Reader Random Poster asked:

"If you did not hold any value stock funds in your taxable account, but rather only, say, a total stock market index fund, would you still make the investment changes?"

I also exchanged emails with another reader Mike on calculating the tradeoff. I made this spreadsheet to help do the calculation:

Tax Cost Calculator

I start with this set of assumptions:

The 21% tax rate on dividends and capital gains consists of 15% federal income tax and 6% state income tax. The calculator shows the tax cost for holding stocks in a taxable account under these assumptions is 0.93% a year. Doing the opposite — holding muni bonds in a taxable account and holding stocks in a tax advantaged account — costs 1.15% a year. An investor is better off with holding bonds in a tax advantaged account. That’s the conventional wisdom, which is correct under the set of assumptions above.

However, the answer will change under a different set of assumptions. If you are in the AMT phaseout zone, you will have to add another 6.5% or 7% to the tax rate on dividends. For someone in a high tax state, the total tax on dividends can be over 30% after you add the state income tax and AMT phaseout.

If we change the tax rate on dividends from 21% to 30%, the tax cost for holding stocks in a taxable account goes up from 0.93% a year to 1.37% a year. The tax cost for holding munis in a taxable account stays the same at 1.15% a year. And that’s with a tax efficient fund that only distributes 2% dividends. What if we change the dividend yield from 2.0% to 2.5%? The tax cost for holding stocks in a taxable account goes up to 1.45% versus the same 1.15% for holding munis in a taxable account.

So there you have it. Enter your own assumptions in the tax cost calculator and see which way is better for you.

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Andrew Kalotay Associates is a fixed income analytics and debt management advisory services company in New York. They sent me a special report they wrote for Mortgage Bankers Association, the industry trade group.

A Financial Analysis of Consumer Mortgage Decisions, Andrew J. Kalotay and Qi Fu

The 60-page report attempts to answer three common questions in getting a mortgage. Two of which are of interest to me.

1. How many points should you pay on your (fixed rate) mortgage? No point, 1 point, 2 points, or a no-cost loan with negative points?

Most of the calculators on the web, including ones created by The Mortgage Professor, use break-even analysis. They show you how long you will break even between different loans. Then they ask you “how long will you keep the house?” That’s actually the wrong question to ask. The correct question should be “how long will you keep the loan?” because you can refinance if the rate goes down.

The Kalotay and Fu paper takes a different approach. It applies “industrial strength” option pricing model to these loan decisions.

A mortgage loan in the U.S. is basically a callable bond. When a borrower gets a loan, the borrower issues a bond to the lender. The borrower is also free to call the bond at par at any time. The call option embedded in the bond has value. The value of the call option differs depending on the interest rate, interest rate volatility, and the remaining term of the loan.

Comparing different loans means comparing the APR for the loan payments, the upfront cost, and the value of the call option. Kalotay and Fu call it option-adjusted APR or APRPlus.

They created a mortgage points calculator for comparing APRPlus. I got some current quotes for a 30-year fixed rate loan from a lender and I calculated the regular APR and the APRPlus:

The 5% loan is a no-cost loan. There is little upfront cost, but it has the highest rate and the highest APR. The 4.5% loan has a high upfront cost with a low APR. After adjusting for the value of the call option, the option-adjusted APRs for all these loans are practically identical.

Even after adjusting for the value of the call option, I think it still biases toward the loan with a higher upfront cost, because the typical holding period for a 30-year loan is much shorter than 30 years even without refinancing.

2. Should you refinance now?

Kalotay and Fu apply the same option pricing framework to the mortgage refinancing decision. When you refinance to a lower rate, you also reduce the value of the embedded option in the loan. The cost savings from refinancing must be sufficient to cover the loss of the option value. This is the same decision framework corporate treasurers use when they decide when to call their bonds.

Because homeowners can’t easily calculate the value of the call option in their loan, Andrew Kalotay Associates developed a mortgage refinancing calculator for us. You enter the information about your current loan and the refinancing offer. The calculator will calculate a Kalotay Refi Score (the higher the better), together with a recommended action. You will get “Don’t Even Think About It!”, “Not Yet!”, “OK, But Not Optimal”, or “Go For It!”

For example, if someone has a $200k mortgage at 5.25% with 28 years to go, refinancing to a 5.0% loan with $2,000 closing cost will get a “Not Yet!”. Cutting down the closing cost to $1,500 will get a “OK, But Not Optimal”. If the closing cost can be reduced to $950 or less, the calculator will say “Go For It!”

I like these option-aware calculators. The mortgage rates are low once again. Try them and see if you should refinance. I already sent out an e-mail to the loan officer I used last time. When the rate hits my target, they will let me know.

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If you pay off the balance within 12 months, all three work pretty much the same. You basically have an interest-free loan for 12 months. Things start getting interesting (pun intended) when the 12 months end.

The 0% APR deal is usually used by credit card companies for balance transfers or purchases on a new credit card. During the promotion period, you are required to pay minimum payments, say 2% of your outstanding balance. After the promotion ends, if you still owe a balance, you start paying interest on that balance at the regular credit card rate.

The “same as cash” deal is usually offered by a retail store. You have to sign up for their store credit card. You also make minimum payments during the promotion period, same as in the “0% APR” deal. If you don’t pay off the balance in full by the end of the promotion period, you pay retroactive interest from the very beginning, at a rate often 20% or higher. It’s called a deferred interest financing program. If you pay one dollar less or one day late, you still activate the retroactive interests. Basically you have this time bomb ticking. If you defuse it before the clock strikes twelve, you escape unscathed. If you miss it, it explodes in your face.

The “no interest, no payments” deal is also a deferred interest program. The only difference is you don’t have to make minimum payments during the promotion period. It’s even more onerous than “same as cash.” Because you don’t make payments, your payoff balance is higher and you owe more retroactive interest if you can’t pay it off.

A reader recently e-mailed and asked me what to do when the lender for his “24 months same as cash” deal offered to give him a $50 credit if he pays it off early. It’s a sign of change in times. Instead of waiting until the end and catching the victims who fall into the trap, the trapper is willing to let the pray go with a parting gift. I made a calculator to show the interest he can earn from money in a savings account for the remaining term is worth about $50. Because the interest is taxable while the credit from the lender is not, he’s better off taking the credit. More importantly, paying it off now gets him safely out of the trap. If he accidentally triggered the trap, there’s more than $600 of deferred interests waiting for him. If anyone else faces the same choice, the calculator is here:

Deferred Interest Financing Calculator

Retail stores love to push these “same as cash” or “no interest no payments” programs because they help the store sell more expensive products. Add a Kindle to your cart in Amazon and you will see an offer like this. The store also receives a kickback from the lender. The federal regulators recently announced some new regulations on unfair or deceptive acts or practices which banned two-cycle billing and universal default by credit card companies. I’m disappointed happy to see that they did nothing to disallowed deferred interest programs like “same as cash” or “no interest, no payments.” The deferred interest programs are evil. They make credit cards look like nice guys. Two-cycle billing is going back one statement cycle. Deferred interest programs go all the way back to the very beginning. If two-cycle billing is unfair or deceptive and must be banned, why should deferred interest be legal?

[Update on Jan. 14, 2009] Upon closer reading of the final rules, I see the deferred interest payment plans like “same as cash” or “no interest, no payments” are actually not going to be permitted after July 1, 2010. See follow-up post Deferred Interest Payment Plans Banned.

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