Archives for September 2016

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When Does It Make Sense to Prepay a Mortgage?

A reader writes in (in reply to last week’s article about calculating the after-tax interest rate on a mortgage), asking:

“I get that the point of calculating an after-tax interest rate is to determine whether it’s better to prepay your mortgage instead of investing. But where do you draw the cut-off? How high does the interest rate have to be in order for it to be better to pay it down rather than invest? Would looking at historical returns for the funds I own would be useful here?”

Prepaying a mortgage provides a safe rate of return. That is, you know that the return you’ll get from paying down the mortgage is equal to the after-tax interest rate on the mortgage.

As such, generally speaking, what you want to do is compare the after-tax interest rate on your mortgage to the after-tax expected return on the safe investments (e.g., bonds or CDs) that you hold or that you are considering buying.

For example, if your mortgage has an after-tax interest rate of 3%, and you are holding fixed-income investments that have an after-tax expected return of 2%, you’re essentially borrowing money at 3% in order to lend it back out at 2%. In most cases, that doesn’t make sense.

Conveniently, it’s fairly easy to get a decent estimate of the expected return for a fixed-income investment. In most cases, just look at the yield.*

Look at After-Tax Expected Returns

A key point here is that, just like we looked at the after-tax interest rate on the mortgage, we have to look at the after-tax expected return for the investments in question.

In the case of tax-sheltered retirement accounts, the calculation is easy. Specifically, if you would be liquidating assets from retirement accounts (or choosing not to contribute to retirement accounts) in order to prepay the mortgage, the return on the investments in question wouldn’t be taxed, so the after-tax rate of return is the same as the before-tax rate of return.

In a taxable brokerage account, however, determining the after-tax return can be somewhat trickier. It’s simply calculated as the before-tax expected return multiplied by (1 – your marginal tax rate). But your marginal tax rate will depend on your tax bracket, what type of investment we’re talking about (taxable bond? muni bond?), and on other factors such as whether or not you’re subject to the 3.8% tax on net investment income.

A Reason Not to Prepay

Regardless of the above comparison of rates of return, it definitely does not make sense to prepay your mortgage if doing so will cause you significant liquidity problems.

For instance, if you have an “emergency fund” sitting in a savings account earning little to no interest (and you truly would need that money in the event of a large unexpected expense), it’s not a good idea to use that money to pay down your mortgage, despite the fact that doing so would earn you a higher rate of return than the savings account is earning.

*Specifically, you’ll want to look at the yield to maturity for most bonds, the yield-to-worst for callable bonds, and the SEC yield for bond funds.

How Do You Calculate the After-Tax Interest Rate on a Mortgage?

A reader writes in, asking:

“I’m in the process of buying my first home, and I keep reading about how I need to know the after tax interest rate on my mortgage. Does that just depend on my tax bracket or is there more to know here?”

If you’re already itemizing every year before you take out a mortgage, the calculation is simple. The after-tax interest rate on the mortgage is the interest rate, multiplied by (1 – your marginal tax rate). In other words, it’s the interest you pay, minus the tax savings you get back.

Example: Celeste is unmarried, with a standard deduction of $6,300 per year. She’s in the 25% federal tax bracket and 5% state tax bracket, for a total marginal tax rate of 30%. She already has itemized deductions totaling $10,000 per year, so she chooses to itemize each year rather than use the standard deduction. If she takes out a mortgage with an interest rate of 4%, the after-tax interest rate on her mortgage will be 2.8% (calculated as 4% x 0.7, because she gets 30% of the mortgage interest back in the form of tax savings).*

But in a situation in which you don’t already itemize, a part of the deduction is essentially wasted, because all it’s doing is bringing your itemized deductions up to the level of deduction you would have already had with the standard deduction. And it’s only the amount beyond that point that’s actually saving you any money on your taxes.

Example: Martin and Johanna are married, with a standard deduction of $12,600 per year. They’re in the 25% federal tax bracket and 5% state tax bracket, for a total marginal tax rate of 30%. Prior to taking out a mortgage, their itemized deductions are just $7,000 per year, so they currently choose to use the standard deduction each year. They’re considering taking out a mortgage with an interest rate of 4%.

Despite the fact that Martin and Johanna have the same marginal tax rate as Celeste, and are considering a mortgage with the same interest rate, their after-tax interest rate on the mortgage will be higher than hers, because they will get less tax savings from the deduction than she gets. Specifically, the first $5,600 of their deduction for home mortgage interest will serve no purpose other than to bring their itemized deductions up to the level of the standard deduction. They will only achieve tax savings for any home mortgage interest they pay that is in excess of $5,600 per year.

So for Martin and Johanna to calculate their after-tax interest rate for the first year of such a mortgage, they would calculate the amount of interest they would pay over the course of the year, then subtract $5,600. The resulting amount would be multiplied by 30% (their marginal tax rate) to determine the amount of their tax savings. Then they would subtract that tax savings from the amount of interest they paid over the year to determine the after-tax amount of interest they paid. And if they divide that after-tax interest amount by the outstanding balance on their mortgage, they’ll arrive at their after-tax interest rate.

A key point here is that Martin and Johanna will have to revisit this calculation whenever they want to know the after-tax interest rate on their mortgage, because the figures involved will change over time. (For instance, the amount of interest they pay each year will decline over time as they pay down their mortgage balance. And their itemized deductions from things other than home mortgage interest will change over time as well.)

*This is a simplification. As we’ve discussed before, your marginal tax rate is not necessarily the same as your tax bracket, but I’m keeping things as simple as possible in our examples. We’re also assuming here that all of the interest on the mortgage does qualify for a deduction. (IRS Publication 936 has the details on that topic.) In addition, if you are itemizing, your state income tax can be claimed as a deduction against your federal taxable income, thereby slightly reducing your overall marginal tax rate.

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Are Commodity-Linked CDs a Good Idea?

A reader writes in, asking:

“I’d love to hear your thoughts on Everbank’s ‘5 Year MarketSafe Commodities CD.’ It guarantees return of principle and offers upside on the performance of several commodities.”

A quick perusal of the CD’s fact sheet (available here) shows three important points:

  • The CD is FDIC-protected against loss (i.e., you won’t get back less than you put in),
  • You may not withdraw any part of the CD prior to maturity, except “in the event of death or adjudication of incompetence,” and
  • The CD’s performance is “based on the performance of six commodities [gold, silver, copper, nickel, soybeans, and sugar.]”

The first two points are pretty straight-forward. The trickiness is all in that last point. If a person read only that statement, he/she might think that the CD provides something like the average return of those commodities, but with no downside (i.e., no ability to lose money), when in reality that’s not the case at all.

Instead, your total return for the 5-year period is equal to the arithmetic average of the annual returns for the commodities in question. (That is, with 6 commodities each having 5 different annual returns, they average those 30 different annual returns, and that average is the total return that you would get.)

For example, imagine a scenario in which each of the commodity prices in question goes up 10% per year for each of the five years. Without taking the time to read the details and work through the math, a person might expect that their CD would match the performance of the commodities. That is, they would expect a 10% compounded annual return, for a total return of 61% over the 5-year period. Not bad for a CD!

But that’s not what you would get. Not even close. Instead, your total return over the period would be 10% (because 10% is the average of the 30 annual returns of 10%).

In addition, the calculation of the annual return for each commodity is capped at 50% each year. And given the volatility of commodity prices, it’s not at all unthinkable that such a limit could come into play.

By way of comparison, it’s currently possible to get a 5-year CD with a 2.3% yield, which would grow your money by a little over 12% over the course of the period. So using this commodity-linked CD instead of a more typical CD would only make sense if:

  1. You expect the six commodities in question to increase in price by, on average, more than 12% per year for the next 5 years, and
  2. You don’t care about not being able to withdraw your money prior to maturity.

More generally, whenever a product offers downside protection and an upside that is linked to the performance of something very volatile, you only get a small portion of that upside. That’s the case with fixed indexed annuities linked to stock or commodity prices, and it’s the case with CDs such as this one.

Qualifying for Social Security on a Deceased Ex-Spouse’s Work Record

Just a quick reminder: the 50%-off sale for the 2016 edition of Can I Retire? ends tomorrow. If you’re interested in a copy, you might as well grab one today.

A reader writes in, asking:

“I was married to my first husband for 26 years, then we divorced when I was 51 years old. A few years later, I remarried. Earlier this year, my husband passed away. I am 63 now and I know that I can get survivor benefits based on my deceased husband’s benefit. What I don’t know is whether is it possible to also get a survivor benefit based on the benefit of my first husband, who is also now deceased?”

In short, the requirements to be able to claim survivor benefits on a deceased ex-spouse’s record are identical to the requirements for claiming survivor benefits on a deceased spouse’s record, but with the additional requirement that you must have been married for at least 10 years prior to the divorce.

So, the full requirements are as follows:

  • You were married to the now-deceased ex-spouse for at least 10 years before you got divorced,
  • You are at least 60 years old (exception: in some cases if you are disabled, you can begin survivor benefits as early as age 50), and
  • You are not married, unless you remarried after age 60 (or after age 50, in some disability-related cases).

As with regular survivor benefits, if you are also receiving a retirement benefit, your benefit as a divorced widow(er) will be reduced (but not below zero) by the amount of your retirement benefit.

In a case (such as the one from the reader above) in which you are eligible for survivor benefits on two deceased spouses’ (or ex-spouses’) work records, you simply get the larger of the two survivor benefits if you file for either of them. (You cannot, for instance, file an application for just one of the survivor benefits at age 60 while allowing the other survivor benefit to continue growing until full retirement age.)

You can, however, use either of the following strategies:

  • File a restricted application as early as 60 for widow(er) benefits — or divorced widow(er) benefits — while allowing your retirement benefit to continue growing until age 70, or
  • File a restricted application as early as 62 for retirement benefits, while allowing your widow(er) or divorced widow(er) benefits to continue growing until full retirement age.

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  • How Social Security benefits are taxed and how that affects tax planning,
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“Can I Retire?” Updated for 2016, 50% Off

Can I Retire Front CoverToday I just wanted to give you a brief heads-up that the 2016 edition of my book Can I Retire? is now available. (The prior edition was released in early 2013.)

The book will be on sale for half-off through Tuesday (9/6). That is, the paperback version will be on sale for $7.50 (rather than the usual $15), and the Kindle version will be available for $2.49 (rather than the usual $4.99).*

To be clear though, for anybody who has read a prior version of the book, I would frankly not recommend purchasing the new version just to see the changes, as the changes are modest. (The biggest changes are simply updates to the tax-related information in the book.)

For those who haven’t read the book, the chapter listing is as follows:

  1. How Much Income Will You Need?
  2. Safe Withdrawal Rates and The “4% Rule”
  3. What if 4% Isn’t Enough?
  4. Retirement Planning with Annuities
  5. How Much (and When) to Annuitize
  6. Asset Allocation in Retirement
  7. Index funds and ETFs vs. Active Funds
  8. 401(k) Rollovers
  9. Roth Conversions as a part of Retirement Planning
  10. Retirement Account Distribution Planning (tax-deferred vs. taxable vs. Roth)
  11. Asset Location
  12. Other Tips for Taxable Accounts

You can find the paperback version here:

And you can find the Kindle version here:

*While I’ve temporarily offered new editions of Kindle books for free in the past, I don’t think I’ll be able to do that going forward. Last time (with Social Security Made Simple) several parties distributed unauthorized versions in numerous places online, and I have spent entirely too much time battling the copyright infringements.

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Can I Retire Cover

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  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
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A Testimonial from a Reader on Amazon:

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