Q: My husband and I are about 30 years old, have been married three years and have a combined annual income of $40,000. We have no children. We are now renting, paying $500 a month, and are considering the purchase of an $84,000 town house. The down payment and closing costs would be a gift from our parents; the estimated payment on the mortgage would be about $1,100 a month. Would it be a mistake to buy a home now? Should we shelter our money elsewhere? We anticipate a slow but steady rise in income; but the housing expense would then require both our incomes in the future.
A: To come up with a reasonable answer I must make one assumption not explicit in your letter: You both intend to continue with your career plans, and the arrival -- either planned or unplanned -- of a child would be a temporary interruption only.
With that assumption, then I think the purchase of a home with the dollar numbers you talk about is a pretty good way to go. Your joint income means a combined federal and state tax bracket of about 40 percent -- more if you're in a high-tax state.
Because almost all of your monthly mortgage payments go for interest rather than principal during the early years of a mortgage (plus property taxes, also deductible), that $1,100 monthly payment really comes down to about $710 a month. This kind of monthly payment is not as scary when compared with your present rent as the unadjusted $1,100 looked.
And that $710 figure was reached after deducting the entire $3,400 zero bracket amount from your monthly payments; if you have other Schedule A deductions -- and you probably will have some even after the passage of any new tax simplification legislation -- the true cost of your monthly payments will be even less.
In estimating your tax bracket, I didn't take an adjustment for an IRA. Aside from the purchase of a home, the best tax shelter you can find is an IRA -- to the tune of $2,000 a year for each of you.
But I suspect that you may have trouble finding the extra cash during the first few years of your homeownership. For most people there are emotional benefits to owning a home that are at least as important as the tax shelter aspects; so if I had to choose between the two, at your age I would suggest the home first.
Q: My wife and I are retired; the mortgage interest rate on our home is a relatively low 8.5 percent. We have money market funds earning about the same interest rate. I calculate that my federal and state income tax would remain about the same as it is now if we paid off the mortgage with the money in the fund account, because we would lose both the interest deduction and the earned interest income. However, the annual mortgage payment (principal and interest) is more than the income from the invested funds. Have we calculated this correctly? Should we pay off the mortgage balance?
A: Yes, your calculations are correct; elimination of the taxable income and the deductible mortgage interest gives you a wash and leaves your tax situation substantially unchanged.
(I say "substantially" because there are some effects. For example, with lower adjusted gross income -- income before deductions -- you end up with a lower "floor" against any medical deductions. And the amount of AGI may have an impact on taxability of Social Security benefits.)
But the picture would be different if you moved the funds to another investment from the money market fund instead of using them to pay off the mortgage.
For example, as I write this, there is an insured municipal investment trust available paying 8.87 percent current yield -- free of federal income tax, though probably subject to state tax. If you were to move the money into this investment, you would get a slightly higher return and still be able to write off the tax deduction for the mortgage interest.
A move like that makes more sense to me than using the money market funds to pay off the mortgage balance.