Feb 25 2009
Effect of Interest Rates on Mortgage Payments
So I am reading another blog and I see the statement “In the past few months interest rates have dropped below 5% on occasion. Of course the lower your interest rate, the lower your monthly payment will be. However, in the whole scheme of things whether your interest rate is 5% or 8% this matters little because both are tax deductible if you itemize your deductions on your federal taxes. You either get a smaller or a larger deduction.”
Wow. This was written by a Realtor.
Let’s look at a basic example. We can compare two mortgages. Both mortgages are for $150,000 with rates of 5% and 8%.
On the 5% loan the monthly payment for principle and interest is $805.23. On the 8% loan the monthly payment is $1,100.65. The monthly payments on the 8% loan are $295.42 per month more, or $3,545.04 per year.
The interest paid in the first year for the 5% loan is $7,449.75. The interest paid on the 8% loan is $11,954.73. A typical married couple making between $65,100 and $131,450 per year will be in the 25% income tax bracket. Therefore the interest deduction will save the holder of the 5% loan $1,862.44 and the holder of the 8% loan will save $2,988.68.
Lastly, the holder of the 5% loan will pay off their principle balance faster. After one year the holder of the 5% loan will owe $147,786.99 on the mortgage and the holder of the 8% loan will owe $148,746.93. The person with the 5% loan now has $959.94 more equity in their home.
After one year the holder of the 5% loan is in far better shape than the holder of the 8% loan.
$3,545.04 (lower payment)
- $1,126.24 (lower tax savings)
—————
$2,418.80
+ $ 959.94 (extra equity)
—————
$3,378.74 Ahead after 1st year
As you can see, the only benefit that the 8% loan has over the 5% loan is the increased tax deduction. However, the increased deduction does not even come close to making the two deals close in value.
The disparity only gets larger as time goes on and the 5% loan continues to pay down principle faster.
Over the course of 30 years the loan with a rate of 8% pays $106,344.46 more than the loan at 5%. The increased tax savings on the 8% loan will be about $26,586.10. The person that bought the house at 5% is $79,758.36 better off than the person that bought at 8%.
The moral of the story is, lower rates are better rates.
