Short answer: that's a really dumb idea. You are currently paying mortgage interest on $500,000 of total debt. Your plan would result in you paying interest on $750,000 of total debt. You have to invest that $250,000 to make way more money than CD rates to even approach the mortgage interest you will pay.
Firstly, the rules on mortgages over $750,000 don't work the way you seem to think they work.
If you follow the worksheet in publication 936, you will see that using the IRS method of calculating interest, you would have $1 million of outstanding loan balance, but only $750,000 of qualified acquisition debt. That means that only 75% of your mortgage interest is deductible. The worksheet does not allow you split out your loans separately and say you are deducting 100% of the interest on the 75% loan and none of the interest on the 25% loan (which is currently zero). What will happen is you will only be able to deduct 75% of the total loan interest you are paying.
https://www.irs.gov/pub/irs-pdf/p936.pdf
It is true that if you do eventually pay off the $250K loan, you would have $750K of qualified acquisition debt and $750K of outstanding loan balance so 100% of the interest would be deductible from that point.
It's also just a bad idea overall from a financial point of view. Let's think about this a minute.
- First, you are borrowing $250,000 for 18 months at 3% (if you have excellent credit); that will cost you $11,250 that you currently don't need to pay.
- Then, by making your mortgage only 75% tax deductible, you are giving up tax savings of $1850.
- If you invest the $250K in a CD (0.8% APR) you will earn $3000, which is taxable, so you net $2340.
You're in the hole $10,760 compared to doing nothing and only refinancing when the interest-free period expires.
If you could get 6% on your investment, you would gross $22,500 in interest, net $17,500 after taxes, so the whole scheme nets you $4450 (which is probably still less than the closing costs on the cash-out re-fi). And if you could get 6% safely, and not lose value in your investment, in which case you are screwed.
The bottom line is that even in the highest tax bracket, the mortgage interest deduction does not make your mortgage free to you, it only reduces the effective interest rate by 1/3. If you re-fi at 3% and can fully deduct the interest, your effective interest rate is 2%. But if you take that cash and invest it somewhere else, you have to make way more than 2% to come out ahead, after figuring the tax impact of the lost interest deduction plus the income tax due on the investment income plus your closing costs. Can you make 6% or more without risking the money?
I would really suggest you sit pat, and then consider your options when the interest-free loan period expires.
