May 23, 2005 — With house prices rocketing higher, a number of Answer Desk readers — including Cheryl in Connecticut — are trying to figure out what to do when they cash out and sell their home. Is it better to carry a smaller mortgage on a new house or invest the money elsewhere? Meanwhile, Hank in Seattle is very worried about the direction of the U.S. economy — and he’s trying to figure out where to hide in case things really get really ugly.
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I have a dilemma. I want to sell my house, I plan to make about $110,000 profit which I will need to put almost all into another house to be able to afford a mortgage. Do I keep some money out and put into a CD or something and earn the interest off of it to help with the mortgage or do I put it all down on the mortgage? Two things: I have a son starting in college this year (barely no scholarship money), and do I have to pay capital gains on this money (first time owner in June, owned for 5 years)?? Help!! — Cheryl, New London, Conn.
Life should be full of such problems. First the easy part: you can exclude up to $250,000 on the gain from the sale of your primary residence -– with certain conditions that sound like they don’t apply to you. Married couples foiling jointly can exclude up to $500,000. And when figuring your capital gain, don’t forget to deduct all of the money you spent improving the house (maintenance doesn’t count) and the cost of selling it, like real estate commissions. (For details, check out IRS Publication 17, starting on p. 111.)
As for how much cash to put into your new house, there’s no “right” or “wrong” way to go. In general, unless you can find an investment that pays more than the mortgage interest you’ll save by increasing your down payment, you’re probably better off putting the money into your new house and carrying a smaller mortgage. But the only way to know for sure is to do the math. So here goes:
Let’s say you put your $110,000 in a 5-year, jumbo CD paying 4.65 percent (the highest rate we could find in your area). At the end of 5 years, with interest compounded monthly, your CD will have grown to $138,730, giving you a pre-tax gain of $28,730 -– according to the CD calculator at Bankrate.com.
But investing that cash in a CD means you’ll have to borrow more on your new home. If you get, say, a 5.25 percent 30-year fixed mortgage (with no points), the extra $110,000 you’ll borrow will cost you $27,810 in interest over the first five years of the loan -– according to Bankrate.com’s mortgage calculator.
Next, you need to look at the tax impact to get the full story. The interest you pay on your mortgage gives you a tax deduction; if you’re in the 15 percent bracket, you’ll save roughly 15 percent of your extra interest payments, or about $4,172. So your net cost of carrying a bigger mortgage over five years is $23,638 -- $27,810 in interest minus the $4,172 in tax savings. On the other hand, if you put your cash in a CD, you’ll owe tax on the interest you earn: In this case, figure 15 percent of $28,730, or $4,310 -– giving you a net gain of $24,420.
When you add it all up: investing the $110,000 in a CD will earn you $4,884 a year over the first five years. Lowering your mortgage by putting that $110,000 into your down payment will save you $4,727 a year. So by investing in the CD, you’ll only come out ahead by about $13 a month. Of course, if you can find an investment with a higher return, you could be a lot better off. But if you go after higher returns, you’re going to have to take on more risk. With those college tuition bills staring you in the face, that’s probably not a good idea.
Still, putting all your money into your house leaves you with little cash for those college bills -- you can’t exactly slice off a piece of the back yard to pay for tuition. One way around that is to take out a home equity line of credit on your new house: it’s roughly the same as taking out that bigger mortgage, but you can spend only what you need and pay interest only on what you borrow. (And the interest payments are deductible, which brings the tax savings back into the picture.) If you can find a home equity line of credit with a lower interest rate than your primary mortgage, you’ll save money and maintain the flexibility of having access to the cash when you need it.
SLEEPLESS IN SEATTLE
With seemingly nothing left to unite the citizens living in the United States, not language, traditions, nor civility, and increasingly more divisive issues on a daily basis, I have to seriously question the future of the United States. Is it time to look seriously at establishing asset accounts or real estate holdings outside our borders? What countries would best weather a collapse of the United States economy/government as we have known it?
— Hank, Seattle
Take a deep breath, Hank. By most measures, the U.S. economy is -– for the moment -– doing pretty well. Gross Domestic Product is rising nicely, inflation and interest rates are still historically low, and new jobs are being created at a reasonably clip.
But you can certainly make the case that the glass is only half full. We've got rising trade deficits, companies sending jobs overseas, surging energy prices, a falling dollar, huge budget deficits, exploding health care costs –- not to mention a Congress that's behaving worse than the average three-year-old in need of a nap. If we thought about it too hard, we might not get out of bed in the morning.
Still, if the U.S. economy (let alone the U.S. government) were to “collapse as we know it,” there would be few places to hide. The $11.7 trillion in goods, services and investments produced last year in the U.S. accounted for about 21 cents of every dollar of global purchasing power. Every year, the global economy becomes even more closely bound together. So it’s inconceivable -– to us, anyway -- that the rest of the world could somehow dodge the impact of an American Apocalypse. As divisive as the shrinking world may seem to have become, we are truly all in this together.
Still, it certainly makes sense to keep some of your investments in non-U.S. assets. If you keep some of your 401(k), say, in a good international fund, the falling dollar will likely work to your advantage. If you believe that our trading partners are doing a better job than the U.S., by all means, invest with them. Capital has always tried to flow where it gets the best return. So if prospects seem better for your investment dollars outside the U.S., send your capital packing.
But direct investing abroad is not for novices: that’s why most people who choose to move a portion of their investments offshore use professionally managed funds. Picking the right foreign country or company requires knowledge of local conditions. It’s often difficult to get information on how your investment is doing. And, even as the U.S. tax code has become ridiculously complex, foreign tax laws and other investment restrictions can be even more onerous.
One answer, of course, is to pick a country and move there -- lock, stock, and IRA. But unless and until you become a citizen of that country and officially bid Uncle Sam farewell, you’ll still have to correspond annually with your friends at the IRS.
But cheer up. Now that the rainy season out there in Seattle is breaking up, and the mountain is out a lot more often, you may find yourself reconsidering the move. Having just visited your city, we think you’d be hard-pressed to find a nicer place to live.
Real estate forecast
I am 34 and ready to buy my first home. Should I wait a few months to see what happens or jump in now?
Charles G. -- Old Orchard Beach, Maine
Sorry, our crystal ball is in the repair shop again. Last month, we asked it another reader’s question -- about where gasoline prices are headed -- and it blew a fuse.
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