If you read the newspapers, it looks like all hell is about to break loose when so many mortgages reset at higher interest rates this month.
A recent news account cited the couple in Sacramento whose mortgage on a $250,000 house was about to rise from $1,400 a month to about $1,900 when it resets. Both spouses worked and generated a high five-figure family income. They were whining about their increased interest and were getting nowhere in their efforts to renegotiate.
Hello? Are they forgetting the concept of marginal tax brackets? Have they forgotten how to increase deductions for W-4 withholding purposes so they don't continue making an interest-free loan to the government?
The last time I looked, a couple with Adjusted Gross Income of about $55,000 was paying combined Federal and California state income taxes at a rate of about 33 percent on every additional dollar earned over that $55,000 threshold.
People forget that when something tax deductible increases, like mortgage interest (or 401(k) contributions, for that matter) then we have reduced the far reaches of our taxable income by whatever amount that increase might be.
When their mortgage interest increased by $6,000 per year, this couple probably reduced their taxable income from, say $70,000 down to $64,000. If they did the math, they would find that the combined fed and state tax rate on these final dollars (called "marginal" dollars because they are at the "margin" or highest reaches of our income) is 33 percent.
This means that paying the $6,000 of increased mortgage expense, they have just reduced their tax bill owed on April 15th by $2,000. Their real cost, in "take-home" pay is only $4,000.
But how do they create those tax savings immediately?
They need the money to meet their new mortgage payment. The easiest solution for most people is to increase their number of dependents used to calculate the correct amount of tax withholding per pay period. For 2007, each dependent claimed is equivalent to $3,400 in income reduction for tax calculation purposes. In this case, we will assume that this couple, until now, has adjusted their withholding arithmetic so that they are typically "tax neutral" at the end of each year. They have withheld something close to what they actually owe in taxes.
Now, they bump their exemptions by two more dependents for withholding purposes. This will reduce their tax withholding by approximately $2,000 per year. What started out as an out-pocket-interest cost of $500 per month has now reduced take-home pay by only $330. Decreasing the withholding tax added $270 per month to take-home pay, and presto, there's the extra $500 per month they need.
Couples who manage to get through the full 2008 calendar year by toughing out their higher mortgage payments will probably find themselves getting a nice fat refund when they file in January if they don't adjust their withholding amount as illustrated above.
It's a lesson in marginal tax brackets that too many people just don't factor in when making financial decisions.
It's also a wake-up call for the rest of us left to figure out how we will foot the bill for the cost of government when millions of homeowners across the country get additional tax deductions (and pay less in taxes) as a result of these resetting mortgages.
Remember, whenever we hear anyone say, "tax cuts" they are really saying "future taxes." Until then, we're borrowing, so "tax cuts" really mean "future taxes plus interest." As Ross Perot would say, "It's that simple." I would add, "It's that scary."