Optimizing Your Mortgage

Optimizing Your Mortgage Under the New Tax Law

The recently enacted Tax Cuts and Jobs Act changed some of the rules related to mortgages. Admittedly, the new law limits what we can do with mortgages, but the tax-advantaged loans can still play an important role in your financial plans.

People take out mortgages for a variety of reasons. Some borrow money from a lender because they don’t currently have enough cash to purchase 100% of the home … or the resources they have aren’t readily available because they’re tied up in employer stock or a business. Others borrow money for home purchases or remodeling projects because the cost of debt is cheap relative to other choices they have for their money.

For example, if you expect the after-tax cost of the mortgage to be less than the after-tax rate of return you could generate if you kept your money invested over the term of the mortgage, you’d be better off borrowing money and keeping your investments in place so that you could capture the expected spread. The actual spread realized on the difference between the mortgage cost and the investment return results in more money available for you to spend, give away or reinvest.

Hypothetical Investment Return vs. Hypothetical Mortgage Cost

Regardless of your reason for mortgaging your home, it’s important to stay on top of the details to make sure you’re optimizing the loan to meet your financial goals.

New mortgages up to $750,000

The new tax law limits the deduction for new mortgages to the interest payments you make on the first $750,000 of funds you borrow to purchase or substantially improve a principal residence or vacation home, combined. You must put the loan in place within 90 days of the home purchase or the completion of the remodel project, and the mortgage must be secured by the property.

If you’re purchasing a new home and need to borrow more than $750,000 to complete the purchase, it’s certainly possible to obtain a bigger mortgage (assuming you qualify with the bank and can afford the resulting loan payment). That said, the after-tax cost of the loan above $750,000 will be higher.

Assume you borrow $1.1 million against the purchase of a $15 million home in 2018. The loan is an interest-only mortgage (i.e. no principal payments are required during the first 10 years) fixed at 4%, and your average federal and state tax rate is 35%. Here’s how the annual cost of the loan compares today to before the law change:

Annual interest cost of $1.1 million mortgage

 Before Tax DeductionAfter Tax Deduction
(New law)
After Tax Deduction
(Old law)
First $750,000$30,000$19,500$19,500
Second $350,000$14,000$14,000$9,100
Total loan cost$44,000$33,500$28,600

As you can see, under the new tax law, your mortgage will cost $4,900 a year more as a result of the tax reform.

Existing mortgages up to $1 million

Thankfully, mortgages of up to $1 million that were in place before December 15, 2017, are grandfathered and continue to be fully tax deductible. In addition, you may refinance your existing mortgage and continue to deduct the interest paid on the new loan. However, if you take cash out and increase the value of the new mortgage, the tax deduction will be limited to the lower balance of the loan you just refinanced.

Limited deduction for home equity debt

You used to be able to also deduct home equity interest on up to $100,000 of debt borrowed against the equity in your home via a primary mortgage, a second mortgage or a home equity line of credit that’s used for any purpose. A home equity line is a revolving loan, secured by your home, which allows you to borrow, pay back, borrow, pay back, etc., up to a fixed dollar amount during the term of the loan, usually 10 years.

To maximize the total mortgage and home equity interest deduction under the old rules, it was common for owners of homes worth more than $1.375 million to finance the purchases with a $1.1 million mortgage (the old $1 million acquisition mortgage limit plus $100,000 of home equity debt). Those days are now over. The new tax law disallows all taxpayers from deducting interest on home equity loans unless the borrowed funds are used to purchase or improve a home, and your total debt qualifies for the acquisition mortgage indebtedness.

Still, if you already have a home equity line in place, or can obtain one at little or no cost, it can be a convenient source of emergency funds if you’re ever in need of cash immediately.

Should I pay down my loan?

From an overall optimization perspective, keeping existing loan balances (mortgages and home equity lines) in place could make sense, regardless of the tax deductibility of the interest, if the interest rate on the loan is low (below about 3.5% or so). For instance, if you have a $1.1 million mortgage against your primary residence from 2013 with a 2.5% interest rate, it may not be worth paying the mortgage down to the $1 million deductible level until the 2.5% interest rate adjusts to a higher amount.

For higher cost debt, ask your wealth manager to figure in the available tax deductions and compare the net cost to investment opportunities elsewhere to determine if or when to pay down a loan.

If you do decide to pay down your mortgage below the maximum deductible level, beware that the tax law is unforgiving. If you later change your mind and want to increase the outstanding mortgage balance, your mortgage interest expense deduction will be limited to the remaining balance of your pre-existing loan.

For instance, let’s say you have a $1 million outstanding mortgage, grandfathered under the prior tax law, and at the end of 2018 you pay it down to $700,000. But then in 2019, you decide to refinance the loan and take $200,000 of cash out to purchase a sports car. Your mortgage interest deduction on the new loan is limited to the interest you pay on $700,000 of the new $900,000 loan balance. However, if you instead used the $200,000 to pay for a room addition, you could deduct interest on an additional $50,000, up to the new mortgage limit.

Make sure a mortgage fits your goals

Of course, optimizing mortgage debt is not for everyone. Some people choose to pay off loans, or avoid them altogether, because they sleep better at night knowing they have little or no debt. Other people avoid or minimize debt in accordance with their religious principles.

But if you’re open to paying a mortgage as a financial strategy, it’s best to consult a wealth manager who can compare the interest cost to your projected income and investment returns to help you decide whether a mortgage is right for you right now.

Note: The section about home equity debt was updated March 12, 2018.