If rising rates are accompanied by lower prices, leading to equal mortgage payments, a larger portion of your payment would go to interest. Is that Good or Bad?

This post is a reply to some commenters with differing opinions.  In an earlier post, I compared two hypothetical home-buyers.  One bought a $550,000 house, with 20% down and a 6.40% 30 year fixed mortgage for a monthly payment of $2752.23.  The other waited until prices declined, but also watched rates rise.  The second buyer bought a $440,000 house, with 20% down and a 8.6825% 30 year fixed mortgage for a monthly payment of.... $2752.23!

I would never encourage someone to pay more for something, or lose money simply for the tax benefit.  It's ridiculous.  Here's a dollar, yippee, I get 33 cents back!

My point was that, despite the same monthly outlay, the second buyer is in better shape.  The reasons, briefly are:

1. Smaller down payment to get to 20%, if anyone still cares about down payments.
2. Lower property taxes
3. Larger income tax deduction
4. Ability to refinance if rates drop again in the future
5. Accelerated payments will have a larger impact

It seems that #3 is the one that some have taken exception to. 

My exact words for #3 were:

3.  Income Taxes.  The entire mortgage payment is not tax deductible (unless you have an interest only), just the interest portion.  So, despite the equal payments, you will pay about $2440 more in interest for the house in the second scenario.  This doesn't sound like a good thing, but it is.  That means a larger income tax deduction.

I received the following comment:

Your point about the mortgage income tax deduction is based on a common mistake. Yes, you get a bigger tax deduction if you pay more interest - but on net you're still paying more money. It's never beneficial to pay an extra $1 of interest just to get $0.26 off your taxes.

To which I noted that in this hypothetical they have an equal monthly outlay, but one has more deductible mortgage interest.  In the end, they are both paying $2752.23 per month, but buyer #2 has approximately $2,440 more in interest in the first year, allowing for a larger deduction.

In response to that I received the following comment:

In response to the response to Ed's comment. Presumably, in the first scenario, the extra 2440 goes to equity, which I expect to get back dollar for dollar at some point. Paying interest, I get back, say, 0.28 * $2440 = $683 in tax deduction. To my way of thinking, I'm down 1757 long term.

Which I have not yet responded to.  The latter comment is the basis for this post.

See the attached spreadsheet.  It is the amortization schedule for the two scenarios.  I am ignoring #s 1, 2, 4 and 5 because no one is contesting those.  Also, for the sake of simplicity we will assume that both homeowners hold the property at least until the completion of the loan.  I know, no one holds property for 30 years.  Let's just pretend for a moment.

So, my response to Walter, the second commenter, is this.  The key difference is somewhat obvious.  It is the $110,000 less paid initially.  This means that, while a larger portion of your payment is going to principal, it is because you have more principal to payoff in the first place.  By viewing the spreadsheet, you can see that in the end, the same payments were made, and some $88k more was paid in interest in the second scenario.  Yes, this means that an additional $88k was paid to principal.  Hmmm... what was the difference in the initial mortgage in the two scenarios?  Look at that, $88,000.

In the end, both own their house free and clear.  We are assuming that the two are basically the same house, just that one purchased today at high prices/low rates, and the other bought later at lower prices, but higher rates.  The additional $88k that went to interest means an actual tax savings of roughly $29k assuming roughly 33% tax rates.  Which brings us to our third comment:

The "deducting interest" argument also assumes that you will pay enough interest - or have enough other combined with other deductions - to exceed your standard deduction. And even still, the part that is in leiu of your standard deduction can't really be counted, can it?

In our hypotheticals the amount paid in interest is 28k in the first case, and 30k in the second.  In either case, it is higher than the standard deduction, which was $10,000 for married, filing jointly in 2005.  No, not all of it is a tax benefit if they don't have any other significant deductions.  But the incremental difference does matter.  In other words, if they have NO other deductions, the benefit is a tax deductible amount of $18k for the first, and $20k for the second.  Remember, this amount will go down each year, as more goes to principal and less to interest.  Nonetheless, it's as much a real benefit as lower property taxes, which no one had any problem with.

Bottom Line:  tax savings is, in fact, a benefit to buying a lower priced property at higher rates.  It is complicated, and not the largest of the five benefits.  In fact, it may be the smallest one.  But it is a benefit.

Comments

[Bronco]

nicely done...! more people need to understand this concept.

[financial freedumb]

Nice details...Thanks! Makes me feel a little better about waiting even though I don't know which way this housing market will move.

[J]

Depends, if you wait more than a year renting, then your a year behind paying it off. And that's assuming the house drops $110k. What if it doesn't drop that much? Only 5%? And you've waited three years to buy? You've lost that time paying rent instead of paying down equity. It's only based on location, there is no bubble in areas where there has been minimal appreciation, so waiting for prices to drop is moot.

[lamoneyguy]

J, I love receiving comments on old posts that I had forgotten about. The basis of this post was a comment that it doesn't matter if rates went up and prices dropped because your monthly outlay would be the same. I was trying to prove that it matters a lot. So, the assumption going in was that prices would drop enough to offset a rise in interest rates.

As to being a year behind in paying off the mortgage. It's a valid point. However, a very small amount of your payment in the first year goes to principal. So, if we are staying with the assumption that prices decline, you are still better off waiting. Of course, if you don't think prices will decline, then it's a totally different story.