When helping clients with their personal financial planning needs, we are often asked if they should pay down their mortgage faster. Rather than answer that question in a vacuum, we need to consider other pieces of your financial life. We need to understand your cash flow, emergency fund and retirement savings situations, as well as debt balances, the type of mortgage you have, your financial behavior, the current interest rate environment, etc., before we can help prioritize where every new dollar should go.
Part of what we consider is the cost of your mortgage interest. Affecting that is the interest rate and the tax savings on the interest deduction. The Fed has already raised rates this year and announced in March it plans to raise interest rates twice more this year and further in 2019 and 2020. If you locked in the current low interest rates with a fixed-rate mortgage, that won’t affect you. If an adjustable-rate mortgage (ARM) made sense for you at the time and the lock will expire before the balance is paid off or you have a home equity line of credit (HELOC), your interest rate is likely to rise, increasing your monthly payment and interest cost. Ouch.
Adding to that, your tax savings from the mortgage interest deduction could be impacted for a few years. Under the new tax law, interest on home equity loan debt is no longer deductible. That is if the loan was used for other purposes than to improve your home (i.e., to pay for college, refinance other debt, etc.). The Interest deduction on acquisition indebtedness (mortgage or home equity debt to buy or improve your home and/or second home) is now capped at $750,000 of debt. This limitation doesn’t apply to debt incurred before December 15, 2017. Also, many people likely won’t even itemize if their total itemized deductions are less than the $24,000 (married) or $12,000 (single) new increased standard deduction. In such case, there would be no tax benefit from the mortgage interest deduction. This tax law change sunsets in 2026. In the meantime, losing the offsetting income tax deduction makes the interest expense even more costly on an after-tax basis. Double ouch.
Perhaps you’re in a position to pay off your mortgage debt (i.e. the balance is small enough and you have excess cash reserves). If not, it might make sense to refinance your debt to a fixed-rate loan in order to keep your interest cost from rising. That could make sense if you plan to stay there or hold the balance long enough to make the interest savings worth the refinancing costs. Interest rates are still low. Pre-December 15, 2017, acquisition debt can be refinanced without jeopardizing the grandfathered interest deduction, if the debt balance doesn’t increase on refinancing.
These changes put paying down ARM and HELOC balances further up the priority list but not before credit card debt. Rates are on the rise there, too, and interest is compounded daily, making the effective rate even higher. And of course, there’s no tax deduction on that debt either.
The answer is still “it depends,” but the thinking is simpler when there’s no tax savings to reduce the net after-tax interest cost—at least for a few years.
Cindi Turoski is a managing member of Bonadio Wealth Advisors based out of our Albany, NY office.