Save Taxes, Hold a Mortgage

As a financial planner, clients often ask me, “Should I pay down my mortgage?” and “Should I pay cash to buy a home?”

Debt-averse financial personality Dave Ramsey believes debt is inherently bad and that financial prudence means paying off loans as quickly as possible. Yet, for many of our clients who work in tech and are in a high tax bracket, holding a tax-deductible mortgage is a way to create wealth.

When the alternative to paying down a mortgage (or paying cash for a new home) is investing that cash in a diversified portfolio tailored to your risk tolerance and long-term financial goals, it’s a good idea to weigh the financial outcome of each choice.

Four Benefits of Holding a Mortgage 

If you’re in your peak earning years, holding a mortgage offers at least four benefits:

1. Get a Big Tax Deduction

Unlike the property tax deduction, which is capped at $10,000, the mortgage interest deduction has no limit. However, the mortgage must satisfy these criteria for interest to be fully deductible:

• The original loan must be no more than $750,000, if you took out your mortgage after December 16, 2017; if you secured the loan prior to that date, you can deduct interest on up to $1.1 million.
• The loan must have been used to buy, build, or maintain a primary or secondary residence (known as qualified acquisition indebtedness).

For example, if you’re in the 50% combined federal and state tax bracket and hold a mortgage with a 6% interest rate, your after-tax interest cost is just 3%. This is a delightful advantage of a mortgage.

While taxpayers can currently deduct the interest paid on only $750,000 of home acquisition debt (see the exception above), beginning in 2026, an interest deduction will be allowed on qualified loans of up to $1.1 million, assuming the relevant provisions in the 2017 Tax Cuts and Jobs Act (TCJA) expire.

2. Participate in Interest Rate Arbitrage 

If your first inclination is to avoid a mortgage altogether, consider how much you can earn if those dollars are instead invested in a diversified portfolio.

It’s a simple comparison between your after-tax interest expense and the expected return on your portfolio. Most of our clients expect a portfolio return higher than 50% of their mortgage interest expense. In the 6% interest rate example, the portfolio return hurdle is just 3% after-tax, an easy bar to beat even for conservative investors. This example assumes you are in the top federal and state tax bracket.

3. Conservatively Turbo-Charge Your Wealth with an Interest-Only ARM (Adjustable-Rate Mortgage)

If you like this strategy so far, you can double down on it by holding a mortgage indefinitely, or at least while you’re in a high tax bracket. An interest-only mortgage locks in a rate for a fixed period (such as 5, 7, or 10 years), requires no principal paydown during the stated term, and generally carries a lower interest rate than a traditional 30-year mortgage. This type of loan provides the most bang for your buck when you use a loan as arbitrage. As with most mortgages, you’re not locked in if you have second thoughts—you can always pay down the loan. Just check with the lender about any prepayment penalties that may be in effect.

4. Stay Liquid

If you use the dollars that would have gone into your home to invest in a taxable brokerage account (rather than a retirement account) holding publicly traded funds, stocks, and ETFs, you can sell these holdings within a day or two to free up cash if you need it. This can be helpful if you need cash for an unforeseen expense. Equity in your home can take much longer and is often more difficult to access.

Be Mindful of Short-Term Investment Risk

The largest risk associated with investing your excess cash is the inherent uncertainty that comes from investing in the market. Especially in the short term. That’s why we always recommend that clients hold an emergency cash reserve of three-to-six months of living expenses.

Performance is never guaranteed, and even the highest-performing assets will underperform at some point. However, without uncertainty, there would be little return (consider the low returns of short-term U.S. bonds). With a long time horizon and a risk-appropriate portfolio, adding surplus cash (not needed for at least five years) to your portfolio is expected to beat what might be a feel-good move to pay down your mortgage or pay cash to buy a home. Here is where a professional advisor comes in, keeping you invested and on track to achieve your goals when the market is volatile.

Shop Around for Low Interest Rates 

Most people start their mortgage shopping by looking for a low-cost loan. If you have a bank or brokerage relationship with a custodian such as Schwab, you may qualify for a discount of up to 1.00% off mortgage interest rates, based on the size of your portfolio.

If you already have a low mortgage interest rate (which means you likely secured your mortgage prior to 2022), consider yourself lucky. Those loans can’t be purchased today and are thus inherently valuable.

The time value of money is at work as well, and the payments made in the later years of the loan are much less expensive than the value of those payments today.

Unlike using a margin loan to borrow against your investment portfolio—it’s expensive and not tax deductible—a mortgage loan has a fixed rate, which is an attractive tax benefit for those in the top tax brackets.

If you’re tempted to park your cash in your home by either paying down your mortgage faster than required or by paying cash outright, consider the long-term benefits of diverting those dollars into your portfolio and holding a mortgage.

Wealth Management at Mission Wealth

Whether to use your excess cash to invest in a diversified portfolio or pay off your mortgage is just one of the many questions we help our clients answer. Our detail-oriented approach to financial planning and investment management enables us to generate and preserve wealth for our clients, especially tech and HR executives. We also specialize in working with Googlers.

For more information about our creative wealth management strategies, schedule an introductory meeting today.

About the Author

Joyce L. Franklin, CPA, CFP® is a Partner and Senior Wealth Advisor at Mission Wealth. She advises employees and executives in tech and human resources on wealth management, tax, and financial planning. She designs, implements, and monitors financial plans, coordinating each client’s goals, values, and risk tolerance.