SubscribeTue 25 Sep 2007
Reading BussinessWeek at the Gym during my visit last week was a treasure trove of information. In addition to learning about Chuck Feeney, I learned something new about the Mortgage Deduction that I didn’t know about. Of course this piece of information is less than beneficial.
Most people typically think of all the mortgage interest as deductible, assuming it falls under the 1 million dollar cap. However this is not true for the many individuals who have refinanced to take cash out of a highly appreciated home. Refinanced mortgage interest is only deductible to the amount of the original mortgage. For instance let’s say I purchased a house 20 years ago for 100k with a 80k mortgage, and now it’s worth 500k. I then do a cash our refinance for a total of 300k. I can only deduct the interest on the original 80k, not the new balance of 300k. However, according to the article in BusinessWeek and my own reading of the IRS Publication 936, it’s possible to deduct the interest on another 100k if it’s in the form of a second mortgage, or home equity line.
I’m generally not a fan of the cash out mortgage, and this is yet another reason not to do it. As is, I don’t advocate taking a course of action purely because of tax issues, and too many people push taking out large mortgage because “it’s deductible.” Taxes are an important part of the financial decision of making process and tax consequences should shape decisions. Decisions should not however ever be made solely to avoid taxes. In this case taking a cash out mortgage may not even be the tax deduction boon one would think.
Also, I’m under the Big Tent at My Two Dollars in the 106th Carnival of Debt Reduction, my article on Mary’s Ann’s Makeover is featured. Please take some time to visit David’s blog, My Two Dollars.
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September 25th, 2007 at 3:42 pm
Do you define cash-back as what’s also called “reverse”?
September 26th, 2007 at 6:28 am
I think a reverse mortgage is where the bank pays you every month, and at the end of the term they own your house (it’s like the bank taking out a mortgage with YOU, rather than the reverse).
I don’t know many details about it, though. For instance, is it like a regular mortgage where for the first 10 years or whatever the bank is primarily paying amortized interest and not principal? That makes it seem like a really good deal for retired people, since they get all that income but lose very little equity in their house. Somehow I doubt the banks are that generous, though.
September 26th, 2007 at 7:25 am
Yeah to echo Jon, a reverse mortgage is what he’s described which is different from a cash back refinance. In the case of reverse mortgage, the banks pays you money. You can live in the home as long as you live. I believe one can choose to either to receive a lump sum payment or monthly payments. Not sure how the details work on prepayment, but Jon is probably right in asserting that banks are not that generous. Still for some older retired folks a reverse mortgage could make good sense.
September 26th, 2007 at 7:34 am
And so in a cash-back refinance, you refinance and also get money?
E.g. If I have $100k left in my mortgage and refinanced to get a $150k mortgage so I’d have $50k spending money? Not unlike a home equity loan, right?
(I’m trying to figure out all the different types of mortgages)
September 26th, 2007 at 8:56 am
That’s exactly right. A Cash Bank refinance takes money from the value of the home, and puts it in your pocket. Similar to Home Equity, but because it’s the primary loan, it’s generally cheaper. For example let’s say you had a house worth 300k, and 100k mortgage, and could either open a home equity line or a refinance into a 150k mortgage and get 50k in cash to use. If the the original 100k mortgage is as the current prevailing rate, the cash back refinance will generally have a better rate. A home equity line or even a 2nd mortgage typically have higher interest rates than a 1st mortgage. This is because the 2nd mortgage and home equity are second in line after the 1st mortgage for the value ofequity in the home in the case of a foreclosure.
In practice things are much more complicated. Closing costs are nearly nil for a home equity while they can be very high for a refinance. In addition if the original mortgage is at a much lower rate than current mortgage rates, it wouldn’t make sense to refinance that 100k into a higher rate.
September 26th, 2007 at 9:16 am
Thanks, Dong.
I’m working on a piece right now about the risks of interest-only mortgages. There’s so many options out there and it can be very confusing. I’m happy with renting for now and for a while yet.