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Mortgage Interest Deductibility

The rules around the deductibility of mortgage interest has changed a few times over the last few tax changes. As we currently stand, if you purchased a house after 12/15/2017 (and were not in contract of purchasing a home before that date), your mortgage interest is deductible up to $750k of mortgage indebtedness.

In other words, if your average mortgage balance for a tax year is $750k or less, the full amount of interest you paid is deductible.

If your average mortgage balance for a tax year is above $750k, only some of the interest you paid will be deductible.

A few other items to consider with this include:

  1. This is discussing your personal home(s). Your rental property does not get included in this.

  2. The mortgage(s) or loan(s) has to have been taken out to buy, build or substantially improve your home. You took out a home equity loan to buy a car? This is not deductible.

  3. The limitation is on total mortgages. If you have a personal home and a vacation home (that is also personal and not a rental), you can deduct total interest paid if both mortgages total $750k or less (not $750k each).

Is it deductible?

Just because you have MORE than $750k of mortgage interest, doesn’t mean you’re losing out on the deduction. You just have to prorate your deduction.

The formula to calculate your prorated deduction is: (total loan limit) / (average mortgage balance) x (total amount of interest paid) = mortgage interest deduction.

If you have an average balance of $1 million in mortgages, you basically only get to deduct three-quarters of the interest you paid ($750k / $1mm = 75%).

If you have a $750k mortgage with a 6% interest rate and a $100k mortgage with a 2% interest rate, can you deduct all the interest paid on the $750k mortgage? No! You must follow the formula, which will result in a lower deduction.

The second step to consider is that mortgage interest is a deduction on Schedule A, also called itemized deductions. The only time you would complete a Schedule A is if your itemized deductions add up to more than the standard deduction. If you want to learn more about different deductions on your tax return, check out this blog I wrote previously.

I am assuming that those who are reading this blog are in a position of potentially exceeding the loan limit of $750k, which would likely mean you are utilizing Schedule A.

Net cost of debt

I’ve heard the recommendation to get your mortgage interest down to $750k so that the full amount is deductible - I certainly don’t hate this advice, but I’m not sure it is always the best advice for everybody.

If I think about debt, one of the most important things to know when considering carrying the debt or paying it off is how much it costs you. Just because a debt is deductible, doesn’t necessarily mean it is a “better” debt.

In order to determine the cost of your debt you’ll want to know the interest rate and if the debt is deductible. If it is deductible, the net cost can be determined based on your marginal tax rates.

I’m going to use an example to illustrate my point. Here are some assumptions to illustrate the situation of K & C, a married couple:

  1. They have $1mm of mortgage debt from a loan taken out in 2020. The interest rate is 4%.

  2. They have a private student loan balance of $50k at 6%.

  3. They have a car loan balance of $20k at 4.5% interest rate.

  4. They have a promotional 0% credit card balance of $6k.

  5. Finally, their income puts them in the 32% federal marginal tax bracket and a 5% state marginal tax bracket.

These numbers and calculations are simplified for illustrative purposes, but here is how to think about the net cost of each debt:

  1. They paid $40k of interest (4% of $1mm) on their mortgage in 2022 - $30k of which was deductible. Their $30k deduction saved them 36% in taxes, or $10,800 for a net cost of $29,200 in interest paid or a 2.92% net cost of debt.

  2. They make too much income to deduct their student loan interest, so their net cost is 6%.

  3. Car interest is not deductible, so the net cost is 4.5%.

  4. Credit cards are not deductible and there is nothing to deduct since it has a 0% rate.

Instead of saying “car debt is bad - never take a loan on a depreciating asset!!!” maybe instead think about the cost of the debt you currently have. Even though student loans are “good debt” because they helped you grow your income, your income is already grown. It may make more sense for K & C to save 6% interest by paying down their student loans instead of saving 4.5% by paying down their car loan.

Getting to my point: just because a mortgage may not be fully deductible, this doesn't mean paying it down is the best use for your dollar. It may make more sense to prioritize other financial goals instead of just trying to get the mortgage balance down to a certain level.

If this couple decided they really wanted to get their mortgage loan down to $750k for the deductible limits… they’d be paying off a debt that costs them 4% instead of the other debts that are costing them more.

This decisions should be taking into account the opportunity cost of giving up other options. If you have an extra dollar to save, what are you going to do with it and why? Just because your full mortgage isn’t deductible, this doesn’t mean paying down the mortgage is the best use for that next dollar.

Final Thoughts

Sometimes financial decisions or recommendations are made in a vacuum. It sounds good to receive the advice: “pay down your mortgage to $750k so the full amount is deductible”. But if the non-deductible mortgage rate is low and you can do something better with that money… this may be a poor recommendation.

As always, there is a financial side to the decision and an emotional side to it. Maybe you want to knock down the mortgage to $750k because that feels like a much more manageable amount - that works! Your finances are personal and its up to you to manage your finances in a way that works best for you.


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