Here is some things I think have either been overlooked or left out entirely:
1. Transaction costs: When buying a house, taking out a mortgage has a cost over paying with cash and buying 100K+ in bonds also has a cost. These costs have to be cover by a higher bond interest rate, which when spread over 5 years will probably add .25% to .5%.
2. Taxes: It sounds like your relative is going to be relying heavily on the home sale difference, taxable savings and possibly a part-time job for 55 to 60, so how much of that is taxable income(aka is he really in the 25%+ tax bracket)? Also would he use the standard deduction or itemize without the mortgage, because if it is the first you can't claim that the mortgage is fully deductible for calculating the equivalent rate. Finally munis may or may not be exempt from state taxes, generally states don't tax their own and tax other states, but this isn't always true.
3. Principle payment: Unless the mortgage is interest only, some portion of the payment goes to principle and there are 3 ways to cover this: higher bond interest rate, periodic selling or maturing of bonds, and other income. Periodic selling or maturing is the best choice in this case. I only point this out because it should be planned ahead of time.
You pointed out 3.3% munis while borrowing at effectively 3% or a margin of .3%. .3% on a 200K mortgage would be $600 more income per year, it that really the difference maker? Also with razor thin margins, one goof could change it from profitable to unprofitable like the mortgage costing too much upfront, standard deduction increases, tax law changes, and/or bond defaults.
Given the thin margin, I wouldn't recommend doing this. If the margin was at least 1%, then I'll would be singing a different tune, but I don't see that happening with munis. You might be able to get it to work with corporate bonds or annuities.
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