WALL STREET GIBBERISH, 2003 SECOND QUARTER NEWSLETTER

The topic this time is seen in far more places than investment publications, but it was the subject of an article in the May 21 Wall Street Journal, so it fits this section. The gibberish is comparing the amounts of interest paid during the terms of mortgages of different lengths. The problem is that the comparison completely ignores the fact that the borrower will have "use" of the money for different periods, which is an important aspect of the so-called "time value of money."

The article talks about a greater percentage of new mortgages being for shorter than the traditional 30 year duration. The sub-headline says "as rates hit a new low, borrowers reduce their interest costs with ever-shorter loans." A sidebar titled "what you save" says "with a shorter mortgage, you’ll have higher monthly payments but lower total costs." It then shows the total interest paid for mortgages of four different lengths and interest rates. A 30 year $250,000 loan at 5.375% has $253,974 in total interest while the same amount borrowed for 10 years at 4.5% results in $60,915 in total interest. One might get the impression that paying less than a quarter of the total interest of the longer term loan is sufficient to make the shorter one the smarter choice.

About the only hint that the shorter mortgage might not be preferable is the higher payments reference. To be fair, the text of the article discusses some of the advantages and disadvantages of shorter mortgages and points out that the monthly payments are almost $1,200 higher for the 10 year loan. Many articles and commentaries that I have seen and heard on this subject do not go beyond the lower total interest payments. The lower interest rate is a clear advantage to the shorter loan, but the comparison should go well beyond that. For one thing, the difference in monthly payments for the 30 year loan is available for other purposes. One such purpose might be investing it. Depending on the possible investments, in one’s own business for example, being able to have a considerable amount of money available at the historically low rate of 5.375% for 30 years might be quite advantageous. The decision as to which mortgage is better can be quite complex and it can include non-financial factors such as the age of the borrower, how long one expects to own the house, and how much one might value owning the house free and clear at some point.

Later the article points out that "people taking out a 10-year mortgage will quickly whittle away one of their biggest tax breaks: the deduction for mortgage interest." Others have in effect advocated borrowing more than might be desirable (or wise) in order to increase the income tax deduction. This type of thinking is even greater gibberish than the total interest paid comparison. The implication is that it is a good idea to borrow to get a tax break, even if doing so does not make sense financially.

It is important to realize that borrowing costs money and decreases cash flow unless the funds received are invested at a higher after-tax interest rate. I hope you all realize that the purpose of investing and other financial activities is not reducing taxes. In effect, the government is subsidizing home ownership through the mortgage interest deduction, one of many activities subsidized through various provisions in the tax code. Borrowing money through mortgages or other loans can make sense for many people. One key in deciding whether or not to do so is considering the after-tax effects of the loan and how the proceeds will be used. In the case of a mortgage, most would not be able to own their homes without one, so having one is usually an easy decision. Refinancing to take advantage of today’s historically low interest rates is quite likely to be a good move. It is the details of the available loans that can complicate the decision and may give rise to gibberish.

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