A couple weeks ago I was exchanging emails with a friend – and reader – and during the exchange he shared from a discussion he was having with a co-worker about tax deductible debt – think mortgage. It seems that his co-worker – a CFO, trained in the ways of finance – was in favor of maintaining a mortgage for the purposes of the tax deduction rather than paying off the debt as quickly as possible.
I thought it was an interesting topic and discussion so I wanted to share it with you here today.
Here’s the question/discussion as presented:
…as you know I have an accounting background and I got into a great debate with my CFO at work about paying off tax deductible debt vs. managing that debt and taking advantage of the write-off, (a mortgage is a great example). I know that DR would say that most should get rid of the debt because they can’t manage it but if you can, does he still want you to pay it off? My example is my home mortgage which is close to being paid off. I’m watching my tax deduction go away and I’m wondering if I should instead be leveraging that option. Let me know what you think.”
Here’s my response:
As for deductible interest, I say it’s nice while you have it but that it’s not a reason to keep it around. Assuming a 25% tax bracket for the sake of the math… if you have an 8% loan you can deduct 25% of the interest… you effectively lower your rate to 6%. Or stated from the other end, for every $1000 of interest you pay, you save $250 in taxes. You’re spending a grand to save $250. In that case, why not give $1000 to charity and have the same tax deduction?
The former example is probably what the CFO is talking about… using the tax deduction to lower your effective interest rate. Again, just using the numbers above for round math, if you can lower 8% to 6% then you might be able to generate an arbitrage situation. On some levels that makes sense but it doesn’t account for either the income tax you’ll pay on the gain nor the risk of having the mortgage. In accounting or finance terms, the CFO is not applying a beta factor.
Consider the last 18 months as an example. If you borrowed $100k from your home to put into the stock market you’d have a mess on your hands. The market went in half while home values tanked but you’d still have the $100k in debt against your home. In that case, you’re screwed on both ends. However, if you didn’t borrow against your home you’re likely set. Paying yourself a mortgage payment once the house is paid off will make you very wealthy very quickly.
I’ll admit that I’m pretty vanilla in my approach here. I’m opposed to debt and am happy to shed it when I can. However, I understand – even if I don’t fully embrace – the notion that some debt is better than other. I suppose I’d rather have a 0% credit card than a payday loan, but I’d really rather have neither.
In the example above, the CFO is using some sound ideas to try to create an arbitrage situation – think something for nothing if you’re not familiar with the term. If my rate is 8% and I can earn 10% then I’m making money for free – assuming no other variable. Similarly, if my rate is 8% and I can lower it to 6% with a 25% tax deduction on the interest, I can then drop my earning rate requirement to 9% and still make an even larger profit on the spread. It, tugging my ear lobe for a charades-like effect, *sounds like* a no brainer. But the catch is that there are other variables and to ignore them is folly.
For starters, the tax model you use for your favor does have a backlash. Borrowing from the above, your 3% spread is subject to taxes. Using the same 25% tax rate lowers your spread to just over 2%. In additional, there are risks at play. Your investment could tank which would swiftly erode your small spread, your income (job) could wilt which hampers you ability to service the debt, or life could strike in the way of health issues, a new child, or pricey repairs which also impede you ability to service debt.
Sometimes it is easy to out think a situation. Sometimes we like to engineer complex solutions because we can rather than because the situation demands it. Sometimes we have to “say it out load” and recognize that often true elegance is found in a simplified solution. Sometimes we simply need to control those things which are within our reach.
And as I shared above, the last 18 months should serve as a wake-up call in that regard. My current employment, the value of my home, and the stock market are all well out of my control and the more complicated my solution the more likely I am to rely on some or all of those factors to win. However, a paid for home may not be elaborate but it is both in my control and largely insulated from those things outside my influence.
In more than one way, that’s a safe place to live.
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