Additional principal payments are qualified expenses for the clergy housing allowance, but they are subject to limitations.
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Video: Q&A: How does the housing allowance work without a mortgage?
A look at how the clergy housing allowance works and why you can still claim it even without a mortgage.
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The mortgage broker was downright giddy when he pulled our credit reports and got our scores. He excitedly told me that he could count on one hand the people that he had worked with with an 800+ score. Yay, I’m a celebrity in his world!
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How A Cash-Out Mortgage Refinance Affects A Pastor’s Housing Allowance
When the Federal Reserve slashed interest rates to near zero in response to the coronavirus crisis, everyone decided that it was a perfect time to refinance their mortgage. There were so many refinance requests that lenders had to artificially raise rates in order to lessen demand and give them a chance to keep up. Rates bounced around quite a bit but have spent the rest of the year near historic lows.
Because of this, a lot of people have refinanced their mortgages this year. If this is news to you, you should really look into refinancing because with a lower interest rate you could save thousands of dollars over the life of your loan.
What Is A Cash-Out Mortgage Refinance?
A choice you have to make when refinancing is how much you want your new mortgage to be for. One option is to borrow the same amount as you currently owe and just enjoy the benefits of a lower interest rate.
The second option is to take advantage of any equity you have in your home and take out a bigger mortgage. Borrowing more than your original mortgage balance allows you to pocket some cash in the process. That’s called a cash-out refinance because you are essentially taking cash out of your home’s equity.
How Does Cashing Out Equity Affect Your Housing Allowance?
Doing a cash-out refinance can affect your mortgage’s eligibility for the housing allowance. Usually, mortgage and interest payments are eligible for federal income tax exemption through the clergy housing allowance. They are eligible because you are using that money to provide a home.
The big question with a cash-out refinance is What are you doing with the cash? If you use it to remodel your bathroom or build a deck, then you are still using the money to provide a home. As such, your entire mortgage payment still qualifies for the ministerial housing allowance.
What if you use the money for something non-home related? What if you use it to pay down debt or send a child to college? This is when it gets complicated. If part of your mortgage is paying for non-housing expenses, then part of it is not eligible for the pastor’s housing allowance.
How To Calculate Housing Eligibility For A Cash-Out Refinance
Luckily, mortgage payments are not an all-or-nothing deal. Using some money for non-housing things doesn’t disqualify your entire mortgage payment from the ministerial housing allowance. Just a portion of it. You can claim a pro-rata portion of your payments as qualified expenses for the housing allowance.
Let’s say you owe $180k mortgage and your house is worth $250k. You decide to refinance and borrow $200k so that you can pay off your student loans. Your new loan is broken down into $180k of housing costs and $20k in student loan costs. Only 90% of the mortgage was used for housing costs, so only 90% of your mortgage payment is eligible for the clergy housing allowance.
If your principal and interest payment is $1,000 a month, then only $900 of that qualifies for the housing allowance. Most of us don’t only make principal and interest payments, though. My monthly mortgage payment also includes escrow money for property taxes and homeowners insurance.
For this example, let’s say you’re like me and your monthly payment is $1,400, with the extra $400 covering insurance and taxes. Does that mean that you can only claim $1,260 for the housing allowance (90% of $1,400)?
Nope! Your property taxes and homeowners insurance are 100% eligible for the housing allowance even if your mortgage principal and interest payments are not. For accurate calculations, you have to break down your monthly payment into the portion that is used 100% for housing expenses (insurance and taxes) and the portion that is only partly used for housing expenses (mortgage principal and interest).
In this example, only $900 of the principal and interest payment is eligible for the housing allowance while the entire $400 for taxes and insurance is. So, $1,300 of the $1,400 monthly payment counts towards the housing allowance. If you just do 90% of the whole payment, you’ll be selling yourself short and paying some unnecessary taxes.
How The IRS Verifies Accuracy
After explaining this to a friend, he asked me what happens if you just claim it all. What happens if you take cash out of your mortgage for non-housing expenses but continue to include 100% of your payment as a housing allowance?
In most cases, nothing. The IRS does not check up on you and verify the accuracy of your housing allowance. That is until you get audited. If you cheat on your housing allowance, they may uncover it in an audit.
But just because the IRS isn’t watching you doesn’t mean that God isn’t. It isn’t necessarily a matter of whether or not you’ll get caught, it’s a matter of character. You get to decide for yourself how you want to proceed.
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Should You Keep A Mortgage Just For The Housing Allowance & Mortgage Interest Deduction?
Keep your mortgage so you don’t lose your housing allowance and mortgage interest deduction!
How many times have you heard that advice? A reader recently asked me about it. Is that really good advice?
I know for most people, keeping a mortgage just for the mortgage interest deduction doesn’t make financial sense (though a lot of people do it). But you pastors have an amazing benefit in the ministerial housing allowance. It made me wonder, could the housing allowance be enough to turn the tables and make a mortgage worthwhile?
Example Mortgage
I decided to calculate it out to see for myself and to share with you. Here are my assumptions for this exercise:
Home Price: $200,000
Loan Amount: $160,000 (20% down payment avoids private mortgage insurance)
Mortgage Type: 30-year fixed rate
Mortgage Interest Rate: 5%
Income Tax Rate: 12%
Based on those assumptions, I calculated out the amount you would save in taxes with the housing allowance and mortgage interest deduction as well as the total amount of interest you would pay over the life of the loan.
I also looked at the opposite extreme, paying cash for the house, but that’s not a very realistic alternative for most people. Because of this, I figured out what the numbers would be if you made bi-weekly payments. The idea behind biweekly payments is that you make a mortgage payment every other week instead of monthly so by the end of the year you’ve made an extra payment, 13 instead of 12. Here are the numbers:
Calculations
Minimum Payments
Annual Principal & Interest Payments: $10,306.98
Total Interest Paid Over Life Of Loan: $149,209.25
Loan Paid Off In: 30 Years
Bi-Weekly Payments
Annual Principal & Interest Payments: $11,165.96
Total Interest Paid Over Life Of Loan: $121,723.99
Loan Paid Off In: 25.25 Years (I rounded it to 25 for my calculations)
No Mortgage
Annual Principal & Interest Payments: $0
Total Interest Paid Over Life Of Loan: $0
Loan Paid Off In: 0 Years
Now, there are a lot of other things that count towards the housing allowance besides just principal and interest payments. You have property taxes, homeowners insurance, utilities, furnishings, etc. However, those are all the same regardless of whether or not you have a mortgage. Here we are only looking at the effects of a mortgage, so those are the only numbers I included.
Here is how total loan costs compare between the three situations:
| 30-Year Fixed Rate | Biweekly Payments | Pay Cash | |
| Total Interest Paid | $149,209.25 | $121,723.99 | $0 |
| Tax Benefit Of Housing Allowance* | $37,105.13 | $33,497.88 | $0 |
| Mortgage Interest Deduction** | $17,905.11 | $14,606.88 | $0 |
| Cost of Loan*** | $94,199.01 | $73,619.23 | $0 |
*Tax Benefit Of HA calculated as 12% of annual principal and interest payment multiplied by the duration of the loan.
**Interest Deduction calculated as 12% of the total interest paid.
***Cost Of Loan is calculated as the total interest paid less the tax benefit of the housing allowance less the mortgage interest deduction.
Other Factors To Note
There are other factors that will affect how this would apply to you personally:
- You have to itemize your deduction to receive a benefit for paying mortgage interest. With the new higher standard deduction, it is possible that you will not itemize and receive this benefit.
- Being in a lower tax bracket will decrease your tax savings and a higher tax bracket will increase them. For 2019, the 12% rate applies to singles with a taxable income of $9,701 – $39,475 and married couples with a taxable income of $19,401 – $78,950.
- Having a lower interest rate will decrease the overall cost of the loan and a higher one will increase the cost.
- Your housing allowance is limited by the fair market rental value of the house. If it is less than your biweekly payments then you will not save as much in taxes as in my calculations above.
What About Opportunity Costs?
So, if you took out this mortgage you would save $55,010.24 in taxes over the next 30 years. That’s great! Except that it will cost you $149,209.25 in interest. That’s essentially giving the bank $3 in order to avoid giving the government $1. Without a mortgage, you may pay more in taxes but you pay less overall.
Those calculations make paying off the mortgage as fast as possible the clear winner. But, as with most things financial, it’s not quite as simple as that. There are opportunity costs involved. An opportunity cost is basically what you miss out on by not making another choice.
You see, ditching your mortgage is obviously best if you’re just going to be spending or sitting on your money. But, what if you invest it? What if you put $160,000 into the stock market when you got your mortgage? Would you still end up worse off financially 30 years later?
Not necessarily. If you invest your money rather than pay off your mortgage you may end out ahead. It’s a possibility, though, not a guarantee. The end results will depend upon your discipline, the investment decisions you make, and the way the market behaves.
What Should You Do, Then?
Wouldn’t life be easy if the internet could just tell you the best decisions to make about everything?
I’m sorry, but I’m not God, so I can’t tell you what’s best in your situation. I can only suggest things to think through as you make your decision:
- Consider your priorities; how does your desire to be debt free compare with your desire to maximize your finances?
- Consider your habits; would you have the discipline to invest your extra money instead of spending it?
- Consider your risk tolerance; do you have the guts to keep your money invested even if the market tanked?
- Consider various scenarios; what rate of return do you need in order to make investing instead of paying down the mortgage worthwhile for you? 5%? 8%? 12%? Is your required rate of return realistic?
Remember, the math clearly shows that giving $3 to the bank to keep $1 from the government is unwise. However, you may have other opportunities that make giving $3 to the bank worthwhile. Talk to your spouse, pray through it, do the math, and I wish you the best of luck!
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Reader Question: What Should A Mobile Pastor Do With Extra Income?
Dear Pastor’s Wallet,
My only debt is my mortgage, a 30/5 ARM with 23 years remaining. I am saving 15% of my pre-tax income toward retirement, have an emergency fund and am saving towards large expenses like my kids’ college, a new car, etc. However, I still have some extra money at the end of the month. Should I pay down my mortgage or invest it in a brokerage account? I have been at my current post for several years and could be moved at any time. My ultimate goal is to be debt free.
What to do with extra income is a common question, and you can find many articles and opinions online. However, most are not written for pastors. They don’t take into account the pastoral housing allowance or some denominations’ practice of moving their pastors every few years.
The above question was written to me by a pastor who had done a lot of research on the pros and cons of each choice. Yet, he vacillated on the decision every month because nothing he read addressed his situation as a mobile pastor. This is how I answered him:
Ditch The Adjustable Rate Mortgage
First, I would refinance to a fixed rate mortgage. Interest rates are going up, so it is best to lock in a lower rate now before your mortgage rate adjusts higher. If you can afford it, refinancing to a 15-year mortgage will give you the lowest rates.
Over the last year, rates have gone up about a quarter of a percent, and some experts expect them to reach 5% in the coming year. The economy is strong and the Federal Reserve has been, and is expected to continue, raising interest rates regularly. That means that mortgages are only going to get more and more expensive.
Build A “Moving Fund”
Second, I would save up some money to build a “moving fund” in addition to your regular emergency fund. This would be extra money set aside to cover the expenses of moving so that you are prepared when the time comes. It should be enough to cover 3 months’ mortgage payments and moving expenses. This way, if you have to move and it takes a couple of months to sell your home, you’ll have the margin to do so.
Don’t invest your moving fund in the stock market. You don’t want to risk losing this money. Instead, put it in a money market or savings account. That way, you can count on it being there when the time comes to move.
Eliminate PMI (Private Mortgage Insurance)
Private mortgage insurance (PMI) is something your lender requires you to purchase if you have less than 20% equity in your home. It is not insurance to protect you. It is insurance to protect your lender in case you default when your house is underwater. PMI usually costs between .5% and 1% of the total loan value annually. That means that for every $100,000 that you borrow, you could be paying up to $83.33 a month in PMI.
If you pay PMI, I would use your extra money to pay down your mortgage until you don’t have to do so anymore. Usually, PMI is no longer required once you have 20% equity in your home. You can double check their specific requirements with your lender.
Pay Down The Mortgage Or Invest?
If you do the things I recommend above, then it doesn’t make a big difference what you do with your extra money.
Mortgage
If you put your money into your mortgage, you will get it back when you move. It will be tied up in an illiquid asset in the meantime, but with a “moving fund” in place, you should have enough liquid assets to last until the house sells.
It is important to note, though, that paying extra on your house doesn’t guarantee you can take a larger housing allowance. Per IRS rules, the housing allowance must be the lesser of:
- The amount you officially designated in advance;
- The amount actually used to provide the home;
- The fair rental value of the home (including furnishings, utilities, etc.).
So, if the fair rental value of your home is $1,500, you can’t take a housing allowance of $2,000 just because you’re paying extra on your mortgage. You may have to pay taxes on the extra mortgage payment, but you’ll have to pay taxes on any gains from a brokerage account as well.
Brokerage Account
Investing your money in a brokerage account makes it more easily accessible, but it doesn’t move you towards your goal of being free from debt. It isn’t a permanent decision, though. There is no reason you couldn’t change your mind, cash out your investments, and put the money towards your mortgage at a later date. The only risk is that the value of your investments can go down.
What Would I Do?
Personally, I would probably pay down the mortgage to the maximum allowed housing allowance and invest the rest of the money. That is, once I had a “moving fund” in place. If you’re not sure what to do, it’s probably safer to invest the money. Then you still have the option to change your mind at any time. Just make sure you don’t invest in overly risky investments if you think you may want to cash them out to pay off your mortgage in the next couple of years.
If you’re at the point where you’re wondering what to do with extra income, congratulations! You’re doing a great job with your finances, setting a wonderful example for your congregation, and positioning your family for financial success. I’m proud of you!
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Act Now For Your 2018 Clergy Housing Allowance
As a pastor, one of your greatest earthly rewards is the clergy housing allowance. Though it’s nothing compared to the rewards you’re piling up in heaven, it is definitely something that should not be overlooked.
Here are some things to remember as you prepare your 2018 clergy housing allowance request:
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Should I Put Extra Into Retirement Or Pay Off My Mortgage Early?
I recently received a message from a reader wondering what she should do with her extra income. Should she put the extra into retirement or towards paying off her house early? She was having a disagreement with a family member and wanted to hear my take on the issue. Well, here it is:
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