Mortgage payoff given new 2018 tax code

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ltlku
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Joined: Fri Nov 16, 2018 6:42 am

Mortgage payoff given new 2018 tax code

Post by ltlku » Fri Nov 16, 2018 7:15 am

I know this question has been posted hundreds of times, but I'd like some advice on this.

I have a mortgage at 2.8%. The rate resets in 3 years to the 5 year treasury plus a 2% margin.

The mortgage amount is $450k. My marginal tax rate is 45% including state taxes.

I have enough money to payoff the mortgage today. I haven't paid it off because I could invest in bonds and match or beat the return on the mortgage. However, the 2018 tax code changes things.

The new tax code means that the mortgage is no longer fully deductible. The standard deduction is now $24000 with a cap of $10000 on state and local tax deductions.

My total itemized deductions are:
10000 (salt) + 12000 (mortgage) + 5000 (charity) = 27000

This means only 3000 of the 12000 of mortgage interest is deductible. In other words, my after tax deduction mortgage rate is about 2.5%.

To compare this to an equivalent bond, I will choose the three year treasury, which currently yields 2.91%. The after tax yield would be 2.91 * (1 - 0.35) = 1.89 since state taxes don't apply.

So it seems my mortgage cost of 2.5 is higher than an equivalent treasury bond at 1.89.

I am invested in index funds (60/40 stocks/bonds). My bond allocation amount is roughly the same as my mortgage. I max out all tax advantaged accounts including 529s.

I am considering taking my bond allocation and paying off the mortgage at the end of the year. The reason is that I earn less on equivalent bonds than the mortgage costs me. Any advice would be welcome.

JBTX
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Re: Mortgage payoff given new 2018 tax code

Post by JBTX » Fri Nov 16, 2018 11:12 am

ltlku wrote:
Fri Nov 16, 2018 7:15 am
I know this question has been posted hundreds of times, but I'd like some advice on this.

I have a mortgage at 2.8%. The rate resets in 3 years to the 5 year treasury plus a 2% margin.

The mortgage amount is $450k. My marginal tax rate is 45% including state taxes.

I have enough money to payoff the mortgage today. I haven't paid it off because I could invest in bonds and match or beat the return on the mortgage. However, the 2018 tax code changes things.

The new tax code means that the mortgage is no longer fully deductible. The standard deduction is now $24000 with a cap of $10000 on state and local tax deductions.

My total itemized deductions are:
10000 (salt) + 12000 (mortgage) + 5000 (charity) = 27000

This means only 3000 of the 12000 of mortgage interest is deductible. In other words, my after tax deduction mortgage rate is about 2.5%.

To compare this to an equivalent bond, I will choose the three year treasury, which currently yields 2.91%. The after tax yield would be 2.91 * (1 - 0.35) = 1.89 since state taxes don't apply.

So it seems my mortgage cost of 2.5 is higher than an equivalent treasury bond at 1.89.

I am invested in index funds (60/40 stocks/bonds). My bond allocation amount is roughly the same as my mortgage. I max out all tax advantaged accounts including 529s.

I am considering taking my bond allocation and paying off the mortgage at the end of the year. The reason is that I earn less on equivalent bonds than the mortgage costs me. Any advice would be welcome.
You will get all kinds of different opinions on here, but if it were me, I'd hold onto the mortgage, at least until it resets. At that point, depending on what the rate is, keep it or pay it off. I would always keep enough liquid funds to be able to pay it off and invest in short term instruments that will mostly offset the interest. Ibonds, treasuries, CD's, maybe some tax exempt. I tend to value having extra liquidity.

If you really are sitting on lots of cash and have no liquidity issues, then yes, you can pay it off, but I look at a 2.8% mortgage when mortgage rates are above 4% as a freebie. There is the chance rates will go up even further and your interest earnings may meet or exceed the interest. At least for 3 years, your mortgage rate can't go up. Interest on bonds can. If rates go down, you always have the option to pay it off any time you want.

toomuchRE
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Re: Mortgage payoff given new 2018 tax code

Post by toomuchRE » Fri Nov 16, 2018 11:46 am

If you are taking standard deduction, you cant take deduction on mortgage. isn't it ??. makes no sense to keep mortgage now if you have $$$ sitting idle

ShowMeTheER
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Re: Mortgage payoff given new 2018 tax code

Post by ShowMeTheER » Fri Nov 16, 2018 11:52 am

I'm in a somewhat similar boat. Generally, do whatever makes you sleep best at night.

My suggestion would be to take advantage of your next 3 years until reset by just paying your monthly mortgage (given that your interest rate is very good). At that time, if you still have more than enough to pay it off without worry and it's otherwise sitting idly by, then pay it off entirely.

Maybe something significant happens in your life between now and then that might matter. Maybe risk free rates are significantly different at that time and it might tilt your decision.

ltlku
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Re: Mortgage payoff given new 2018 tax code

Post by ltlku » Fri Nov 16, 2018 11:56 am

toomuchRE wrote:
Fri Nov 16, 2018 11:46 am
If you are taking standard deduction, you cant take deduction on mortgage. isn't it ??. makes no sense to keep mortgage now if you have $$$ sitting idle
I am close to taking the standard deduction. My after tax cost of this mortgage is roughly 2.5%. The money is not totally idle, it's invested in short term bonds earning around 1.9% after taxes. So, I'd save roughly 0.6% times the mortgage amount while maintaining the same risk level. As stated above, I'd lose the liquidity of having this cash on hand.

Soon2BXProgrammer
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Re: Mortgage payoff given new 2018 tax code

Post by Soon2BXProgrammer » Fri Nov 16, 2018 12:24 pm

ltlku wrote:
Fri Nov 16, 2018 11:56 am
toomuchRE wrote:
Fri Nov 16, 2018 11:46 am
If you are taking standard deduction, you cant take deduction on mortgage. isn't it ??. makes no sense to keep mortgage now if you have $$$ sitting idle
I am close to taking the standard deduction. My after tax cost of this mortgage is roughly 2.5%. The money is not totally idle, it's invested in short term bonds earning around 1.9% after taxes. So, I'd save roughly 0.6% times the mortgage amount while maintaining the same risk level. As stated above, I'd lose the liquidity of having this cash on hand.
options in my mind.

Ask to recast the mortgage. this is when you make a large payment and they change the payment amount going forward, instead lopping off the payments at the end.. this is a good mix.. it helps with liquidity if you have a cash crunch after making a huge contribution towards the mortgage but don't actually pay it off.

save and pay it off in a lump when its done.

save and realize you don't want to pay it off, but actually invest the funds more aggressively.

--

i personally basically did the recast option, then paid it off.. but my new mandated payment was like 700 a month vs the 1700 it was.

ofckrupke
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Re: Mortgage payoff given new 2018 tax code

Post by ofckrupke » Fri Nov 16, 2018 1:03 pm

In your bracket (which should include the 3.8% NIIT for the hypothetical taxable bond alternative of a 3Y treasury, btw), a mix of state-specific and short-term national muni funds, or a term-specific muni ETF (e.g. iShares® iBonds® Dec 2021 Term Muni Bond ETF, IBMJ) are likely more appropriate alternatives than the 3Y treasury note.

Another tweak to your comparison is that sensibly you'd accelerate some years of charity into a payoff year using a Donor Advised Fund, so the effective aftertax rate on the mortgage for a comparison ending at the reset date would be like [1.54% + 2*(2.8%)]/3 = 2.18%.

Another point is that as a bond alternative, a full payoff pays back not all at the reset date, but over the course of the now remaining mortgage term, so the use of an alternative that matures at the reset date isn't actually as appropriate as for a partial prepayment. Today it seems like the post-reset 2% spread to 5Y treasury will "always" result in a pretty good return on prepayment/payoff compared to fixed income alternatives over a wide range of considered maturities/durations, but who knows.
Depending on recalculations suggested in earlier paragraphs, you may consider retaining liquidity until closer to the reset.

OregonDucksFan
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Re: Mortgage payoff given new 2018 tax code

Post by OregonDucksFan » Fri Nov 16, 2018 1:55 pm

I'm in the same situation. I am waiting on the first year that itemized deductions (with mortgage interest) COMPLETELY falls below standard deduction. It also doesn't hurt to wait a couple months to see if the new Congress will change the tax code.

ltlku
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Re: Mortgage payoff given new 2018 tax code

Post by ltlku » Fri Nov 16, 2018 2:17 pm

I am not considering a partial prepayment because that would effectively drop more of the interest into the "non-deductible" category since my total itemized deduction would then fall below the standard deduction.

The 3.8% NIIT does apply, so my math was slightly off on the treasury yield. I've considered IBMJ (iShares Dec 2021 Muni Bond) since it matures close to my reset. It currently has an SEC yield of 2.05%. Since my local tax rate is about 10% (NYC), this comes to 1.85% after tax.

My mortgage resets every 5 years, so the new rate will be the treasury + 2% in late 2021. I don't see how I will be able to get a 5 year bond (with the same risk) at that time that yields higher than the mortgage rate either. There is one more interesting thing to note is that the periodic cap is 2%, so the most it can go up to is 4.8%.

Currently, the 5 year muni rate is 79% of the 5 treasury rate, so let's use that going forward. If the 5 year treasury is below around 5% in 5 years, I will be better off paying off the mortgage for those next 5 years as well. If the 5 year treasury is above 5%, since I get capped, I will be better off investing in muni bonds.

5YR Mortgage After tax Mortgage Estimated 5 Year Muni Rate
1% 3.00% 2.66% 0.8% Payoff
2% 4.00% 3.21% 1.6% Payoff
3% 4.80% 3.65% 2.4% Payoff
4% 4.80% 3.65% 3.2% Payoff
5% 4.80% 3.65% 4.0% Not Payoff
6% 4.80% 3.65% 4.7% Not Payoff
7% 4.80% 3.65% 5.5% Not Payoff
8% 4.80% 3.65% 6.3% Not Payoff
Last edited by ltlku on Fri Nov 16, 2018 2:29 pm, edited 1 time in total.

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Cycle
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Re: Mortgage payoff given new 2018 tax code

Post by Cycle » Fri Nov 16, 2018 2:25 pm

I'd save the .6% and pay it off. I paid mine off despite the logical thing being to keep it.... But there's something to be said for having less financial obligations... 12 less bills to pay every year

ofckrupke
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Re: Mortgage payoff given new 2018 tax code

Post by ofckrupke » Fri Nov 16, 2018 3:01 pm

ltiku,

it sounds like you are way on top of this...and should probably be offering rather than asking advice here. (How's that for a welcome?)
If the illiquidity premium seems to answer for its risk, on a commitment of this scale, then go for it.
Do think about gift bunching with a DAF since you will be deep in the std deduction after the note is retired.

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BL
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Re: Mortgage payoff given new 2018 tax code

Post by BL » Fri Nov 16, 2018 3:59 pm

ofckrupke wrote:
Fri Nov 16, 2018 3:01 pm
ltiku,

it sounds like you are way on top of this...and should probably be offering rather than asking advice here. (How's that for a welcome?)
If the illiquidity premium seems to answer for its risk, on a commitment of this scale, then go for it.
Do think about gift bunching with a DAF since you will be deep in the std deduction after the note is retired.
+1
I have heard Fidelity mentioned here for DAF (donor-advised fund). If you pay off mortgage this may be your last year to itemize.

rgs92
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Re: Mortgage payoff given new 2018 tax code

Post by rgs92 » Fri Nov 16, 2018 4:36 pm

The new high standard deduction makes all itemized deductions a lot less valuable since you only get a marginal benefit.
That is the tax savings on this amount: (total itemized deductions minus the standard deduction).
I don't think this has really sunk in yet for many people.

You don't even get personal exemptions anymore.
Things have changed a lot.

As a personal simple example:
$12K mortgage interest + $10K property taxes + $6K State Income taxes = $28K Total Itemized deductions.
Standard Deduction for a married couple is $24K.

So I get a whopping $4,000 additional deduction for itemizing, about $1,000 in tax savings. I might as well rent...

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BL
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Re: Mortgage payoff given new 2018 tax code

Post by BL » Fri Nov 16, 2018 7:12 pm

rgs92 wrote:
Fri Nov 16, 2018 4:36 pm
The new high standard deduction makes all itemized deductions a lot less valuable since you only get a marginal benefit.
That is the tax savings on this amount: (total itemized deductions minus the standard deduction).
I don't think this has really sunk in yet for many people.

You don't even get personal exemptions anymore.
Things have changed a lot.

As a personal simple example:
$12K mortgage interest + $10K property taxes + $6K State Income taxes = $28K Total Itemized deductions.
Standard Deduction for a married couple is $24K.

So I get a whopping $4,000 additional deduction for itemizing, about $1,000 in tax savings. I might as well rent...
From H&R Block:
Under the TCJA, the deduction for all state and local taxes combined cannot exceed $10,000. These taxes include state and local income or sales taxes, real estate taxes, and personal property taxes.

ltlku
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Re: Mortgage payoff given new 2018 tax code

Post by ltlku » Fri Nov 16, 2018 10:42 pm

ofckrupke wrote:
Fri Nov 16, 2018 3:01 pm
ltiku,

it sounds like you are way on top of this...and should probably be offering rather than asking advice here. (How's that for a welcome?)
If the illiquidity premium seems to answer for its risk, on a commitment of this scale, then go for it.
Do think about gift bunching with a DAF since you will be deep in the std deduction after the note is retired.
Thanks for compliment. I'm a long time reader of the forum. Maybe I'll contribute going forward now that I have an account. Thanks for the suggestion on the donor advised fund as well.

ltlku
Posts: 5
Joined: Fri Nov 16, 2018 6:42 am

Re: Mortgage payoff given new 2018 tax code

Post by ltlku » Fri Nov 16, 2018 10:48 pm

rgs92 wrote:
Fri Nov 16, 2018 4:36 pm
The new high standard deduction makes all itemized deductions a lot less valuable since you only get a marginal benefit.
That is the tax savings on this amount: (total itemized deductions minus the standard deduction).
I don't think this has really sunk in yet for many people.

You don't even get personal exemptions anymore.
Things have changed a lot.

As a personal simple example:
$12K mortgage interest + $10K property taxes + $6K State Income taxes = $28K Total Itemized deductions.
Standard Deduction for a married couple is $24K.

So I get a whopping $4,000 additional deduction for itemizing, about $1,000 in tax savings. I might as well rent...
State income taxes and property taxes are capped at a combined $10,000, so your mortgage interest of $12,000 may be fully non-deductible at this point. In this situation, I'd consider prepaying as well.

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