Low rates … for life!

By Don Kuehn

For the past few years, the Federal Reserve has been holding interest rates at very low levels in an attempt to boost economic activity and guard against a depression. There has been a corresponding reaction in the housing market. Thousands of AFT members have seized the chance to save serious money every month by refinancing their home loans or upsizing into new homes at near-record low interest rates.

Many people look upon mortgage interest as one of the few dependable deductions they still can take against their federal income taxes. While that’s true, the real value of those deductions is quite small, especially with the new, lower tax brackets. And the lower the monthly payment, the smaller the tax break.

Dropping your 7 percent interest rate by 1 5/8 percent on a $50,000 loan would save you only about $53 a month, whereas the same reduction on a $400,000 mortgage would bring a potential savings of $422 per month.

The rule of thumb used to be that you refinanced a mortgage only if there were a spread of two percentage points or more between what you'd been paying and the new rate. But with some lenders offering low-cost refinancing, no points and few closing costs, there really is no rule of thumb anymore.

According to the U.S. Census Bureau, 15.4 percent of all housing units in America had a primary mortgage that was refinanced. The most popular reason to refi was to capture a lower rate, but the second most popular reason was to draw cash from the home’s equity. The median amount of cash pulled from home loan refinances in 2001 was $24,513. About 1.8 million owners have loans on their property that equal or surpass the value of the home.

Shedding older loans in favor of lower-rate mortgages has represented a great opportunity for most consumers. But if you are standing on the doorstep of retirement, there may be unintended consequences in the push to refinance. Like other Americans, many near-retirees are living on the edge of financial disaster. In addition to credit card and other revolving debt, mortgage debt is not just an immediate threat; it is one that can hang over retirees for the rest of their lives. Today, nearly a third of all households headed by someone 65 to 74 years of age are carrying mortgage debt.

Many people retire from the workaday world without retiring their mortgages. This could prove more taxing than they thought. Here’s an example of two similarly situated couples:

At age 65, Fred and Ethel are able to live comfortably – mortgage-free – on $16,000 a year from Social Security added to $24,000 from their IRAs. They don’t owe any tax on the Social Security, but their IRA withdrawals are subject to taxation like ordinary income. After taking all of the standard tax deductions, they owe about $600, leaving them with $39,400 in after-tax income.

Another couple, I’ll call them Ricky and Lucy, think they could live on the same amount as their neighbors, but at age 50 they took out a 30-year, $200,000 fixed-rate loan at 6 percent. They owe $14,400 a year ($1,200 every month) until they reach age 80—long after the paychecks stop.

To keep pace, they would have to withdraw enough from their IRAs to augment Social Security and to meet the $14,400 lug in annual mortgage payments. How much? More than you might think.

Now, in the 16th year of the mortgage, just $8,400 of the $14,400 annual payment goes toward interest, and that amount will decline every year as more of each payment applies to principal. That tax deduction shrinks a little bit every year.

If Ricky and Lucy can come up with another $5,000 of itemized deductions, they can creep above the standard deduction Fred and Ethel take, but the additional withdrawals from their IRAs will drive up their total income and make some of their Social Security taxable.

Ricky and Lucy need to generate a pretax income of more than $58,000, according to Glenn Frank, a financial planner quoted in the Kansas City Star. That means part-time work or drawing more than $42,000 from their IRAs and paying more than $4,300 in federal taxes. Add their state tax burden and they’ll have to draw even more from their retirement accounts. At this rate of withdrawal, those IRAs aren't going to last very long. In effect, the $142,000 left on the mortgage is costing them more than $18,000 a year.

Say they just wanted to get out from under the load and pay off the mortgage? They owe $142,000, so they’d have to withdraw at least $217,000 and pay almost $52,000 in federal income taxes, while state taxes vary. That’s probably too much to expect from almost anyone of modest means who hopes to live comfortably on $39,400 a year.

Of course, many people have designed a retirement plan that revolves around building as much equity in their house as possible, then downsizing to smaller quarters or moving to a more tax-friendly state. In that case, assuming the property is priced to sell and is in a favorable location, debt load becomes almost irrelevant.

If you have refinanced to take advantage of today’s low rates, good for you. But if you are approaching retirement and have a loan that will be with you long into your retirement years, what do you do?

Take time to figure out a schedule of accelerated payments that will lead to being mortgage-free by the time you retire. It could be as simple as making an extra payment a year, or adding a small amount to your monthly payment. Consult with your lender about the mechanics of making any extra payments to be sure the money is credited toward the loan principal.

You might even refinance into a slightly more costly 10- or 15-year mortgage. If you are considering a new loan, tailor the duration of the payments to how long you expect to work.

You toil for decades to support your plans for a happy retirement. It would be a shame to cancel your retirement plans just to support your house.

Don Kuehn is a retired AFT senior national representative. This column is intended to increase knowledge and awareness of issues of importance to members and retirees. For specific advice relative to your personal situation, consult competent legal, tax or financial counsel. Comments and questions can be sent to dkuehn60@yahoo.com.