Home Mortgage or No Home Mortgage

Home Mortgage or No Home Mortgage

Having mortgage debt on a personal residence is an interesting paradox for many wealth creators.  No matter how much risk you might currently be exposed to via business or investments, the home, and mortgage financing, create a tension that is caused by:

  • The family home is a naturally supercharged emotional topic
  • The differences in how each person was raised and what role money, and specifically debt, played in your history
  • Your investment experience and comfort with debt

3 common strategies for debt

In general, wealth creators fall into three camps as it relates to having a home mortgage.

  1. Debt free:  These individuals want to pay cash for their home—and generally other major purchases as well.
  2. Quick payers:  They will use financing to purchase a home but will make large principal payments to shorten the life of the mortgage. They also tend to choose shorter-term mortgage products like 15 year mortgages. Note:  these people tend to struggle when an expensive home purchase or home development project is funded with debt, even if only for a short period of time.  The size of the debt balance fosters increased stress levels, ultimately becoming the impetus to rapidly reducing the outstanding balance.
  3. Debt analyzer:  These people view home mortgage debt as a choice, in essence, an investment decision.  Because they have ability to be debt free (as is the case with most wealth creators), it really comes down to whether they believe their other investment assets will return more than the after-tax cost of the mortgage.

 

What is the after-tax cost of a mortgage?  

This is most critical to the debt analyzer.  Because the interest paid on a home mortgage can potentially be an income tax deduction, the after-tax cost of the mortgage is generally a rate lower than the stated mortgage interest rate.

For example, an individual with a 5% mortgage, in the 35% federal marginal income tax bracket, and able to utilize all of the mortgage deduction, would have roughly a 3.25% after-tax mortgage rate.

 mortgage rate X (multiplied by) 1 minus the marginal income tax rate

This becomes the bogie or hurdle rate you could use to assess your mortgage decision. In other words, if you have investments that are returning more than the hurdle rate (3.25% in our example) you might decide to place a mortgage on the property.

To the contrary, and applicable in this environment of very low cash returns, you might choose to take low yielding cash—essentially zero—and pay down the higher cost mortgage debt.

In both cases, it boils down to an investment allocation decision.

Four keys to smart mortgage decision-making

  1. Find a mortgage broker that is able to review various options, not just sell product.  This will require running scenarios and alternatives to make sure the debt solution is customized to your needs.  (I will be writing more about this shortly.)
  2. Understand what your emotional tolerance is for debt, and how it might differ from your spouse.  What you learned about money from your parents (your money history) will have a huge impact on your debt strategy.
  3. Know your payback plan.  If you are going to use debt financing for your home, explore the various strategies that will optimize your payback needs.  This may require the combination of various strategies, for example margin debt, line of credit, and traditional mortgage.  It will also require an understanding of what assets will be used for the planned principal payments.
  4. Be cognizant of the many specific tax considerations regarding mortgage financing; tax deduction phase-outs and debt balance limits to name a few. Make sure to review any mortgage with your CPA before you sign loan documents or take action.
John Christianson
john@highlandprivate.com
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