Prepaying A House Is More Attractive: Tax Reform and Mortgage Interest

The recent tax reform passed by Congress and signed into law at the tail end of 2017 significantly lowered the marginal tax brackets for a majority of Americans. However, one of the consequences of the law is a dramatic shift in the after-tax cost of mortgage financing. As a result, quite literally overnight, paying down a mortgage in advance may have become significantly more attractive.

Why you should care: For a huge number of Americans, their mortgage no longer receives any tax benefit whatsoever and is quite likely now an attractive asset to pay down.

Mortgage/Bond Equivalence

This post describes in all of its gory detail why pre-paying mortgage debt is financially identical to investing the money in the market and earning the equivalent rate (ignoring taxes). The only differences are:

  1. Mortgages truly have no risk, either from market or credit
  2. The proceeds from the ‘investment’ accrue by interest avoided rather than by interest earned. From a net worth perspective, they are completely identical.

It of course follows that mortgages are leverage, and if the money can earn a higher return than the mortgage rate, than the total asset value will be greater than paying off the debt. However, the opportunity to pay down mortgages is very useful to consider as the fixed income, bond portion of a portfolio. A subsequent post will detail how 99% of investors have a lot more risk than they think they do by virtue of their mortgage.

The Tax Reform And Mortgage Interest: Standard Deductions

Prior to 2018, the tax filing situation for most middle and upper class American households implied that mortgages received preferential treatment. This is because of a concept known as the standard deduction. Note, in the following section, I’m ignoring the alternative minimum tax. See notes at the bottom if you are curious about it.

In 2017, a married couple filing jointly would be able to deduct the greater of:

  1. $12,700
  2. The sum of all of their deductions including state, property, and local taxes, charitable contributions, and mortgage interest

In 2018, the same couple is able to deduct the greater of:

  1. $24,000
  2. The sum of mortgage interest and the maximum of their combined state, property and local taxes and $10,000.

Confused yet? This is the important part. Let’s show an example.

Beer Goggles for Mortgage Prepayment

Prepaying your mortgage now likely looks a lot better than it did on December 31. Let’s assume we have a couple with the following general characteristics:

  • They have combined income of $150k. This put them in 2017 in the 25% marginal tax bracket. 
  • They have a mortgage for $310k
  • Their mortgage is financed for 30 years at 4.5%. This means their first year of interest payment is approximate 0.045 * $310k = $14k.
  • They have property taxes of $7,000 and state taxes of $7,500, a total of $14,500.

In 2017, they had $14,500 of taxes and $14,000 of interest, for a total of $28,500 of deductions. Since this is greater than $12,700, they receive an incremental benefit to their taxes worth almost $4,000. The math for this is tax rate of 25% multiplied by ($28,500 – $12,700). In 2018 however, they have $10k of SALT deductions, $14k of interest, and receive $0 incremental benefit relative to the standard deduction. Graphically, this happened:

The numbers, after-tax, show why this now matters.

So What Does this MEAN?

First, it means you are likely now paying more, after-tax, for your mortgage than you were in 2017. The overall tax brackets fell such that taxes for many also fell (excluding a lot of high income earners in high cost of living states). However, the hypothetical couple above is now absolutely paying 1.1% more on their mortgage, after tax treatment, than they were in 2017.

Second, it means that if your mortgage cost is an after-tax expense, then PAYING IT OFF is an after-tax return. As I’ve shown here, pre-paying mortgages is like buying a bond with the exact same compounding effects and same net worth implications. This is important because there are not many zero risk, tax-free instruments out there that pay the same amount as your mortgage might cost.

A 30 year treasury note yields 3.2%, less the 25% tax rate for an effective after tax yield of 2.4%. Over 30 years, the impact of an additional $1,000 towards principal vs buying a Treasury is significant. One must carefully consider whether or not the tax code revision is a gamechanger in terms of their overall portfolio goals. A guaranteed, tax-free riskless yield may not be the worst investment with equity valuations stretched.

Appendix: AMT and More Expensive Houses

AMT used to be a pain for high earners with lots of deductions, but suffice it to say you received a full tax benefit on your mortgage interest in 2017. In 2018, the AMT phaseouts and caps has been altered so significantly that I doubt many households at all will run afoul of it.

For people with more expensive houses, the calculus in the preceding example is slightly different. Suppose for example that the house was the full $750k ($33.75k of interest) with permitted under the new tax legislation. In that case, the following occurs. The first $14k of interest receives no tax benefit, but at the margin, each dollar beyond that receives 25% of tax credit. Therefore the marginal tax rate on the mortgage remains as it did in 2017, though the average rate is higher. There is a kink point at the $14k of interest mark whereby each dollar after that point becomes an after tax return. However only an individual homeowner can assess their own situation to know whether its worth basically paying through the tax advantaged area to reach the tax exempt area.

3 Responses

  1. Ryan says:

    Great article and thank you for breaking down the tax law for me! My article was much more of a high level because I didnt understand the tax law as well as you. Thanks for detailing it!

    • FatTailed says:

      Thanks for reading, and the point of your article (linked here) is correct.

      Using a tax deduction to justify an interest expense is not a great argument. Sure, it makes the after-tax cost of that debt cheaper, but it’s still dollars out the door.

      The tax reform is a total game-changer though. Municipal bonds, which are the most comparable asset to a mortgage now, are likely nowhere near as high of a yield as the typical home mortgage. It’s completely changed everything for homeowners!

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