Mortgage Improvement for My CPA
A very successful business associate of mine had a 30-year, $589,000 mortgage with an interest rate of 4.375% on a home he planned to occupy indefinitely. He enjoyed significant benefits from the income tax deduction associated with the mortgage interest. He contacted The Streisand Team requesting a quote for a new 30-year fixed rate mortgage at an interest rate of 3.625%, a rate reduction he believed would produce a significant savings over time.
Instead of the mortgage he requested, I recommended my own solution—a 10-year, 3.00%, Interest-Only Adjustable Rate Mortgage (ARM). This would create a much greater savings because not only would he save on the reduced interest rate, but he would also not pay any principal on the new loan, thus creating an opportunity for a significant tax benefit. In addition, he would gain more control over his cash flow and would be able to invest these additional resources. We also recommended that he increase the mortgage to $750,000. This would provide additional funds, $161,000, to be invested.
His monthly payment with my mortgage solution would be $1,875 versus his existing mortgage payment of $3,745, a monthly savings of $1,870. With my solution, over a 10 year period his total savings would amount to $224,400 ($1,870 X 120 months). In contrast, the 30-year fixed mortgage he proposed would have reduced his monthly payment to $3,420, a difference of only $325. Over the same 10-year period, his total savings for his proposed mortgage would have been only $39,000 ($325 X 120 months).
Being a CPA, he quickly realized the interest-only option I proposed would maximize his income tax deduction since the entire payment would be for interest. Note that on a traditional 30-year mortgage, part of the monthly payment is applied to principal and part to interest, and over time, the portion applied to interest decreases, diminishing the tax benefit. In contrast, the new loan we created for him provided a fixed deduction amount, which is always an attractive benefit for high-income tax rate clients.
He expressed concern about his interest rate risk due to the conversion that would take place in year 10. After discussing the various scenarios, we concluded that if interest rates increased during the 10-year period, we could easily modify the mortgage accordingly. If rates remained in their current range during the 10-year period, in year 10 (when the mortgage converted to a variable rate), we could revisit all options, and in any case he would not be required to keep the variable rate mortgage. I told him that in year 10, he might consider a 5-year ARM, which typically offers an interest rate of about 1.5% below the rate on a 30-year fixed rate mortgage.
My client also realized that in addition to the tax savings, he could invest the money freed up by his reduced mortgage payment, and ultimately use the generated investment asset to reduce the principal amount of the mortgage after year 10. Assuming that we applied these funds ($1,875/month net of tax is $1,037) to a 4.0% tax-free rate of return, this would create an asset of $152,678 with the additional cash out of $161,000 the investment account would have grown to $392,722.
One other factor must be considered. To fully compare the two mortgage scenarios, the amortization of the principal on the old mortgage during the 10 years would amount to 119,000, giving a savings of 43,678 ($152,678 less $119,000). Therefore the benefit of our recommendation using a 4% rate of return over 10 years is $84,007. Note that with a 5% rate of return (not unreasonable), the benefit would be $116,565, and with a 6% rate of return, it would be $152,254 (see diagram).
In summary, by applying this optimal strategy to restructure my client’s mortgage, we allowed him to (1) enjoy a significant tax benefit and (2) gain control over his cash flow. He was able to invest these newfound resources to create a significant asset that would ultimately outperform the net after-tax interest cost of the original mortgage. In addition, should the home increase in value (as expected), he would accumulate this additional wealth.