I was 11 years old and Dwight Eisenhower was the new president of the United States the summer my parents bought their first house. I was always curious about the details of our family's finances, and Dad, who was an accountant, always was eager to teach me. I recall that our 90-year-old house cost $15,000, and the interest rate on the mortgage was 4.75%; funny how those things stick in your mind.
My father's salary at the time was $7,500 a year, which sounded like a king's ransom to me. But his monthly take-home check was only about $450, and the mortgage payment took $100 of that. I was too inexperienced at the time to think of this housing payment as a manageable 22% of take home pay. But I did realize that the mortgage payment was a lot easier to handle than the $150-a-month rent Dad had been paying for our previous address. I remember thinking, "Isn't that odd; you can own your own house for less than it costs to rent one!" That impressed me.
Need A Deduction?
U.S. income tax policy is certainly arranged to favor the American dream of owning the roof over your head. Years ago, when Congress in its wisdom decided that interest on car loans and credit cards would no longer be deductible from taxable income, they didn't have one second's debate about the deductibility of home mortgage interest; that was and is a sacred cow. It is such a cultural icon that many retirees who can afford to pay off their mortgages feel like they are foolish not to owe the bank money!
Take the case of Doris and Robert Mayer. At the end of this year, they plan to retire at age 64 from their teaching careers. They live in a pleasant but ordinary brick ranch-style home, which they bought new in 1984 for $100,000. As the trees in their subdivision have matured, the value of their home has grown to something like $225,000. Including a home equity loan they took to buy a new Buick two years ago, they owe the bank a total of $50,000 and their payments are $1,000 a month.
When Bob and Doris first came to our offices, they asked us to help them decide whether to pay off their mortgage and home equity loan when they retire, a simple enough assignment at first blush. Doris thought that it would feel wonderful to have no debt on their home, but Bob figured it might not be wise to lose the tax benefits. You probably hear this sort of question frequently.
I've discovered that many people think about their retirement housing decisions purely in financial terms, and their imagination does not wander beyond the home they now occupy. For many, I think this is because they feel insecure as they contemplate life without a paycheck. Others simply seem to be content where they are.
After getting a bead on the Mayers' living expenses and retirement resources, I prodded them a little bit about their dreams and changes in lifestyle that they might enjoy. But this was a stoic pair. They grew up in central Maryland, and this is the only home they need or want. "Just tell us if it makes sense to pay off the loans!" OK, OK.
The blended interest rate on the loans was 7.5% or $3,750 a year. My first question was, "If you pay off the loans, where will the money come from?" "From our joint credit union account," they replied in unison. "Well, there are a couple things to consider," I offered. This year your marginal federal, state and local tax rate will be 34%, which means the deduction saves you roughly $1,250. So, your after-tax cost of the loan is $2,500.
"Now contrast that with the $1,000 interest you earn by keeping $50,000 at 2% in the Credit Union, which is really only $660 of after-tax income. It's easy to see that you would be $1,840 ahead of the game by taking the money out of the bank and paying off the loan. And you would feel better, too."
Bob and Doris left the office holding hands. Paying off the house had really been their lifelong dream. I would have been doing them a disservice to suggest that they might consider investing the cash for a higher return than the credit union offered, or that they might use their cash for living expenses, allowing them to postpone Social Security a few years and receive a higher benefit. These people are uncomfortable with risk. They never had a brokerage account, and both had elected to stay in the "old" state retirement plan with a defined-benefit pension. Paying off their house was the happiest result for the Mayers.
Housing Bubble?
Sometimes the numbers and the circumstances indicate that renting makes more sense than buying a home. With the benefit of hindsight, Bill and Helen Torray think that's a terrible idea.
Two years ago, they sold their big home in the Midwest when Bill retired at age 60 and moved back to Virginia to be near their daughter's family. Though they had $400,000 available to pay cash for a very nice place, they decided not to buy a home right away. The younger family expected to move up to a larger home themselves within two years, and Helen wanted to remain flexible so they could buy their next house near the grandchildren and enjoy being part of their growing up. They decided to rent a house for $2,400 a month and add the house money to their stock portfolio.
Fast forward two years. Their daughter's family has indeed moved to a Maryland suburb, and it's time for the grandparents to look for a new house nears the kids. But to their dismay, the Torrays discover that home prices have skyrocketed 40% and their stock portfolio has shrunk by 30%, a double whammy that had never crossed their mind! Now the house they would have wanted costs $560,000 and their cash has shriveled to $280,000. The home they could have paid cash for two years ago will now require a mortgage payment of $2,400 a month even with a 50% down payment. These were not happy campers when they first came to our office to see if we could help them decide what to do now.
After listening to this sad tale, I understood clearly that living near their family was this couple's most important goal at this stage of their lives. They weren't big on entertaining at home, didn't fancy gardening or boating or have a hankering for the country club life. But they did want to travel and were looking forward to taking their grandchildren to the historic cities of Europe. Two trips a year might cost something like $15,000. That's what they had their hearts set on.
So we took a look at their assets and sources of retirement income: nearly $22,000 a year combined Social Security benefits, no pensions and a $1,000,000 IRA, which Bill reminded me was the remains of what had been $1.4 million when they first retired. I did a few calculations and presented my first conclusion for their reaction. "If you use the $280,000 remains of your Midwest house proceeds to put down on that $560,000 new house, you cannot afford the travel that you've been dreaming of."
I had figured that their Social Security check plus a 5.5% annual withdrawal from their IRA would provide pretax income of $77,000. (If your Monte Carlo simulator would only allow them $40,000 a year, you might read with interest our Regarding Retirement column in the November/December 2000 issue of this magazine.) Mortgage payments and income taxes would knock that down to $39,000. Another $15,000 annually for travel leaves about $2,000 a month for everything else. That's a pretty tight budget for folks who live in a half-million dollar house. Our new clients agreed that it didn't sound like much fun. They started grumbling about the inexperienced broker who had loaded them up with aggressive growth funds, but I assured them they were still in a very good place, and I had a better idea that would let them live their dreams.
"Only you can decide," I said, "because it's your life. My job is to suggest possibilities. Here's what occurs to me. A big 10-room house doesn't sound like what you really want at this stage of your life. It's what you have always had and what you are used to. But do you really want $500-a-month utility bills, a $6,000 annual property-tax bill, a lawn, gardens and trees to maintain and three bathrooms to keep clean? And when you are traveling, you'll have to get somebody to look after your half-million dollar investment.
"Before we even talk about the numbers, I wonder if you wouldn't really enjoy living in a spacious, modern two-bedroom apartment overlooking a pool and gardens that someone else maintains for you. And when you take little Cynthia to London, you'll just stop the mail and lock the door! If you could find this dream place 10 minutes from your daughter's home, wouldn't it be perfect?" I could tell from their faces that they were intrigued by the idea, so I went on with the financial aspects.
"You'll have to do some research and some exploring to find a really nice apartment complex, but here's a rough idea of how renting could help you afford the sort of retirement that you have pictured. I am pretty sure you can find a wonderful apartment home that will cost $10,000 a year less than carrying the mortgage on that $560,000 house you described. That's $10,000 a year more you'll have to spend on the things you really want."
It was Helen who interjected. "Yes, but there would be no tax deduction if we rent, so our income tax bill would go up, offsetting some of that savings."
She was right and wrong, so I had to point out several issues. "That's true, Helen; rent does not provide you a tax deduction. However, your annual tax bill as a renter will still be lower than if you bought the big house; lower by as much as $5,000. The reason is that you would still have that $280,000 from your last house, and you would gradually use that up to provide money for living expenses over the next nine years. This will mean you'll take far less out of Bill's IRA, every dollar of which would be taxed as ordinary income.
"If you bought the large house, using your $280,000 as the down payment, you would have to take $55,000 a year from the IRA to maintain your lifestyle ... and still not be able to afford the travel you have planned. But if you rent a nice apartment for $1,600 to $1,800 a month, and gradually spend down the $280,000, you can probably take just $15,000 a year from the IRA. So your housing costs (with utility and maintenance savings) would be lower by about $10,000 and your income taxes would shrink by about $5,000. There's your travel budget."
It was Bill's turn to object. "Sounds great, except for one big item. If we own a house, it will appreciate in value over the years. Ten years from now, that could make a big difference. After all, missing out on the recent housing-price boom is one of the reasons we are in this bind right now!" He folded his arms across his chest and leaned back in his chair, satisfied that this was a deal-breaker. But I was ready for his challenge.
"That's true, Bill, you would miss out on the appreciation of house values, if there is any. But there is one more very large plus to the rental scenario that is more than offsetting. You see, by spending down your $280,000 and taking less out of your IRA than you would if you bought the house, your IRA will grow faster. If you take out only $15,000 a year instead of $55,000 a year, and if the portfolio can earn 7% a year, after nine years your IRA could be worth $1.6 million instead of $1.1 million. That's a half-million-dollar improvement. Do you think that house would appreciate a half million in nine years, coming on the heels of the unusual spurt of the last few years?"
"Well, probably not," Bill allowed as he unfolded his arms. "You know Helen, they've just opened that Mediterranean Arms place over on Washington Boulevard. Maybe we could drive over this afternoon and take a look."
J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.