When you should (and shouldn't) keep tax-deductible debt

Some people keep low-interest, tax-deductible debt in an attempt to earn more on their investments, playing the 'tax game.' But to make it worthwhile, this strategy requires earning back a bigger return on investment than you probably think.

By , Guest blogger

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    A home for sale in Alameda, Calif. Some people will take on debt with super-low interest rates, including some types of mortgages, in an effort to make a return on their investments.
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In a recent article, I discussed why some folks keep tax-deductible debt. One reason relates to the “tax game” – keeping low interest rate, tax-deductible debt and attempting to earn more on their investments.  After a recent discussion about this issue, it occurred to me that this concept is still misunderstood.

Sometimes this argument is a bit oversimplified. For example, if your mortgage rate is 4%, you only need to earn 4.01% to “win” the game, right?  Wrong.  What’s often left out of this argument is one very important factor:  tax implications – both good and bad.

This is best illustrated through an example. Sticking with the 4% rate assumption, we’ll use a beginning mortgage balance of $300,000 and assume a 30-year fixed rate loan.  We will also ignore taxes, maintenance and insurance because you may have those expenses regardless of whether you have a mortgage.  Plugging these assumptions into a financial calculator or spreadsheet and assuming payments are made at the end of each period yield the following:

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  • Monthly payment = $1,432.25 (360 payments)
  • Total interest paid over the life of the loan = $215,608.51

Now assume that you are considering whether to pay this loan off in 15 years or invest that additional payment elsewhere.  The first step will be to determine what that additional payment would be.  Using our trusty calculator or spreadsheet, we find that you need an additional monthly payment of $786.81.  The monthly payment and total interest paid amounts for this scenario are as follows:

  • Monthly payment = $2,219.06 ($2,219.06 – $1,432.25 = $786.81)
  • Total interest paid over the life of the loan = $99,431.48

So paying this mortgage loan off in 15 years rather than 30 years would yield an interest expense savings of $116,177.03.  But this is not your actual savings because you have been receiving a tax deduction for interest paid.  Assuming that you are in the 28% tax bracket and that all of the mortgage interest paid was tax deductible, the net savings would be roughly $83,647.46 ($116,177.03 x 0.72).

We have figured out what the actual savings from paying off the mortgage early, but now we need to compare that to something.  We need to start with considering what the interest savings represents.  The interest savings represents the gain that you would need to accumulate by investing that additional payment over those 15 years in order to break even.  However, to compare apples to apples, we need to adjust the interest savings (the investment gain we are targeting) for capital gains taxes.  Assuming that all gains are long term and that the applicable tax rate is 15%, the result is an adjusted gain of $98,408.78.  If we stay disciplined and invest that extra payment of $786. 81 each month for 15 years, we would invest a total of $141,625.80 ($786.81 x 180).  Adding the adjusted gain from above to the monthly investment amount gives us a future sum needed in 15 years of $239,565.58.  Hang on — we are almost there.

Now we have the interest saved and the future sum needed, but we still need a rate of return to compare to the mortgage rate.  Plugging in the future sum needed ($239,565.58), the monthly payment that we will allocate ($786.81), the amount of time we will invest (15 years or 180 investments), and the amount we currently have allocated toward the future sum (zero), we can solve for the rate of return.  This gives us the following rate of return:

  • Approximate rate of return needed to break even = 6.56%

So in order to be indifferent between the two choices, you need to earn a compound return of more than 6.5% over that 15-year period.  The purpose of this exercise certainly isn’t to say this is impossible, but just don’t be fooled into thinking that it is as black and white as some may make it seem.  That said, remember that this mortgage rate is fixed – a known variable for the life of the loan – while future investment returns and future tax rates are both unknown variables.

This particular example may not fit every scenario, but it can be used a simple way to illustrate my point.  Using this same scenario, a lower tax bracket (less of a deduction) results in a higher spread needed to break even, and a higher tax bracket (more of a deduction) results in a lower spread, all else being equal.

Over the course of my career, I have learned to question everything and to take nothing at face value.  Financial rules of thumb and cultural financial “knowledge,” both of which are commonly shared, are often incomplete or plain wrong. I suggest that you also question the rules of thumb and cultural knowledge to see if they hold up for you. Most likely, they won’t.

Learn more about Matt on NerdWallet’s Ask an Advisor.

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