Unless you’re super rich or super poor, you’re probably going to take out a mortgage at some point in your life to buy a house. The questions are how much will you borrow and how quickly will you pay your mortgage off? Today, 63 percent of American households hold some type of mortgage. Part of this reflects Uncle Sam’s past encouragement. The government encouraged home ownership for years by letting households deduct mortgage interest payments as well as property taxes on their federal income taxes. State income taxes, most of which piggy back on the federal income tax return, have generally done the same.
The deductibility of mortgage interest and property taxes continues. But in 2017, the Tax Cut and Jobs Act (TCJA) effectively eliminated the tax break to mortgages for most households. (It also limited the deductibility of property taxes as well as other state and local taxes.) First, it roughly doubled the standard deduction. Second, deductions for interest on mortgages initiated after 2017 were limited to mortgage values below $750,000 — down from $1 million. Finally, the deductibility of interest on home equity loans was eliminated.
Thanks to these and other TCJA provisions, the share of household that is actually itemizing their deduction and, thus, taking advantage of the mortgage interest deduction is projected to shrink to roughly 10 percent.
Mortgages Are Now Tax as well as Financial Losers
Truth is, mortgages have always constituted a bad financial move and, at most, a tax wash. On the financial side, taking out a mortgage means borrowing at a safe rate, i.e. short of losing your house, you have to repay. But the safe borrowing rate is higher than the lending rate. Hence, if you are definitely someone who is going to repay what they borrow, you are, effectively, borrowing at a high rate in order to lend at a low rate. For example, today’s 30-year Treasury bond rate is 2.3 percent, whereas the 30-year mortgage rate stands at 3.8 percent. That’s a whopping 1.5 percent point differential! I.e. if you could afford to pay off such a mortgage immediately, you’d earn an extra 1.5 percent on the amount paid off for the term of the mortgage and do so with absolutely zero risk.
Why do you call the mortgage interest deduction a tax wash? Even those who did or still do deduct their mortgage interest weren’t and aren’t lowering their taxes on net because by mortgaging their homes, they have more money to invest than would otherwise be the case. But if the interest on a bond that has the same maturity (term) as the mortgage, they have to pay taxes on the interest earned. Hence, the heralded mortgage tax break came with a potential, if unacknowledged tax increase.
Yes, not everyone who takes out a mortgage to invest will invest in a bonds of equal risk and maturity. Some may borrow to invest, say, in the stock market. But once we risk-adjust the return on stocks or, for that matter, any other investment, we get back to the same answer — mortgages are major financial losers and can have offsetting tax burdens. This is also true for the vast majority of people who take out mortgages not to invest, but to buy a house. For them, there’s no option. They can’t buy their homes with cash. While such households have no option but to make a bad financial investment (borrowing at a high rate is a financial investment even if it’s not perceived as such), it’s still a bad financial investment.
Calculating the Gains from Avoiding Mortgage Debt
Let me use my company’s MaxiFi personal financial planning software to illustrate, in the clearest possible terms, why mortgages can be very big losers, particularly today when they are no longer represent a tax wash but rather a higher tax liability. I’ll take the case of a 30 year-old married couple named Jack and Sue who were able, thanks to an inheritance, to buy their house with cash. The illustration is based on a company case study (covered in a New York Times article) done a while back when mortgage and interest rates were somewhat different than they are today. But you’ll get the point.
Jack and Sue both work in Massachusetts making $37,500 a year each. They have a $450,000 home for which they pay $4,500 annually for property taxes, $2,250 for homeowner’s insurance, and $2,250 for maintenance. These amounts are assumed to stay even with inflation. The couple currently holds $90,000 in regular (non-retirement account) assets and $75,000 in 401(k) accounts — all invested in 30-year Treasury bonds yielding 2.545 percent. They’re currently looking to retire at 67.
Last Thanksgiving, Jack’s uncle, Jim, who is badly out of date on the tax code, advised Jack to take out a mortgage and invest the proceeds to reap “sizable” mortgage-tax benefits. Jack’s uncle suggests the couple borrow 80 percent on their house for 30 years (i.e. take out a 30-year mortgage on their house for 80 percent of its value) and invest the proceeds in 30-year Treasury bonds. Jack likes the idea and is eager to proceed. But Sue is skeptical. She wants to see evidence that the tax breaks, which she also doesn’t realize are negative, plus paying a relatively high rate on the mortgage will improve their living standard. Is she right to be skeptical?
Jack and Sue’s Huge Losses from Mortgaging their Home
It’s easy to run the comparison with MaxiFi Planner. In the case study, I took Jack and Sue’s current situation, i.e. no mortgage, as the program’s Base Plan (profile). I then entered an alternative profile in which the couple follows Uncle Jim’s advice and a) borrows $360,000 for 30 years on their house at the then-prevailing 4.15 percent mortgage rate and b) invest the proceeds in 30-year Treasuries yielding the then prevailing 30-year bond rate of 2.45 percent. Next, I compared the difference in lifetime discretionary spending under the two profiles.
What happens to their lifetime discretionary spending? It falls 3.93 percent — from $2,453,242 to $2,360,512, i.e., by $92,730 — far more than what they earn in a year! And that’s before taxes!
What about their lifetime taxes? They’d rise by about 2 percent. So, Uncle Jim is wrong about the couple’s saving taxes from taking out a mortgage. But this tax increase is rather small. The main reason taking out a mortgage is a major financial mistake is that Jack and Sue have to pay a higher rate on their borrowing than they can earn on their saving.
What about couples with higher incomes? Same story. If we scale up Jack and Sue’s inputs by a factor or 1.333, so their combined earnings are $100,000, not $75,000, mortgaging their home means a 3.64 percent reduction their lifetime discretionary spending totaling $109,709 in present value. Again, this exceeds a year’s pre-tax labor income. If we double all of Jack’s and Sue’s inputs (scale factor of 2.000), the couple’s lifetime discretionary spending falls by 3.30 percent. The decline, in this case is $138,323, roughly one year’s post-tax labor income. Using a scale factor of 3.333, so the couple jointly earns $250,000 annually, the percentage reduction is actually larger — 4.10 percent, with a fall in lifetime spending of $245,716 or just under one year’s pre-tax earnings. Finally, with a scale factor of 6.666, so the couple earns $500,000 annually, there’s a 6.10 percent lifetime discretionary spending decline amounting to $546,820. It’s interesting, but not surprising, that the loss from mortgaging declines and then rises as households become richer. This reflects the substantial non-linearity of our tax system.
The bottom line?
Sue was right. Mortgages are sure losers, both as part of a strategy to invest and as a tax gimmick. All of us should carefully consider paying off our existing mortgage as quickly as possible (without becoming too cash poor to cover an emergency) and, thereby, join the roughly 37 percent of American households who are mortgage free. And we should, to the extent possible, ignore the financial advice of our uncles during turkey time.