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Deducting Your Mortgage Interest Under the Tax Code

One of the best justifications for owning a home, at least for financial reasons, is the tax savings that result from deducting mortgage interest. The deduction for mortgage interest stands as one of the few remaining tax deductions for the typical middle class taxpayer. Despite the changes to the tax code over the past several years and the repeal and limitation of many non-housing itemized deductions, mortgage interest is still deductible. On first and second mortgages and home equity lines of credit (with some limitations) for first and second homes, your mortgage interest deduction is still a good financial incentive to buy a home.

Your Mortgage Interest Deductions

Under the current tax code, mortgage interest on first and second homes is generally deductible as long as these loans total less than $1.1 million, making homeownership one of the best ways to trim your tax bill. The examples below illustrate how the mortgage income tax deduction affects the after-tax homeownership.

Listed below are the topics covered in this document.

  • Homeowner Profile
    Gross Income - $35,500
    House Price/Mortgage Size - $115,000 - $23,000 down = $92,000
    Loan Type - 30-year Fixed-Rate mortgage at 10%
    Property Tax - 1.23% of home value ($1,415)
    Filing Status - Files jointly/four exemptions

According to the tax code, this homeowner's deductions for mortgage interest and property taxes would be evaluated at a 15 percent marginal tax rate. Non-housing itemized deductions (i.e., state and local taxes, non-mortgage interest and so on) is estimated at $2,000 and the standard deduction is $5,450. Under the current tax system, the homeowner saves $1,071 because of the mortgage interest deduction. You can figure what your own costs and savings will be by substituting your own tax figures for those on the chart.

  • Example of the impact of the Mortgage Income Tax Deduction on Annual Homeownership Costs:
    • Before-Tax Homeownership Costs
      Mortgage Interest=$9,177
      Property Taxes=1,415
      Total of Before-Tax Homeownership Costs=10,592
    • Itemized Deductions
      • Homeownership Deductions
        Mortgage Interest= $9,177
        Property Taxes=1,415
        Non-homeownership Deductions= 2,000
        Total= 12,592
      • Standard Deductions=5,450
    • Total Itemized Deductions=$7,142
      Multiply Total Itemized Deductions by Marginal Tax Rate to get Homeownership Tax Savings:
      $7,142 x .15 = $1,071
    • After Tax Homeownership Costs = Homeownership Tax - Before Tax Savings:
      $10,592 - 1,071 = $9,521

Two Kinds of Debt

Under the current tax system, there are two different kinds if debt. Money you borrow to buy, build or substantially improve your residence is called "acquisition indebtedness." Money you borrow against the equity in your home, or money you take out when you refinance your home for any reason except home improvement, is called "equity indebtedness."

When you borrowed the money is also important. Home loans taken out before October 14, 1987, are exempted from the new rules. You may fully deduct interest paid on these loans, regardless of their size or what you used them for. Any refinanced debt you incurred before October 14, 1987, is rolled into your total acquisition indebtedness. On loans made on or after October 14, 1987, you can deduct mortgage interest paid on acquisition indebtedness up to a total of 1.0 million. This means you could buy a home for $250,000, a beach home for $200,000, and add a family room to your first house for another $100,000, and still have $450,000 to spend on these homes for further improvements before you reached your limit for interest deductibility. The $1. 0 million is not cumulative. As you pay off a loan, you would add that amount to your total purchasing or improving up to two residences.

Your equity indebtedness limit is $100,000. That means that you can borrow up to $100,000 of the equity in your home and use it for whatever you want. This is a change from the pre-1986 tax rule that limited your equity borrowing beyond the purchase price to certain qualified expenses, such as home improvements, medical and education expenses.

Refinancing Your Mortgage

Interest rate have declined recently, and many homeowners have taken advantage of this drop by refinancing their mortgages. In the past, refinancing your mortgage has proved to be an excellent opportunity both to lower your interest rate and monthly payment and take equity out of your home.

When refinancing your mortgage, you will probably pay 3 percent to 6 percent of the loan amount in closing costs-for surveys, legal fees and paperwork fees. Many of these closing costs are deductible, but not necessarily in the year that you refinance. I f you are considering refinancing your mortgage under the current tax rules, however, there are a couple of things to bear in mind. If you refinanced before October 14,1987, for a longer term than was remaining on the pre-October 14 loan, you may only de duct the interest paid on the mortgage for the term that was remaining on the old loan. So if you refinanced a loan with 15 years remaining for a 30-year loan with lower payments, you can only deduct the mortgage interest paid on the new loan for 15 year s. The one exception is if you had a balloon mortgage payment come due after October 13,1987 and you refinanced it to a loan of not more than 30 years; you get the deductibility for the full term of the longer loan. Any refinanced debt you incurred before October 14,1987, is rolled into your total acquisition indebtedness.

In the past many homeowners have refinanced mortgages on their appreciating properties to draw on their equity to buy a new car or take a vacation. Under the new tax system, homeowners will no longer have unlimited mortgage interest deductions when drawing on equity. Any equity debt incurred is subject to a limit of the amount of on equity. Any equity debt incurred is subject to a limit of the amount of the existing debt plus $100,000. Say, for instance, that you bought your house 10 years ago and have seen the property grow in value from $70,000 to $230,000. If you refinance your mortgage (on which you now owe $50,000), you may only deduct the interest paid on the total of your acquisition indebtedness in the property ($50,000) plus $100,000. You will be able to deduct the interest paid on $150,000.

Second Mortgages

A second mortgage allows the homeowner to cash in on some of the equity that has built up in the home over time. Some lenders call a second mortgage a "junior lien." Getting a second mortgage is very much like taking out your first mortgage (i.e. you w ill be required to pay closing costs of 3 percent to 6 percent of the loan value).

You may deduct the interest paid on second mortgages made on or after October 13,1987, up to the $100,000 limit had already been reached when the first mortgage was taken out. The amount of second mortgages made before that date is part of your acquisition indebtedness total figure. This means that if you had $50,000 left on your first mortgage as of that date, and had taken out a $25,000 second mortgage on the property prior to October 14,1987, you would have an acquisition indebtedness of $75,000.

Home Equity Lines of Credit

While the 1986 tax reform called for consumer interest deducibility to be phased out by 1991, interest deductions on equity indebtedness now are limited only by the $100,000 cap. This means that interest paid on home equity lines of credit - loans secure d by your principal or second home - is still deductible.

Where the traditional second mortgage gives the homeowner money in one lump sum the home equity line of credit allows homeowners to use the equity in their home like a giant credit card. The lender allows the homeowner to borrow at will against the equity in the home, and charges interest only on the portion of the equity borrowed against. Therefore, your interest deductions for a home equity line of credit depend on whether you borrow against the equity during that year.

Loan Type Varies Interest Deduction

As we've said, the mortgage interest tax deduction is one of the best financial reasons to buy a home. You may be wondering, however, what total interest charges are like on the typical home loan. In the chart, you can compare a 30-year fixed-rate loan with 15-year and bi-weekly mortgages for the same amount. As you can see, the amount of interest you pay over the life of your loan depends on what kind of mortgage you determine is best for you.

$75,000 MORTGAGE

30 Year Fixed RateAt 10% 15 Year Fixed Rate At 10% Bi-Weekly Mortgage At 10%
Monthly Payment $658 $806 $658
($329 X 2)
Interest Cost First Year $7,481 $7,398 $7,434
Fourth Year $7,336 $6,606 $7,061
Mortgage Balance First Year $74,583 $72,726 $74,476
Fourth Year $73,052 $64,732 $69,817
Interest Cost/Life $161,942 $70,062 $104,331
Difference from 30-year -$91,880 -$57,611

The Tax Benefits of Selling Your Home

The IRS allows a Capital Gains Exclusion of either $250K or $500K (single or married) on the sale of primary residences. There is no life-time cap on this exclusion. Every 2 years of residence during a 5 year period, you can sell your home and pocket the gain, up to the exclusion, and start over. In other words, assuming that your only residence is your home, every 2 years you can sell your home, pocket the gain and do it again!

You should consider these questions

  • Is the next interest rate adjustment on your existing loan likely to increase your monthly payments substantially? Will the new interest rate be two or three percentage points higher than the prevailing rates being offered for either fixed-rate loans or other ARMs?
  • If the current mortgage sets a cap on your monthly payments, are those payments large enough to pay off your loan by the end of the original term? Will refinancing a new ARM or a fixed-rate enable you to pay your loan in full by the end of the term?

What Are The Costs of Refinancing?

The fees described below are the charges that you most likely to encounter in a refinancing.

  • Application Fees
    This charge imposed by your lender covers the initial costs of processing you loan request and checking your credit report.
  • Title Search and Title Insurance
    This charge will cover the cost of examining the public record to confirm ownership of the real estate. It also covers the cost of a policy, usually issued by a title insurance company, that insures the policy holder in a specific amount for any loss caused by discrepancies in the title to the property. Be sure to ask the company carrying the present policy if it can re-issue your policy at a re-issue rate. You could save up to 70 percent of what it would cost you for a new policy.
  • Lender's Attorney's Review Fees
    The lender will usually charge you for fees paid to the lawyer or company that conducts the closing for the lender. Settlements are conducted by lending institutions, title insurance companies, escrow companies, real estate brokers, and attorneys for the buyer and seller. In most situations, the person conducting the settlement is providing a service to the lender. You may want to retain your own attorney to represent you at all stages of the transaction, including settlement.
  • Loan Origination Fees and Discount Points
    The origination fee is charged for the lender's work in evaluating and preparing your mortgage loan. Discount points are prepaid finance charges imposed by the lender at closing to increase the lender's yield beyond the stated interest rate on the mortgage note. One point equals one percent of the loan amount. For example, one point on a $75,000 loan would be $750. In some cases, the points you pay can be financed by adding them to the loan amount. The total number of points a lender charges will depend on market conditions and the interest rate to be charged.
  • Appraisal Fee
    This fee pays for an appraisal which is a supportable and defensible estimate or opinion of the value of the property.
  • Prepayment Penalty
    A prepayment penalty on your present mortgage could be the greatest determent to refinancing. The practice of charging money for an early pay-off of the existing mortgage loan varies be state, type of lender, and type of loan. Prepayment penalties are forbidden on various loan including loan from federally chartered credit unions, FHA and VA loans, and some other home-purchase loans. The mortgage documents for your existing loan will state if there is a penalty for prepayment. In some loans, you may be charged interest for the full month in which your prepay your loan.
  • Miscellaneous
    Depending on the type of loan you have and other factors, another major expense you might face is the fee for a VA loan guarantee, FHA mortgage insurance, or private mortgage insurance. There are a few other closing costs in addition to these.

In conclusion, a homeowner should plan on paying an average of 3 to 6 percent of the outstanding principal in refinancing costs, plus any prepayment penalties and the costs of paying off any second mortgages that may exist. One way of saving on some of these costs is to check first with the lender who holds your current mortgage. The lender may be willing to waive some of them, especially if the work relating to the mortgage closing is still current. This could include the fees for the title search, surveys, inspections, and so on.

The information contained in this brochure is intended to help you ask the right questions when considering refinancing your loan. It is not a replacement for professional advice. Talk with mortgage lenders, real estate agents, attorneys, and other advisors about lending practices, mortgage instruments, and your own interests before you commit to any specific loan.

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