Mortgage Debt: A Tool to Help Plan Your Finances
September 24, 2013
For most of us, a home mortgage represents the single biggest liability on our personal net worth statement, which includes assets (what you own) minus liabilities (what you owe). But you can also think of your mortgage or home equity line of credit (HELOC) as a financial tool for planning that deserves as much attention as any other part of your net worth.
After years of extremely low interest rates, borrowing costs may be poised to rise, so now could be a good time to take out a mortgage or refinance. To that end, let’s take a look at some factors you should consider.
Income tax basics
When evaluating a home mortgage or equity loan, you can't ignore the impact of income taxes and should always crunch the numbers on an after-tax basis.
Home mortgage debt remains one of three sources of tax-deductible interest expense left to individuals who aren’t engaged in a trade or business (investment interest expense and student loan interest expense being the others). For home mortgage debt, Internal Revenue Service rules say you can deduct the interest expense on up to $1 million of home-secured debt used to purchase or make capital improvements on your qualified principal and/or second residence.1
You can also deduct the interest expense on up to $100,000 of home equity debt secured by your home, whether in the form of a regular loan or revolving line of credit.2
When refinancing, keep in mind that any extra cash you take out beyond the value of the old loan will count toward the $100,000 home equity debt limit if the proceeds are used for something other than capital improvements to your home.
Finally, any "points" you pay when taking out a mortgage loan can be deducted either in the year you took out the original mortgage, or over the life of the loan in the case of refinancing.
Important questions to ask before taking on a home loan
Before you shop around for the best mortgage or home equity loan, be prepared to answer the following questions:
- How long do you intend to stay in your home? Knowing when you plan to sell your home will help determine whether a fixed or variable rate structure is best. It also influences any refinancing decision, since you want to be around at least until the "break-even" point, when any costs involved are offset by the new lower rate.
- How long have you held your current mortgage? If you plan on staying in your home indefinitely, consider structuring the new loan for no longer than the term left on your old loan. For example, if you have 20 years left on a 30-year loan, consider a new loan for 20 years or less. Otherwise if you start over with another 30-year term, you could end up paying more over the life of the loan, even with a lower rate.
- Is your current loan the original mortgage, or a previous re-fi? Even though you have to amortize any points paid on a refinancing over the life of the loan, you can deduct the remaining unamortized points from a previous re-fi in the year of the new refinancing. Any potential tax savings will impact the economic decision to re-finance and should be taken into account.
As you look for loans, you'll likely focus on getting the best rate and keeping costs low. Although these are important considerations, you should also focus on the lender's range of mortgage options, as well as on the level of service and attention you can expect to receive. Look for a lender who is committed to making sure you get the right loan for your needs and that your loan closes on time.
To prepay or not to prepay?
Once you've found the right loan, and have borrowed no more than you need, it may make sense to prepay the principal. You can prepay in small increments over time, or in a lump sum at some point prior to the final due date.
When does it make sense to prepay?
- After-tax opportunity cost. Number crunchers might focus solely on the after-tax cost of money. For example, for a couple with a combined marginal income tax bracket of 40%, a 4% mortgage loan would actually cost 2.4% on an after-tax basis.3 Can you do as well or better with an alternative use of your money? Remember that prepaying a mortgage is a risk-free proposition.
- Liquidity preference. Even if you can't do as well or better with an alternative use of the money, a preference for liquidity might keep you from paying off a low-rate mortgage prematurely if the opportunity cost is negligible to you. Diversification could play a role here, as well.
- Income tax considerations. Don't forget: The $1 million mortgage debt ceiling is limited to acquisition debt (purchase or capital improvement). Once you've paid off the original mortgage, you'll be limited to the $100,000 home equity debt ceiling unless you make capital improvements or buy another home.
- Psychological considerations. For some folks, a strong desire to be debt-free may override other considerations. In that case, opportunity costs and income taxes take a back seat. After all, you can't put a price on peace of mind.
Whatever your individual circumstances, goals and preferences might be, you should think about using mortgage debt to your advantage, within the context of your overall personal financial plan.
1. Up to $500,000 for married filing separately.
2. Up to $50,000 for married filing separately.
3. Assumes full deductibility.
Charles Schwab Bank and Charles Schwab & Co., Inc. are separate but affiliated companies and subsidiaries of The Charles Schwab Corporation. Investment products offered by Charles Schwab & Co., Inc. (Member SIPC) are not insured by the FDIC, are not deposits or obligations of Charles Schwab Bank, and are subject to investment risk, including the possible loss of principal invested. Charles Schwab & Co., Inc. does not solicit, offer, endorse, negotiate or originate any mortgage loan products and is neither a licensed mortgage broker nor a licensed mortgage lender. Home lending is offered and provided by Quicken Loans, Inc, Equal Housing Lender. NMLS# 3030. Quicken Loans Inc., is not affiliated with The Charles Schwab Corporation, Charles Schwab & Co., Inc. or Charles Schwab Bank. Deposit and other lending products are offered by Charles Schwab Bank, Member FDIC and Equal Housing Lender.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. Please consult with your tax advisor on the deductibility of home equity line of credit interest payments for your specific tax situation.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers are obtained from what are considered reliable sources. However, accuracy, completeness or reliability cannot be guaranteed.