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New Ways to Think About Your Mortgage

Baird's Tim Steffen discusses the role of a mortgage in your financial plan.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Thanks to the new tax laws, carrying a mortgage may make less financial sense now than it did in the past. Joining me to share some thoughts on the role of a mortgage in your financial plan is Tim Steffen. He is director of Advanced Planning for Baird.

Tim, thank you so much for being here.

Tim Steffen: Always good to be here.

Benz: Tim, let's talk about the tax laws that went into effect in 2018. Can you sum up the major changes, Tim?

Steffen: Sure. There were really two significant changes affecting mortgages and loans, plus another on the deduction side. The first one is, the amount of debt on which you can deduct interest. The rule had always been, you can deduct the interest on up to $1 million of debt on your primary home and a second home. Beginning December 15 of 2017, that changed to $750,000. So, the amount of debt on which you can deduct the interest is now lower. However, if your mortgage is in place before that date, you're grandfathered under the old rule. So, as long as you got a loan out before that date, you can have up to $1 million of debt. If you bought a new home since mid-December of 2017, you have to be more conscious about this $750,000 threshold. So, that's one of the changes.

The second one has to do with home equity loans. Just in general, home equity loan interest no longer deductible. So, the traditional home equity loan where you take some money out, you use it to buy a car, consolidate some of the debt, pay off a tuition bill, something like that. That interest is no longer tax-deductible. If you use the proceeds for something specific to the house, like some home improvements, put a new roof on, some landscaping or whatever it might be, that is considered a home acquisition or home improvement loan. That's still tax-deductible as a part of the new rules now.

The other thing that's changed though, and it's not for mortgages specially, but just in general is, all the other changes to the tax deductions where they cap the state tax deduction, they increase the standard deduction. As a result, many fewer people are itemizing deductions. It used to be that about 30% of taxpayers would itemize. That's down to about 10% or so. We're waiting for the new numbers to come out for 2018, but that's about what we're expecting. So, even though the mortgage interest deduction is still there, many fewer people are actually going to benefit from it now under the new rules.

Benz: So, there's that, and there's also what's been going on with rates. We've seen interest rates tick up a little bit. So, how should you approach that? People who had thought maybe they would refinance, what role do interest rates play in all of this?

Steffen: It's certainly a big part of it. If you look at where interest rates were maybe last fall, they took a dive earlier this year. They kind of bounced back a little bit. They may be still about 0.5 point less than what they were maybe last fall, but they move all the time. So, it's the kind of thing where you got to kind of keep an eye on it. But if you're seeing your rate drop by half a point, or you're seeing rates lower than your own rate by half a point or more, it might make sense to look at doing some refinancing and see if you can save some on that monthly mortgage payment.

Benz: Certainly, people who--do you think if you're in some sort of floating rate product, should you consider locking it in?

Steffen: Yeah. If you've got a variable-rate mortgage, you're probably getting a better rate than what's out there today, but that's not guaranteed. It's going to come to an end at some point. So, you got to look at what is your term. If you are in the last couple of years of that, you might want to look at maybe locking in. If you've got some more time, you can maybe play the interest-rate game for a little while yet. And there's not a lot of people who are expecting interest rates to fall dramatically again. So, we'll see where that goes. But if you've got a variable rate, you've got a bit of a risk there. As you find something that's attractive, it might make sense to lock it in at some point here soon.

Benz: One thing I often hear from our readers about is sort of a household capital allocation question. Should I prepay my mortgage, pay down more on my mortgage than I need to, or invest in the market? How should people approach that mortgage prepayment question? How aggressive should they go at paying down the mortgage?

Steffen: We look at it a couple of different ways. One is, let's say, you are an individual who has some cash sitting on the sidelines and you are thinking should I take that and invest it, or should I put that towards my mortgage. The math side of it is pretty simple. If you could earn more in the market than your--or however you choose to invest it--versus what you are paying on the mortgage, you are going to be better off for the long run. You'll have more net worth at the end of the day. If you can earn 7% but only pay 4% on the mortgage, for example, you are better off keeping the mortgage. And you got to take taxes into account there, because that 7% might be taxable, the 4% might be deductible, it might not be.

Benz: And the mortgage paydown is guaranteed, right?

Steffen: Correct.

Benz: That's a guaranteed benefit to me--

Steffen: Right. Exactly.

Benz: --whereas it's open-ended what I'll do in the market.

Steffen: Again, who knows what the market is going to do for you there. Exactly. So, there's the pure math side of it. If you think you can do better with your investments than you can do in the market or think you can do by paying off your mortgage, you're better off with keeping the loan. The other side of that, though, is there is a certain psychological aspect to having a mortgage. And what we tell folks is, if you sleep better at night knowing that your mortgage is paid off, then pay it off. And yeah, maybe you give up a little bit on the investment side by doing that. But if you feel better about your finances, if you like getting rid of that fixed expense every month, especially if you are moving into retirement where you don't have the fixed income coming in anymore, in those cases, maybe just paying off the mortgage, leaving a little bit investment return on the table, that's okay, too.

Benz: You referenced the tax law changes around home equity loans. Let's talk about that, how people should approach the HELOC as a part of their financial plan. It had been kind of conventional wisdom that if you have a home and have home equity, that you should think about that as kind of next-line reserves in a financial emergency. Is that still wise?

Steffen: Yeah. People talk about, well, you got to have an emergency fund, you got to have an emergency fund. Well, one way to fund that is just putting some cash to the side. But another is, easy access to borrowing like a home equity line of credit or HELOC. A lot of people use that as their emergency fund. Keep in mind, with a HELOC you are not paying any interest on that until you actually draw down on it. So, you can have the line sitting off to the side waiting for you. But until you actually take any money out it, it doesn't cost you anything.

Benz: Might have some annual servicing fees, right?

Steffen: Exactly. Yeah, there's a small annual fee typically. And shop that around. You can always see if you can find a better rate on that somewhere. But yeah, the home equity line can be a great way to have some emergency money sitting off to the side. So, if you've got that home repair or car repair, medical expense, something like that that comes up, it can be a great way to help fund some of that.

The home equity line of credit though is something we really encourage people as you are getting into retirement--keep that home equity line available. Once you get into retirement, banks are going to be a lot less likely to want to give you that line. They say, you don't have an income stream coming in every month, how do we know you're going to be able to pay that off. Get the line set up and established before you retire. And then, once you're retired, you've still got the line available to you, you can still tap into it.

Benz: Tim, always great to get your perspective. Thank you so much for being here.

Steffen: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.