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:
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.)
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?