Now that we’ve compared the two early payoff options, let’s address the final common question. This time we'll introduce a new couple with different circumstances. Dave & Amy are both 40 with two children, living in Oregon. Their combined taxable income is $550,000 per year, putting them in the marginal tax brackets of 35% for the feds, 9.9% for state, and 2.5% for local. Dave & Amy have combined savings of $2,000,000 and are buying a second home for weekend and summer vacation use. They are under contract to purchase a home in Washington state for $1,000,000. The question is: should they pay cash or finance 75% of it?
The cash option is straight forward. They pull $1,000,000 from investments and close on the house. The upside is no loan costs and no interest on a loan. The downside is the opportunity cost of the investment money not working for them anymore and tax benefits they will forego (interest as an itemized deduction).
The second option is to put 25% down and finance the remainder ($750,000). As of today (8/29/2021), loan rates on a second home in White Salmon, Washington are 2.75% for a 15-year fixed rate loan, or 3.00% for a 30-year fixed loan. In either case, Dave & Amy will be able to take the mortgage interest as an itemized deduction from their federal and state income taxes. To make the family cash flow identical to option 1, we will assume Dave & Amy pay the mortgage from their investment accounts rather than from their regular income. Assuming Dave & Amy’s investment performance is an average annual 8% return, financing their second home for 15 years comes out ahead by $1,047,617. Financing for 30 years comes out a staggering $5,505,400 ahead!
Finally, to determine how likely this outcome is we’ll look to statistics and historical return data. As with previous examples, we assume Dave & Amy invest in a globally diversified 60/40 portfolio with 1% total annual expenses. The probability of getting an 8% average annualized return over a 15-year time horizon is 68.44% The breakeven rate of return is 0.79%. The probability of getting this average annual return or higher or a 15-year time frame is 99.64%. Looking at the same statistics for a 30-year time horizon, there is a 96.41% chance of achieving an 8% average annual return or higher over 30 years. The breakeven rate is 0.944% The probability of achieving a 0.944% average annual return or higher over 30 years is better than 99.99%.
As in previous examples, the same rebuttal can be presented to option 2, “what if you don’t get 8% return on your investment account?”. Once again, we turn to the statistical analysis of the historical return data. Using the data set employed above, we find the probability of exceeding 8% return after expenses over a 10 year time horizon is 67.72%. The break-even rate in this case is 2.18%. The probability of getting at least 2.18% over 10 years is 98.62%.