rate, the more short-term capital gains taxes you will pay on your investments. I hope that makes sense. When a fund manager buys and sells within the fund, you will pay capital gains taxes on that. You will also pay capital gains on dividend distributions within the funds. That is why when you are choosing funds for your portfolio, it's important to buy "tax-efficient" funds if you are in this higher tax bracket.

So by carrying your mortgage you are getting the tax break based on your marginal tax bracket, plus you are gaining about 3% or more annually by investing the money in mutual funds (I don't do stocks at all, as I know I cannot beat the professional fund managers returns you get in mutual funds). But it boils down to what funds you actually hold and their tax efficiency that will give you your final numbers.

For actual figures, talk to a CPA this spring when s/he is doing your taxes and they can give you a concrete number based on your taxes and investment level. For us, I estimate a net gain of about $10,000/year for carrying a mortgage.

If you are going to hold your money in cash and you don't want to invest it, then the above is all moot and you should just pay off your mortgage.

[Free Thinker]

ACK! THis is where I get all confused! I guess right now I don't need to worry about it, b/c we currently don't have a mort. but if we build in a few years, I'd like to know if we should have a large down payment, or if we should invest it instead. Right now we are saving our money,a nd I just put it in a CD drawing 5.44 APY? That was the highest I found, and it's just an 8 month CD, afterwich I will try to figure out exactly what to do w/ it since I know we won't be using it for at least antoher year or more. I guess the key is to see what we are making, and see if the proposed interest knocks us to a lower tax bracket? Is that right? I know we won't make more than you posted for sure!

Also, on the mutual funds, how do I know that the funds I put money in are the right kind? Honestly we know not very much about investing, and are trying to learn! We have started putting our IRA money into a mutual fund instead of a low paying CD in the last year or so, so we should start doing better! DH is just kind of leary of putting a significant amount of money into a Mutual fund, so we are only putting in our yearly allowances, and then banking anything else for our "house fund." We wer planning on having a large part of the house money saved before even starting to build (in 2008-2009) but maybe we should put that money in another type of Mut fund and plan to just pay a mortgage? I just DO NOT know!

[Herausgeber]

You really, really need to find a good financial planner. Preferably someone who is fee only. Ask your accountant for recommendations.

[velochic]

Free Thinker, you can learn this stuff by just reading some good books. I disagree that financial planners are worth their fees (even fee only ones). They're just going to help you with your asset allocation (and charge you anywhere from $800 - $2500) and you can figure that out if you educate yourself. And you know your investing personality better than anyone. You know the level of risk you are willing to take.

Check out these resources for educating yourself:

"A Random Walk Down Wall Street", by Burton G. Malkiel

"Investing for Dummies", by Eric Tyson

"Mutual Funds for Dummies", by Eric Tyson

"Boglehead's Guide to Investing", Taylor Larimore, et al (I actually post to some investing boards and the authors of this book hang out there and will answer your questions)

"Common Sense on Mutual Funds", by John Bogle

Also check out books by William Berstein (Four Pillars of Investing) and Larry Swedroe (The Only Guide to a Winning Investment Strategy...).

Check out the tutorials on Morningstar.com.

Financial Planners want you to think you're going to fail in investing without them. It's simply not true. There are tried and true principles that if you read them, learn them, and follow them, you can invest with confidence (things like "don't try to time the market... invest for the long-haul"). If I can do it, so can you. I will say one thing... I invest only in mutual funds. I feel that you would have to buy 100 stocks to be as diversified as mutual funds allow you to be.

Read these books and then you'll feel much better about making your financial decisions.

[velochic]

Oh, and if you are going to be using the money in a couple of years or less... you're doing the right thing with CD's. Keep it in cash, don't invest it. Maybe check out some Money Market Mutual Funds like the ones at Vanguard.com or Fidelity.com. You will get as good or better rates and the money is much more liquid... so liquid you can write checks from these accounts and still be getting like 5.5+ percent, compounded DAILY. (Of course, they have minimum balances, though.)

[Herausgeber]

I like velochic's book list (even though we disagree on the usefulness of financial planners ), and I would add Andrew Tobias's The Only Investment Guide You'll Ever Need. I bought it when I was 19, and I doubt I would have half the assets I have now without the early nudge and education I got from reading that book.

Even using a good planner works best if you are also educating yourself along the way. I don't think you should ever be dependent on one, but sometimes they can be a great help in getting the overall picture in order, especially if you are feeling paralyzed by all the options. IMO, the most important financial decisions aren't a matter of squeezing an extra percentage point of interest out of your emergency savings or shaving $20 a month off your grocery bills; they're about using the right mix of tools to meet your short, medium and long-term goals. As velochic pointed out, even carrying debt can be a great tool for building wealth. I know I am in no hurry to pay off my 4 percent interest student loans or my 6 percent mortgage while my other investments are gaining 8-10 percent.

[WNB]

Originally Posted by Free Thinker

I'm not offened That was the thread I kept reading! I keep trying to do the number crunching, but I still don't get it! I'd LOVE to understand it, though! We do have a CPA, and he suggests us to not pay off everything so fast (we have a small business) but we always just pay it off ASAP b/c we don't like "oweing" for anything. HOw do you figure out how the interest earned on said 100,000 (say it's 5,000 per year) is counted on your tax return? Is it capital gains (and at what percent is it taxed) or is it included as just "income" and you pay income tax on it, too? How is the tax deduction from interest paid taken off? My DH and I keep talking about this, and I guess we just dn't get it. Say you owe 100,000 at 7%, and have a CD of same amount, 100,000 drawing 5%, so in one year you have:

Paid 7,000 interest on mortgage (okay, so I know this is not exact)
Made 5,000 interest on CD (agian, not exact)

You made 100,000 from working, so you own roughly 36,000 in taxes. You get to deduct the 7,000 in. paid (93,000 income) but you made an extra 5,000 from the CD (98,000 in income) so now you only owe 35,280? Meaning you saved $720?

Or

You made 100,000, so you owe 36,000. You paid 7,000 in interest, so you have an income of 93,000 (making taxes 33,480) and you had a capital gain of 5,000 (which you owe capital gains tax on 13%? I ca't remember $650) making total taxes owed 34,130 (so you saved 1,870).

Am I doing this right? Anyone know?

The tax rate depends on the type of income. Wages are taxed at various rates ranging from 0 to 35% (something like that, not sure what the actual max rate is). Interest income (like from CDs) is treated like wages. Money made from other investments (like the sale of stocks or bonds or a house) is considered a capital gain (or loss, if you lose money), and it is taxed at a 15% rate for "long-term" gains -- gain from an investment held at least 1 year. (I am not sure what the short-term capital gains rate is.) Dividends (earned when you hold stock in a company that decides it is going to pay out some of its profits to the shareholders) used to be treated like wages, but I think now are counted as capital gains and taxed at a more favorable rate.

[p.s]

Just checking back on this thread...and really gland that Velochic weighed in b/c I'm not good with numbers

I would also second the rec'ed books; my personal favorite being Andrew Tobias' b/c of his sense of humor.

For a good basic investing 101, Eric Tyson's book for Dummies (and any AMERICAN who has saved up enough to have to "worry" about how to invest it is NO dummy).

We have both stocks and funds, but being super conservative for our age, have a disproportionate amount in too conservative venues.

I think the bottom line is if you have all the bases covered (not living on the edge and saving), then what is most important is what allows you to sleep well at night. Some people sleep better without a mortgage. Some like to take the risk that their money could earn more in stocks/funds, and invest it.

I enjoy reading finance stuff and am a card carrying member of the doomsday club. Historical trands aside, I think the world and economy are changing, mainly b/c of burgeoning populations and rapidly declining resouces. Looked at globally, US America is a voracious hog on a feeding stampede (IMO) and this can't be sustained. Japan and EU are little brothers, that additionally have unsustainable social benefits and fiscal policies. China, India, and whatever second and third world countries are scrambling faster that you or I can think or believe, to get their share of the economic pie, while completely disregarding the enviroment.

Which leads me to my point that I don't think the future will be the same as the past. There have always been negative nabobs but IMHO, now is not the same as 20, 50 (post WWII), or 100 y ago as evidenced by population statistics, global climate changes, and even talk about the end of the supply chain. There are swaths of bodies of water whose most populous organism is....algae. And 100 y ago, was the fear of aquifers drying out an issue?

Some of the books that I have also enjoyed reading are all of Peter Lynch's (for one man's view), anything on or by Warren Buffet and Howard Hughs.
Recently read Money, a Memoir...interesting take on women and finances.
For mass medialization of the issues, Thomas Friedman's Lexus and the Olive Tree and The World is Flat.
Currently reading The Coming Generational Storm by Kotlikoff and Burns.
And we get the Economist, which i used to read cover to cover, but now with a baby, just read pertinent articles. IMHO the best way for me as an individual investor to make intelligent decision is to know/understand the world to the best of my ability.