Sunday, January 29, 2006

Your Mortgage Interest Deduction

It's tax time, and homeowners all over the country right now are relishing the fact that the U.S. government allows us to deduct the amount we paid in mortgage interest from our taxable income.

Oh, how we adore this bigger-than-most tax deduction. And the press coverage it gets is astounding.

Here's a quick for-example for those who care:

If Joe Q. Average owes $100,000 on his home, and he's borrowing this money at, say, 5.5 percent, then this last year he paid $5,500 or so in mortgage interest. This means that for Joe, when it's time to file his taxes, he (generally!) won't have to pay income tax on $5,500 of his income. If Joe is in the 25% tax bracket, he just "saved" roughly $1,375 in taxes. Glory, glory, hallelujah. And so on.

Over the years we've molded this mortgage-interest tax deduction into some sort of Tax System Holy Grail, it seems. Yes, our government is basically subsidizing home ownership, effectively reducing our bank's interest rate by a percentage equal to whatever tax bracket we're in. It's to the point that I hear stuff like this all the time:

"No, you don't want to pay extra on your mortgage! You'll lose the tax deduction!"

Do folks really know how this works, mathematically? Well, sometimes. From a recent article in USA Today:

Scenario 2

A couple in their 60s who want to retire in five years have $1.5 million in assets. They owe $100,000 on their home on a 15-year mortgage that they refinanced this year at 5%. They earn $250,000 a year. Should they pay down their mortgage? Or will they need the tax deduction?

Cook's [financial planner] advice:

"There's no way the couple should pay off their mortgage or accelerate the pay-down of principal any faster than the loan's amortization rate. The deduction of mortgage interest will be helpful at tax time. Their annual income should allow for them to easily make their monthly payment. And they have sufficient other assets to enable them to weather any financial storms. So paying off their mortgage just to 'have the house free and clear just in case' seems unnecessary and inappropriate."

Note that part about "The deduction of mortgage interest will be helpful at tax time." Helpful? Probably. But we have to be careful: This applies more to the couple in the scenario than it would to Joe Q. Average.

Not paying off the house makes financial sense only if the couple were using that $100k — the money they're contemplating using to pay off their home — to earn a rate of return better than 5 percent. (More on the math, and the tax implications, here. Chances are that this couple is in the 35 percent tax bracket. The mortgage deduction will save them $1,750 in taxes. Their effective investment rate to beat is 3.25 percent, after all taxes. )

Maybe our couple from the scenario is doing that, or can do so. Maybe they're not, or can't. Therein lies the risk: Can their investment of the $100k do better than a 3.25 percent annual return, after accounting for all taxes on investment profits? That's the roll of the dice they must make.

(Before I get yelled at, yes, I'm aware that beating that return would be easier if some sort of tax-advantaged investment were used. And I'm also aware that the higher the tax bracket you're in, the better the mortgage-interest deduction is for you.)

But when it comes time for our Joe Q. Average to sort out what the mortgage-interest tax deduction really means to his net worth, there is no "set in stone" answer. He really ought to consider his tax bracket, grab a calculator, and think of it like this:

The mortgage interest deduction means I get to pay the bank $5,500 in interest rather than paying the government $1,375 in taxes!

Now ... how good a deal is that?

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— Posted by Michael @ 3:13 PM


Good job, Michael. That is the appropriate way to look at it. I've never understood why it's considered stupid to pay less money to the government than it is to pay more to some bank/corporation.


Governments time to time float new new schemes so that the accrual is higher than expected.And needed is planning as per the budget or the financial planning of the country.Say savings in a certain group of certificate/schemes may be exempted but people avail and again raise a loan on it to pay off their taxes.Salaries classes have no way out.The deduction at source is a beautiful tool and we are to remain happy calculating how, much,more or less we are going to pay the Tax.For business man as a whole ,he has the belancesheet to show loss or some marginal loss or profit and they are the actual gainers.Who ia plentily rich has other option to look after investment in which scheme will be more profitable form him.It is only the middle class problem.For big companies,big ways are aleady there.


Personally, I'd pay the mortgage off. We are accelerating our mortgage payments by about 1 payment a year. I'd actually like to increase that to 2 payments per year.

I'll take the reduction in interest payments to my bank over the tax deduction.


If they financed at the end of the previous year and made the 1st 12 payments on the loan in the current year, interest would be appx $5,390. Standard Deduction for a Married Couple filing a joint return is $10,000. So unless the fictional couple have other itemized deductions, the interest on the mortgage won't reduce their taxes at all. Granted the Real Estate Taxes may be significant and they may indeed have enough itemized deductions to exceed the standard deduction.

Too many people assume that their mortgage interest will lower their taxes, but it is not a given.


I'm glad to see you writing about this. I find the way it's usually stumped to be maddening (don't pay off the mortgage because of the tax break...UGH)

The way I think of the deduction is just that the government "helps" me pay the interest on my loan and that keeps it mighty clear enough for me :)


Michael, ditto w/ the accolades! Although we have an obscenely low mortgage rate (3.99%), we are aggressively making extra payments, contrary to the advice of all the "financial gurus". Why? because down the road: 1) we'll be able to drop some life insurance, knowing that our home is free and clear; 2) retiring earlier can be more attainable knowing the mortgage monkey is off our backs! 3)At that point, taking the standard deduction will be like a "freebie"; 4) If the tax law is changed re: the mortgage deduction, we won't care!!

Anonymous makes a great point that it's often difficult to get over the $10,000 itemized deduction threshold, thus making the interest deduction worthless.

I'd like to add 3 additional points: first, if you're in an AMT position, your mortgage interest isn't necessarily allowed as a deduction. Second, whether or not you're in an amt position, once your AGI exceeds certain thresholds,(I believe for Jt-married it's $145,950 this year) you need to reduce your itemized deductions by 3% of the amount over the threshold. Third, if it's a "push" between itemizing and taking the standard deduction, I'd opt for the standard deduction to further reduce the risk of audit (however remote it is anyway!)



Good Comments. Another thing is if you schedule your accelerated payments for pay-off with your last paycheck, then your expenses in retirement go down substantially. Withdrawals from an IRA for living expenses can be smaller allowing you to get taxed at a 15% rate

Anonymous Anonymous
, at 3:31 PM, January 30, 2006  


Great topic! I would also like to add paying off your mortgage will give added Security when the storm clouds come rolling.No one ever calculates risk.


I've just started reading financial blogs and am amazed at how many people are paying off their mortgages early. Can't people find better returns on their money than 4 or 5 or 6 percent. The tax deductions is only part of the equation. It is a question of opportunity cost. The 4% money you are loaned for your mortgage can make you at least 10% in the market. Why are y'all giving that money up? For security I guess.


I am responding to Bradley's comment. I am originally from the UK, and recently paid off the mortgage on my London flat. This was a no brainer for me. In the UK, you get no tax deduction for mortgage interes, so it is worthwhile to pay off your mortgage asap. I have just bought a house in the USA, and even though I get a tax deduction for mortgage interest, I still want to pay off my mortgage asap. I could invest my money in stocks (as Bradley suggests), but stocks are risky, hence the higher average returns they offer. I see no point in gambling with the money for my house. Higher returns = higher risk.


Great topic, Michael, and well said. I would think an honorable mention should go to the potential heaps o'cash a homeowner might save by paying off the mortgage early. Ditto's on the financial security of owning your own home free and clear of debt, regardless of the interest rate. This is a big plus for those of us on the other side of our 40's or 50's.


I know where the oft-quoted "10 percent returns in the market" come from, but it falls far short of a guarantee.

You might earn double-digit returns in the market.

You will still have to make your mortgage payment if something goes wrong.


Excellent post Michael. I've railed against this prevailing misconception too. If you'll pardon a bit of self promotion, my PF blog centers on this very topic. Instead of making an additional 1 or 2 mortgage payments per year, I'm making an additional 68 P+I payments per year.


I think you make a great point. Doing anything strictly for the sake of a tax deduction amounts to paying a dollar in the expectation of getting (at most) 35 cents back. I enjoy the mortgage deduction. I'm happy that some of the money I send back to the bank ultimately comes back to me from the feds. But I have no illusions about the overall balance of trade involved.

That said, comparing the return you get by prepaying a mortgage to the returns you can get in the stock market isn't entirely apples-to-apples. There are two key differences between the two. First, the mortgage prepayment is risk-free while the stock market investment is definitely not. I think we've all been reminded of that over the last five or six years.

Second, money put into the stock market is much more liquid than money put into mortgage prepayment. If bad times come, it's far easier to convert your stock to cash than it is your house. In either case, you might be selling low. But with mortgage prepayment, you're having to uproot your family and find another place to live. This is mitigated somewhat when you pay off your mortgage; that's one less bill per month, after all. But not entirely.

So is it better to pay off the mortgage or invest the money elsewhere? The answer, as is usually the case, is "it depends." Comparing rates of return is only the beginning.


This is a very interesting discussion. I believe you should have a very long mortgage.

Before you start paying off your house, I recommend fully funding your 401K. For a couple this is up to 30,000 dollars. In this case you save 30,000 * .25 = 7,500 from the government every year. This does not include the interest that you will get from the investment. Lets say the 401K interest is 6% which will then earn 1,800 for that year. 7,500 + 1,800 = 9,300 saved. If you invested that 30,000 dollars to pay down your mortgage then the govement will take 25% of that 30,000, which is $7500. So instead of gaining 9,300 you lost $7500. This is a total of 16,800 dollars of lost revenue for that year. That lost revenue is greater than one half of the initial 401K investment.

People talk about paying down the mortgage for security reasons. On the surface this sounds nice but in actuality it is not. Unlike other investments, Your home value will increase no matter how much you owe on it. So paying down the mortgage does not improve the home gain. Also, you still have to pay the mortgage and interest payments until you completely pay it off. If you pay 1/2 of the loan the morgage and interest payments do not change. Lets say you are at 1/2 of the loan. You then lose your job. There is no bank in the world that will let you refinance the remainding of the loan, because you do not have a job. Also you cannot get the money out of the house because you do not have a job. You will only be forced to sell and move for the money placed inside the house. If the money was in a 401K then you could cash it out (yes you would have to pay penalties but at least you will have cash and a home.



"Unlike other investments, Your home value will increase no matter how much you owe on it."

You forgot to say "OVER THE LONG TERM", or "OVER 15 or so years". Right now we are looking at flat prices or even decreases in a lot of populated areas.

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