About two-thirds of American homeowners have some sort of debt on their homes, usually in the form of a mortgage or home equity loan, and it’s no wonder. As the Federal Reserve has pumped trillions into keeping interest rates low since the Great Recession, it has become easier and easier for homeowners to manage the payments on that debt. Then, when you add to that the tax deductibility of nearly all home-related debt, the argument against paying off your mortgage gets even stronger, especially when considered in light of the “opportunity cost” of missing out on a raging bull market in stocks over the last nine years.
Now, however, it seems the times are a-changin’.
With the passing of last year’s Tax Cuts and Jobs Act, effective beginning in 2018, the deductibility of mortgage and home equity debt has been reduced, but perhaps not in the straightforward way that many assume. Mortgage interest is still deductible, at least in principle (pun intended), for the vast majority of homeowners. However, whether they actually receive that deduction or not will depend on a myriad of other factors. I’ll walk you through some of the relevant details in this article.
How the Mortgage Interest Deduction Works
First, let’s start with the basics and a little background information. First, it’s important to note that none of the changes I’m about to discuss affect your 2017 taxes, so as you collect the tax forms from your bank or mortgage company in the next few days, don’t worry about the new tax law from that standpoint.
It also bears pointing out the basic fact that the mortgage interest deduction allows you to deduct the amount of interest you pay on your mortgage or home equity line of credit (“HELOC”), not necessarily your full mortgage payment. The principal, taxes or insurance portions of your payment are not deductible. On a typical 30-year mortgage, the majority of your payment is interest in the beginning stages of the loan, but that gradually changes so that you begin to pay more principal on each payment as time goes on. The payments on 15-year mortgages and older 30-year mortgages will have significant principal portions, and thus will not be completely deductible.
Now, the interest that you pay was (and still is under the TCJA) deductible as an itemized deduction. This is important because whether or not you can deduct it depends on whether or not you itemize, which will depend, in turn, on the total amount of your itemized deductions. So the mortgage interest deduction only mattered if, once you added up all of your itemized deductions (things like charitable contributions, medical expenses, property taxes, state and local income taxes, and some miscellaneous expenses), the total was more than your standard deduction.
Now even under the old rules, nearly all of the deductions mentioned above were limited in one way or another (making the analysis even more complicated), and mortgage interest was no exception. Under the previous tax law, “only” mortgage debt up to $1 million dollars could be deducted as an itemized deduction. Also, there was also an important stipulation even under the old rules that many homeowners overlooked (or were simply unaware of), which is that mortgage interest was only deductible to the extent it was used to acquire one’s principal residence, and home equity loans were only deductible to the extent the proceeds were used to “materially improve” the residence, with the generous exception that up to $100,000 of home equity debt could be deducted regardless of purpose. But practically speaking, these limitations affected very few Americans, because very few of us have mortgages over $1 million or HELOCs over $100,000. In addition, the tax forms that we receive at year end (on IRS Form 1098) from the banks do not differentiate between the usage of the loan funds, so it’s hard to imagine that many taxpayers worried too much about it, even if they were aware of these distinctions!
Can You Write Off Mortgage and HELOC Debt in 2018?
Now for 2018 the rules have changed in several ways, some of which are subtle and easy to miss. First, the amount of mortgage or HELOC debt eligible for the deduction has been reduced, from $1 million down to $750,000. More importantly, mortgage and home equity debt that is not used to purchase or improve your personal residence is not deductible at all! However, there remains the important question as to whether the IRS form that homeowners receive will delineate between purchase/improvement debt and non-purchase/improvement debt, or how the banks and mortgage companies would know how you use the funds anyway.
But focusing on the mortgage interest deduction rules alone is not enough to determine if it is still deductible to you. You still have to take into account your other itemized deductions to see if itemizing makes sense. (Remember, itemized deductions only matter when they are, in total, greater than your standard deduction.) First, keep in mind that the standard deduction has been almost doubled for 2018, from $6,350 to $12,000 for single filers and $12,700 to $24,000 for those who are married filing jointly. However, many of the formerly popular itemized deductions were limited by the TCJA for 2018, including a cap on the state and local tax deduction (SALT) to $10,000 in total and an elimination of a variety of miscellaneous deductions. When taking all of these factors (and more) into account, many less people will itemize on their tax returns this year.
Again, if you don’t itemize, you don’t get a tax deduction on mortgage interest.
So Should You Pay Off Mortgage Debt That’s Not Deductible?
Let’s say then that you’ve determined that, in 2018, your mortgage or HELOC debt is no longer deductible. If that’s you, should you then pay it off? If you have the financial means to do so, that is certainly a good question, and a careful analysis of your current tax and financial situation is required to answer adequately.
Here are just a few of the important factors to consider:
- What interest rate are you currently paying, and is it fixed or likely to increase in the future?
- Can you refinance at a lower interest rate without exorbitant fees?
- If you’re planning to pay off your mortgage from your investments, what are the tax consequences of selling them?
- If you want to tap your retirement accounts to pay it off, what are the tax consequences of that?
- Do you have cash available to use? If so, how much cash should you keep on hand for emergencies or other short-term goals?
- Do you have free cash-flow you can allocate to extra principal payments? If so, is that the best priority or should you save for retirement instead?
Let’s assume you have a 30-year, fixed rate mortgage at around 4-5%. One aspect in particular that we encourage clients to consider is whether the after-tax interest rate they are paying is likely to be higher or lower than the expected long-term return on their investments. If it is likely to be higher, or even close to it, then that is one vote in favor of paying down the mortgage. From that standpoint, the current low mortgage rate environment has made the argument for paying off a mortgage less attractive in recent years, although with less tax incentives the argument may begin to reverse in 2018. We will see what happens to mortgage rates in the months and years ahead as well, but many investors believe they are headed eventually higher if the global economic expansion continues.
As always, as our clients’ Personal CFO for Integrated Wealth Management, it’s not our job to make these decisions for them. Instead, we help clients frame the choices appropriately, so that they can make the decision that makes the most sense for them.