Dear Gary,
We have very nearly paid off our mortgage! We put a lot of spare money into it because the mortgage had a higher interest rate than any safe investment we could find. But for some personal reasons we would like to have a different house, probably one that is nicer than our current one. My husband says that since interest is tax-deductible, getting a new house makes financial sense especially with today's fairly low interest rates. So he's all for it. To me, as much as I'd like to have a new house, it feels as if we have finally "caught up with our tails" only to begin chasing them again. Can you give us some perspective?
Thank you,
Rebecca

Congratulations, Rebecca! It sure does feel good to own a home without a mortgage. Financial life is much easier without a mortgage payment.

On the other hand, she and her husband have a lot of company in wanting a bigger and better home. According the National Association of Home Builders the average home has increased in size from 1,500 square feet in 1970 to 2,265 square feet in 2000. That's a 50% increase in just 30 years.

Rebecca's husband isn't the only one to think that the deductibility of mortgage interest makes a more expensive home a good deal financially. But sometimes the 'conventional wisdom' isn't really wise. So let's pull out our calculators and take a look at mortgages, taxes and housing prices.

We'll assume that Rebecca is in the highest tax bracket. That would mean she gets the biggest possible benefit from the deductibility of mortgage interest. In 2002 the top bracket is 38.6%. So for every dollar of interest that Rebecca pays the mortgage company her tax bill would be reduced by 38.6 cents. Not such a good deal. In fact she could cut out the middle man and just give a buck to a friend. I'm sure that the friend would be willing to give her 40 cents in return!

Is it really that simple? Probably not. There are other factors to consider.
Some people would argue that it's still a good deal because of the benefits of using OPM (other people's money). That's an old idea. And one that does indeed work well when prices are increasing.

Let's see how it works. Suppose Rebecca buys a house and she's paying a mortgage at 8% per year. But with the tax deduction the true cost of the mortgage is really 4.9%.

How did we get the 4.9% figure? To calculate the true cost of your mortgage, first you'll need to know how much your deduction will be worth. To get that multiply the interest rate on the mortgage (in this case 8%) by your tax bracket (38.6%). That works out to 3.1%. Next you'll subtract the deduction rate from the mortgage interest rate to get your true cost to borrow (8.0% minus 3.1% = 4.9%).

Now back to OPM. For Rebecca to benefit from the money she borrowed the house would need to appreciate by more than 4.9%. Is that possible?

The Office of Federal Housing Enterprise Oversight publishes an index that compares housing prices going back to 1980. For the first quarter of 2002 housing prices across the U.S. had increased by 171% compared to 1980. That works out to about a 4.4% annual increase in price. So it would be close for Rebecca.

There were some regional differences. Some areas did quite well for awhile. But others did not. For instance, in the Northeast prices dropped after 1989. Prices didn't return to 1989 levels until 1998. So all housing markets aren't created equal. Even though you can't predict the future, studying the history of your community should give you an idea of how lively the housing market is.

As Rebecca has pointed out there are also personal reasons to want a nicer home. And only she can put a value on what a nicer home would mean to her family.

Should Rebecca go ahead and buy the bigger house? That's up to her. But if they are going to do it, her husband is right. Low mortgage rates does make it easier. Whatever they decide I hope that they enjoy their home and it's never a financial burden to them.