New tax rules were passed in 2018 that have altered how big of a mortgage borrowers should get.
Today, the ideal mortgage amount is $750,000 if you can afford it. You can now only deduct the interest on up to $750,000 of mortgage interest. In the past, that figure was $1,000,000.
Back in 2002, a $750,000 mortgage cost around $50,000 to $65,000 a year in interest expense given mortgage rates were 5%-6.5% for a 5/1 ARM or a 30-year fixed. Multiply the annual interest expense by three, and you get $150,000-$195,000, the minimum annual income recommended to take out such a loan.
For example, a $750,000 mortgage costs around $30,000 to $40,000 a year in interest expense given mortgage rates are now 3% for a 5/1 ARM or 4% for a 30-year fixed. Multiply the annual interest expense by three again and you get $90,000 to $120,000, a far cry from the $150,000-$195,000 you originally needed to make! Note, banks still only lend out 3-4X your income despite a drop in rates.
It is aggressive to think that someone who only makes $90,000 – $120,000 a year in gross salary can afford a $750,000 mortgage, but it’s also absurd that one can borrow $750,000 dollars nowadays for only 3% still! I’m not recommending everyone with impeccable credit scores, great financial habits, and steady savings rates all get $750,000 mortgages. I’m just saying that it’s now possible for someone making $90,000 – $120,00 a year to service $750,000 worth of debt at today’s rate if the bank approves.
REASONS WHY THE IDEAL MORTGAGE AMOUNT IS $750,000
1) The law says so. The maximum mortgage interest indebtedness is $750,000 dollars according to the IRS. In other words, if you have a $2 million dollar mortgage that costs $70,000 a year in mortgage interest, only $35,000 of the mortgage interest can be deducted from your income. Your tax savings is simply $35,000 X tax rate. The IRS also stipulates that you can deduct the interest on a $100,000 Home Equity Line Of Credit if the money is used other than to build, improve or purchase your home. Crazy but true.
2) Maximum government subsidy. The home mortgage interest deduction is one of the largest government subsidies available to all citizens. In an environment when all it seems like the government does is take, take, take, citizens get something tangible and immediate back from the government. The government helps subsidize your lifestyle and lower your taxes. To not take full advantage of such subsidy is a shame, unless you love paying taxes!
3) Keeps you disciplined. For those who live in expensive cities such as San Francisco and NYC, keeping a $750,000 dollar mortgage limit helps keep you from going overboard and buying too much house. Plenty of nice houses now cost over $2 million dollars for example. By keeping your borrowing to $750,000, you are forced to come up with a higher downpayment. You might think going the standard 20% down ($400,000) and borrowing $1.6 million is fine, but it is not ideal. You start justifying what’s an extra $600,000 in debt at that price, losing your financial discipline. I can assure you that everything because more painful the more you borrow: less deductions, higher mortgage payment, and more stress.
4) Asymmetric risk and reward. In America, when you borrow a ton of money from a bank and can’t pay it back one day, you don’t get stoned to death, castrated, or impaled in the heart by a spear. Instead, you hand back the keys to the bank who agreed to take on your home as collateral in case of non payment. If you are lucky to live in a non-recourse state, the bank can’t go after your other assets! If you live in a recourse state, then a short-sale or foreclosure will temporarily slaughter your credit score for 3-7 years. Better your credit score then your private parts right? Meanwhile, if you happen to invest in the right cycle, you can make a massive amount of money when you finally sell or rent the property out without having to give the bank any of the upside! Isn’t America great?
5) You make closer to the ideal income. How much mortgage interest you can fully deduct is based on how much money you make. Make too much, and your mortgage interest deductions get phased out. Make too little, which is under $79,500 based on existing rates, and you will feel the strain of the mortgage payments. If you or your household make between $150,000-$300,000, you are in the sweet spot to take on a $750,000 mortgage. Be aware if have an adjusted gross income of over $166,800, your mortgage interest starts to get phased out. For every $100 of income over $166,800 you lose $3 of itemized deduction X 33.3% up to a maximum loss of 80 percent of your itemized deductions. Lower rates have moved everybody closer to the ideal income!
MORTGAGE AMOUNTS ARE DIFFERENT FOR EVERYBODY
If you live parts of the country which have wonderful $500,000 homes, then awesome! There is never a need to borrow $750,000. The standard deduction of roughly $6,000 for singles and $12,400 for married couples is probably good enough for most. For those of you who live in expensive coastal cities, then consider $750,000 dollars as the cap on how much you should borrow and calculate your mortgage payment to income ratio, loan-to-value ratio, and home value to cash left over after downpayment ratio.
Some of you reading this have liquid assets north of $750,000. A $750,000 mortgage is therefore nothing to be afraid of because everything is just accounting. Your goal in this low interest rate environment is to minimize your debt interest expense by refinancing your mortgage and maximizing your government subsidies. Imagine refinancing your mortgage to 3% while making 16%+ returns on your investment guaranteed after rebalancing your portfolio? You’re essentially borrowing money for free and then some!
Don’t be afraid of mortgage debt. Instead, cherish what the government has given us and live a wonderful life knowing you are optimizing your finances.
Wealth Building Recommendations
Shop around for a lower mortgage rate: Check the latest mortgage rates online through Credible. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible from them or your existing bank. Credible allows you to compare multiple real quotes, all in one place for free. When banks compete, you win.
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Updated for 2020 and beyond.