Q: In the September/October issue of AARP magazine, a column advises a soon-to-retire couple to switch their small mortgage to a much larger...
Q: In the September/October issue of AARP magazine, a column advises a soon-to-retire couple to switch their small mortgage to a much larger one at 6 percent, interest-only, and invest the leftover proceeds in municipal bonds at 4.5 percent.
Apparently, the reason is to gain a tax deduction. I feel this is potentially harmful advice. What is your opinion?
— B.I., Seattle
A: I agree with you. For the vast majority of people soon to retire in America, borrowing is a bad idea.
Here’s the broad brush: A couple can replace an old 6 percent mortgage with high monthly payments with a new and larger 6 percent mortgage that is interest-only for 10 years.
As a consequence, they will have more tax deductions, lower income taxes and more investment income, and they may live happily ever after. (The article is at www.aarpmagazine.org/money/paying_house.html.)
Unfortunately, there is something called the fine print. Here are a few things that weren’t mentioned:
• Risk is real. Interest-only mortgages are variable-rate mortgages. So your payment will rise and fall with interest rates. If interest rates go down, your monthly payment will go down.
Better still, the value of bonds you’ve purchased will rise because of the fall in interest rates. That’s a big win.
But it can also work the other way.
If interest rates rise, your mortgage payment will go up, and the value of the bonds you have purchased will go down. This will make it more difficult to cure the problem by paying off the mortgage.
• Deductions may not be deductible. The standard deduction for a couple this year is $10,000. Unless your itemized deductions are greater than $10,000, you will be better off taking the standard deduction. Worse, you will benefit only from the portion of your itemized deductions that exceeds $10,000.
As I have pointed out in many other columns, most homeowners and most of America will benefit from homeownership tax deductions only if their charitable donations and other deductions exceed the $10,000 standard deduction. Only then will their homeownership deductions reduce their income taxes.
Retired people can often obtain the lowest risk benefit by paying off an old mortgage. It reduces the income they need to meet their expenses. It also means they can have a $10,000 standard deduction with little or nothing in itemized deductions.
So their tax bill goes down with no risk. Because the standard deduction is indexed to inflation, it rises. Only relatively affluent retirees are in a position to benefit from itemized tax deductions.
• Tax-free income doesn’t necessarily lower your taxes. The formula for the taxation of Social Security benefits includes income from tax-free bonds. So even if the newly borrowed mortgage money is invested in municipal bonds, the additional income may cause Social Security benefits to become taxable.
• Fees can reduce your income and benefits. It costs money to refinance a home mortgage. It also costs money to have others manage your investments.
The average municipal-bond fund, according to Morningstar, has expenses exceeding 1 percent a year, while 10-year-maturity AAA-rated bonds are yielding about 4 percent. So you can net about 3 percent and still have interest-rate risk by borrowing, or you can get twice that, 6 percent, simply by paying down the existing mortgage.
On balance, borrowing in retirement is a very iffy proposition.
Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at email@example.com. Questions of general interest will be answered in future columns.