The Real Interest Rate on Your Mortgage

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20160513_061855 (1)People suffer financial hardship largely due to limited math skills. Myths, frequently perpetuated by the financial services industry, are created, repeated, and reinforced to keep people poor and enslaved. Financial services companies are there to provide financial services and collect a fee for that service, not make you wealthy.

Today we are going to dispel a few of those myths and start you thinking differently about money, investing, and wealth. Armed with the real math you can avoid stupid money mistakes. Early retirement (any retirement for that matter) and financial independence requires you to manage your money wisely. This means you will need to put aside the lies you have been told from young on.





The Mortgage Lie

A thought experiment: You have a 10% interest rate mortgage, itemize so you can deduct the interest, and are in the 25% tax bracket. What is your interest rate after taxes?

Another similar experiment: Your credit card charges you 10% interest. You carry a balance. The credit card is used for personal only so the interest is not deductible. You are in the 25% tax bracket. What is the interest rate on the credit card after taxes?

Your bank wants you to think tax deductible interest somehow lowers your interest rate after taxes. To avoid lawsuits they say stupid stuff like: May be tax deductible. Speak to your tax professional. Most tax professionals perpetuate the bad math. Your cost for the above mortgage example is 10% even if you can deduct every dollar of interest. The interest rate never changes due to deductibility, but the cost does. A better question is how much does it cost after taxes? I hear it all the time. People tell me they are only really paying 7 ½% interest (using the above example) after taxes. No, you are not. You are paying 10%.

The illustration becomes clearer when you take an example of a non-deductible expense. In the above credit card example with essentially the same numbers as the mortgage, we review the facts without a tax deduction. How much does it cost? I argue your interest rate (or cost) on the credit card is closer to 15%. You need to earn $150 to pay the tax and have $100 left over to pay the credit card interest.

If it does not jump out at you, re-read this section again. Some facts: A tax deduction does not lower the effective tax rate or cost! But, a non-deductible expense costs more than the stated price because you need to earn more, and pay the tax, to have enough left over to cover the cost. Get it?

The bank is not your friend. They only provide safekeeping of your temporary money for a fee. You can write checks, borrow, and earn modest interest on savings with a banking institution. They are there to collect a fee for said services. They do not care if you get rich, reach financial independence, or ever retire for that matter. Banks are in business to earn fees. Period. Before you run to your tax professional, question him. Make sure he understands the math. Too many so-called professionals are also mathematically challenged. Tax deductibility is a gimmick to pry more cash out of your wallet.

By the way, if you want a $10,000 deduction I have a better idea. Instead of giving it to the bank in the form of interest, contribute the money to a non-profit organization. It’s tax deductible! The non-profit will put the money to better use than the bank and you get the exact same deduction. Isn’t that nice?




My Giant Escape

Safety light I use on my bike.

Safety light I use on my bike.

I own a bike and hope you do to. For decades I rode a Huffy around town. Last year I upgraded to a new Giant Escape. It was time. The Huffy had seen better days. The Giant Escape set me back a hair over $600, including lights and the carrying rack. I bike to work about 100 times per year. In NE Wisconsin it is unsafe to bike during parts of the winter. My office is 15.1 miles, driveway to driveway. It takes an hour for the trip, a bit longer if the wind is against me.

Biking is great exercise and a great boost to my wallet. The $600 investment paid for itself in less than a summer. Of course, extraordinary claims require extraordinary proof.

The IRS says I can deduct over $.50 per business mile. I don’t use the IRS numbers in calculating what I save. My vehicles are bank repos and I run them for 15-20 years before repeating the process. I estimate my cost to run my car is closer to $.30 per mile. Gas, wear and tear on tires, oil changes, eventual brake pad replacement, and depreciation set me back about 30 cents a mile. I exclude insurance in my savings because I pay insurance whether I drive or not. The same applies to depreciation. A vehicle will wear more when driven, but will still depreciate some if left in the garage.

On first blush you might think I save $9 every time I bike to work. You should stop blushing; it is the wrong answer.

30 miles round trip x .30 = $9

The formula is simple so why does it cost more to drive my car? The answer is simple:

Earn $15 – $5 tax – $1 cost of work = $9

As you can see, I need to earn $15 to pay for the car I drive to work. The $1 cost of work is an estimate of the excess cost of working versus staying at home. Work clothes are not free. By biking to work I can work fewer days per year and retire early due to lower living expenses.

Since I save $15 per bike trip to the office and do so ~100 times per year, the savings quickly covered the purchase price of the bike. When I drive to work, the first $15 goes to cover transportation costs. The depreciation and maintenance on the bike maybe approaches 1 cent per mile. Therefore, the first $.50 goes to cover transportation to work, after taxes.

See how fun math is?

In the near future I will expand on how a bike is one awesome, mega-powerful way to super charge your financial life.

Lottery

We finish our lesson today with the biggest math problem of all, the lottery. It seems like a couple time per year the lottery in these parts gets really big. People yammer about it ad nauseam. Somehow, people have convinced themselves the lottery is an acceptable expense if the prize exceeds the odds. The logic goes like this:

Odds are 100 to 1 to win

Tickets cost $1 each

The jackpot rises to over $100

Ergo, it is a good idea to buy a ticket

No, it is not! The odds are still massive against you. The lottery is even worse. Like 450 million to one to win. Given enough time and lottery ticket purchases in similar situations have an expected return higher than the ticket costs. True. If you live a couple million years! The lottery is a waste of money. Sure, somebody will win. Sure, it could be you. No, it will not be me. I already won because I did not play.

If you play the lottery, consider an alternative. Instead, put the money into a retirement account. A lifetime of lottery ticket purchases should provide a comfortable retirement without any additional funding. You see, small changes create outsized results as time grows your investments many times over.

Hope you enjoyed today’s math lesson. I bet it was more fun than math in high school. When math affects you directly it is always more interesting. Always keep in mind what is really happening with your money. Don’t let anyone snooker you into a stupid investment or bank product with the BS tax deduction story.




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Keith Schroeder

10 Comments

  1. Stephen on May 13, 2016 at 8:40 am

    Keith, would greatly appreciate if you elaborated on your process for purchasing bank repo vehicles. What are the pros / cons? How would some start searching for these vehicles? Seems like a number of different paths after doing a quick google search.

  2. Ace on May 13, 2016 at 3:32 pm

    Keith, how do you figure that the credit card interest rate is 15%? What assumptions are you making to get from 10% to 15%? Can you show your MATH? Thanks!

    • Keith Schroeder on May 13, 2016 at 8:56 pm

      Ace, I do some rough rounding. If you owe $100 in interest you need to earn $130-$150 to pay to drive to work, eat at work, and pay for work clothes to have $100 left over to pay the interest. I think people are getting too hung up on exact math when your tax rate and drive to work will be different from mine. The concept of tax-deductible interest does not lower your interest cost, but non-deductible interest requires additional earnings to cover taxes and other expenses to have a remaining balance available to pay the interest.

  3. Michael Lambert on May 13, 2016 at 4:34 pm

    Very insightful. I’m trying to follow the math. If I’m in the 25% tax bracket by my figuring I need to earn $133.33 to have $100 after tax. How is the $150 figure arrived at?

    • Keith Schroeder on May 13, 2016 at 8:58 pm

      Michael, I am doing back-of-the-envelope math once I illustrate the concept. The 25% tax bracket is federal taxes. I jump ahead without clearly stating state taxes (7.65% in Wisconsin), transportation expenses to get to work, plus other minor work related costs such as work clothes and lunch.

  4. Michael on May 13, 2016 at 5:24 pm

    On the bike to work question, how do you account for the lost hour of bike riding? I can, for example, take a subsidized by my employer bus ride to work with about a 2.5 hour round trip, or a 5 ish hour bike trip, or less than an hour’s drive. Certainly a closer employer would be better, but I like where I am. I value my time off at much greater than my hourly rate of pay. Arguably I pick up extra, and so value time at my overtime rate, but in most cases I value my dad time at on the order of 15x my hourly rate, so the drive makes more sense, doesn’t it?

    Likewise, one area I disagree with MMM on is many home repairs. Granted I like when I can do it myself, but when I hire a guy (at a rate approximately my OT rate at work) and it’s done right the first time (versus my mis measured corners and occasional electric shocks). And again, doing myself uses that dad time, or Jiu jutsu time, or beekeeping time, etc, all of which I value more than work time.

    Where is mybthunki

    • Keith Schroeder on May 13, 2016 at 8:52 pm

      Michael, I can bike to work and back in about two hours. If I drive I take forty minutes there and back, plus an hour at the gym or working out. Not much of a time hog and I love the peaceful ride. I equate biking to money in the post, but it is not about money for me; it is about enjoying a wonderful day outdoors.

  5. R on May 16, 2016 at 12:56 am

    One thing to note as well, you can only deduct mortgage interest rates if you itemized and if that is higher than the standard deduction. My parents re-finance their mortgage from a 30 to 15 year loan and been paying more every month. The last couple of tax seasons, they didn’t even itemize since they didn’t pay that much interest.

  6. valuecont on September 29, 2016 at 6:11 pm

    I don’t get this math. Lets say I make $100K and am in 30% tax bracket. A mortgage of $10,000 would reduce my income to $90K and my tax liability would be
    90 *.30= $27K. Since the credit payment of $10K is not deductible, I’ll still pay $30K. So I did save $3K in reduced taxes. How is that not a saving?

  7. Keith Schroeder on September 30, 2016 at 1:46 pm

    Valuecont, you are looking at it from a marketing standpoint. Let’s say you owe $10,000 in interest to your credit card. How much does it cost to pay that interest? Well, you need to earn enough to pay the tax to have enough left over to cover the interest expense. Therefore, it costs around $15,000 to cover the credit card interest, including tax. How much do you need to earn if the mortgage interest is 100% deductible? $10,000, not $7,000 ($10,000 – $3,000 from lower tax bill). Just because there is a bigger refund does change the facts, only the timing. Tax deductions do not decrease the cost; non-deductible expenses increase the cost! Get it? I hope so. Knowing this one simple math hack can change your financial life and prevent financial institutions from working you over. Best wishes to you, valuecont.

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