The Biggest Mistake That High Net Worth Investors Are Making in 2024
And why your financial advisor probably won't tell you.
High-net-worth investors in the US historically owned their homes outright. But when mortgage rates were at record lows in the 2010s, it became fashionable (and smart) to take out a cheap mortgage instead of paying cash for your home. But recent changes in interest rates and tax law have meant that the numbers have changed quicker than the fashion. Jumbo mortgage rates are now near 7%, over double what they were during the pandemic. Additionally, mortgage amounts over $750,000 have not been tax deductible federally since 2017, effectively creating a double tax on high earners who choose to borrow over the limit. State taxes can pile on the pain as well.
For a quick example– let’s take a hypothetical high-net-worth household in California who recently bought a house for $3,000,000 with a $2,000,000 mortgage.
Pretax income: $800,000 per year, salary/bonus.
Assets:
Primary Home, $3,000,000
Taxable Investments, $1,500,000 (60% stock, 40% bonds)
Retirement Investments, $1,000,000
Potential Assets–unvested stock, accounted for in annual income above.
Liabilities:
Mortgage, -$2,000,000 @6.75%
No other debt.
This is pretty standard stuff for high-earning W-2 employees. Careers tend to accelerate faster than the ability to save, so it’s very common to have incomes close to seven figures but still need a mortgage.
This balance sheet looks completely standard, but can you spot the mistake? It’s not obvious, but I calculate that the portion of the mortgage over $750,000 carries an effective interest rate of 14.3%! How could this be?
The reason why is that the excess part of the mortgage is not tax-deductible, while your investment returns are taxable. The calculations get extremely complicated here because the rate of tax on investment income for high earners varies from 36.1% to 53.1% in California and California lets you write off slightly higher mortgage amounts for state income tax purposes, but these numbers are broadly correct. The numbers aren’t quite as bad for older, cheaper mortgages, but they’re generally still unfavorable.
If you’re earning 5% interest on your bond portfolio (for a round number), California will knock that down to 2.35% after taxes. Your mortgage costs 6.75%, so you’re losing $33,000 per year if you have the entire amount of what you could use for your mortgage in bonds. If you’re in stocks, the calculations change because of the huge amount of volatility so you could win or lose big by taking a mortgage and letting your stocks ride, but even assuming the best possible tax treatment on your investments, you would need to earn 10.6% annually. Few investors would willingly borrow from their broker for 10.6% interest, but that’s exactly what the economic equivalent is here.
This is a very high bar to clear, and you’re almost always better off not having a jumbo mortgage over the amount that’s tax-deductible. Given that most investors attempt to run balanced asset allocations, high-net-worth investors in the US who have large jumbo mortgages are facing effective interest rates of 10-14% on the amount of their mortgage over $750,000, depending on how they invest and their state of residence. The solution here is to pay the mortgage down to $750,000, preserving the full mortgage interest deduction.
Why is this so common? There’s a simple conflict of interest between financial advisors and their clients here. Financial advisors almost always earn money on assets under management, so they rarely tell clients to pull money out of investments to pay off debt! Doing so would decrease their earnings. This is a massive blind spot for high-earning investors who rely on their advisors. And investors who self-manage their investments generally don’t connect the dots either, because the costs of their decision are hidden in their annual tax bill.
Bottom Line
Jumbo mortgages are expensive and currently not tax deductible above the $750,000 threshold, and many investors who could otherwise pay them off don’t realize how much it’s costing them. This isn’t intended to serve as personalized legal, tax, or investing advice, but if you or a family member is a high-net-worth investor with a large mortgage, consider whether you’re falling into this common trap. Paying attention to cost of capital avoids unnecessarily bleeding money to the government.