For every single individual taxpayer who has a mortgage on their principal residence, your mortgage rate just went up with the new tax bill and I can prove it.

Part of the new tax bill was some limitations on the mortgage interest deduction and some changes for itemized deductions in general. My father is a pretty savvy taxpayer, considering we have been discussing taxes in great detail for over a decade, and I was over helping him move some furniture last week when we started discussing the tax bill and how it will affect his mortgage interest. If he needs some help fully understanding how the mortgage interest deduction is affected by the new tax law, then perhaps we should dig deep and try to see how it will all work.

So, taxpayers with existing mortgages between $750,000 and $1 million are still ok to claim all their mortgage through the year 2025, but it will affect new homebuyers who have large mortgages. Once again, a portion of those large mortgages will be not deductible. That’s simple enough to understand and a slight change of what the existing rules were.

Another part of the tax bill was doubling the standard deduction and limiting the state and local tax deductions to $10,000 per year. This is going to cause many taxpayers not to even itemize at all which is going to have the effect of making mortgage interest either entirely not deductible or partially deductible at best. Let’s go through some examples.

Example 1

Joint Taxpayers make $250k and live in MN. Their state tax liability is $14k plus they pay $3k of real estate taxes and have a mortgage with interest of $10k per year ($250k mortgage at 4%). In 2017 they are able to deduct everything so they have $14k + $3k + $10k = $27k itemized deductions. The standard deduction was $12k so they were able to deduct their entire $10k of mortgage interest and benefit from it. $10k deduction at their 35% combined tax bracket means they saved $3,500 on their taxes.

In 2018 that same situation leads to a different result. They are limited to just $10k of state tax and real estate tax and they still have $10k of mortgage interest. That’s $10k + $10k = $20k of total itemized deductions. The standard deduction is now $24k which means they are not itemizing at all in 2018.

In 2017 they were paying 4% on their mortgage, but after factoring in the tax deduction that saved them $3,500 it was really an effective rate of 2.60% on the mortgage. They were paying only a net 2.6% on their mortgage every year. In 2018 they still pay the bank 4% but now they get zero tax savings so their effective rate is the full 4%. That’s a big increase in your interest rate to go from 2.6% up to 4.0%.

Example 2

Joint Taxpayers make $700k and live in MN. Their state tax liability is $60k plus they pay $8k of real estate taxes and have a mortgage with interest of $20k per year ($500k mortgage at 4%). In 2017 they are able to deduct everything so they have $60k + $8k + $20k = $98k itemized deductions. The standard deduction was $12k so they were able to deduct their entire $20k of mortgage interest and benefit from it. $20k deduction at their 48% combined tax bracket means they saved $9,600 on their taxes.

In 2018 that same situation leads to a different result. They are limited to just $10k of state tax and real estate tax and they still have $20k of mortgage interest. That’s $10k + $20k = $30k of total itemized deductions. The standard deduction is now $24k which means while they are still itemizing they are really only deducting $6k of that mortgage interest. The $6k tax deduction saves them at their combined tax rate of about 46% which is $2,760.

In 2017 they were paying 4% on their mortgage, but after factoring in the tax deduction that saved them $9,600 it was really an effective rate of 2.08% on the mortgage. They were paying only a net 2.08% on their mortgage every year. In 2018 they still pay the bank 4% but now they get only $2,760 tax savings so their effective rate is 3.45%. That’s a big increase in your interest rate to go from 2.08% up to 3.45%.

So looking at these examples, how does that change your thinking? In both examples the effective interest rate on the mortgage has increased dramatically about 1.4%. It moves the needle towards paying down your mortgage. If you have invested assets earning a 6% return, after tax that would be closer to 4.0% suddenly the difference between your rate of return on your invested assets and your effective mortgage rate isn’t as big as it used to be. Making a choice to pay down your mortgage is a big decision, but fully understanding the effective interest rate on that mortgage is a key first step. Each tax situation is different, and each person has different interest rates or return on invested assets, but whatever your mortgage rate is, it just went up with the new tax bill and you should be looking carefully at your financial plan.