Is the Home Mortgage Interest Tax Deduction a Good Deal?

Is the Home Mortgage Interest Tax Deduction a Good Deal?

Interest payments on home mortgages have long been tax deductible in the United States. In fact, prior to the Tax Reform Act of 1986, interest on all personal loans was tax deductible. The deductibility of loan interest dates back to the introduction of the income tax system in 1913 when, according to an article in the NY Times, it was difficult to distinguish between personal interest and business interest in a nation full of small proprietors.

Regardless of Congress’ initial intentions, the home mortgage interest deduction eventually became a stepping stone to home ownership. The reason for this is that it effectively decreases the cost of borrowing to buy a home. There are, however, some limitations that reduce the value of this deduction.

For starters, you must elect to itemize your deductions, and the mortgage interest (and other deductions) only reduce your tax bill to the extent that your itemized deductions exceed the standard deduction. Another limitation, but one which does not impact the majority of Americans, is that interest is only deductible on the first $1M of mortgage debt. A similar limit of $100k applies to home equity loans regardless of their purpose.

Another important thing to keep in mind is that an income tax deduction is very different from an income tax credit. Whereas the former reduces the amount of your income tax that is subject to taxes, the latter directly reduces your tax bill.

Take, for example, an individual in the 25% federal income tax bracket. For every $1000 in mortgage interest that they pay in excess of the standard deduction, their tax bill will be reduced by $250 (plus whatever state income tax benefits they might enjoy). In contrast, a $1000 tax credit would reduce their total tax bill by $1000.

While the home mortgage interest tax deduction is undoubtedly beneficial to those with mortgages, many people use it as an excuse to keep their mortgage when perhaps they shouldn’t. We could debate all day long whether or not you should pay off your mortgage early – with the alternative being to keep your mortgage in favor of putting extra money into your investments. In my opinion, the mortgage interest deduction should be just a small part of this decision.

Let’s consider a simple example…

The standard deduction for 2011 is $11, 600 for married couples filing jointly. Let’s assume that a married couple buys a $300k house on January 1st with 20% down, resulting in a $240k fixed rate mortgage at 5%. Over the course of the first year, they will pay a total of $11, 919.58 in mortgage interest. Let’s further assume that they donate $3k to charity and pay $3k in property taxes.

Taken together, these mortgage interest and charitable contributions add up to $17, 919.58 in deductible expenses. Sounds great, right? Assuming that they’re in the 25% tax bracket, this works out to a tax savings of $4, 479.90 — or does it?

The reality is that they would’ve been able to take the standard deduction regardless, so we really need to subtract that out to find out the marginal gain from itemizing. The standard deduction would have reduced their tax bill by $2, 900 ($11, 600 x 0.25) so they’re really only gaining $1, 579.90 in additional tax savings.

That’s $1, 579.90 tax savings in return for paying an extra $11, 919.58 in interest — a 13% tax savings. While this 13% savings is far better than nothing, it’s nowhere near as good as one might expect based on their tax bracket. And if they hadn’t made that charitable contribution, the benefit would have been less.

As with anything, you’ll need to run the numbers and decide what’s best for you. Just be aware that when someone warns you not to pay off your mortgage because you’ll be giving up that huge tax deduction, the numbers aren’t nearly as good as you might think.

16 Responses to “Is the Home Mortgage Interest Tax Deduction a Good Deal?”

  1. Anonymous

    Great article! Just one comment: While your $ interest paid from Year 1 to Year 2 and so on decreases, which in turn reduces overall deductibility, property tax generally increases with the passage of time and that should offset a portion of loss of deductibility due to drop in interests dollars. So hypothetically on a 300K @ about 3.25% loan, interest dollars might drop from 10K in Year 1 to 7.5K in Year 10, the corresponding $ property tax (depending on the region) could potentially make up for the difference and in some cases make even exceed that.

  2. Anonymous

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  3. Anonymous

    But none of this is the full story… no-one factored in “opportunity cost”. If I have $250K in cash there is a strong argument for NOT using it to buy a home, but instead, to go ahead and get a mortgage. Because then I get the mortgage interest deduction PLUS I get to earn interest on the $250K I did not spend. In times of good interest rates, I can actually MAKE money this way. So although rates suck now, they may be 5% or higher a few years from now, and I’ll earn that on my $250K each year going forward. The moral of the story: run ALL the numbers or seek professional financial counceling before making such a decision.

  4. Anonymous

    Good or bad, our state taxes put us out of standard deduction territory.

    Your right on with your observation though, not everyone is getting the full deduction on mortgage interest.
    The simplest way to discover what’s going on is to go to your tax software, and enter zero for mortgage interest. Then put it back. See what the difference is. Divide that by your interest number and you’ll see the savings.

  5. Anonymous

    And … people forget that when you take out a loan to purchase other investments, like corporate stocks or a small business, that interest is deductible too. If the choice is between borrowing to buy a house and borrowing to buy something else, the mortgage deduction isn’t much of a factor.

  6. Anonymous

    Another point to consider is that as you pay down the mortgage over time the interest paid drops. So for example today on a $250k loan you’d be paying about $10,000 in interest a year or more. But if thats a 30 year mortgage they say 20 years from now you’d only be paying about $4800 a year in interest. Also 20 years from now inflation would make that equivalent to closer to $2400 in todays dollars.
    As you pay less and less interest it is harder and harder to qualify to itemize and you have less and less chance of seeing an actual tax benefit.

    The tax deduction is worth a lot more at the start of the loan and worth virtually nothing at the end of the loan term.

  7. Anonymous

    For my wife and myself, we are able to take full advantage of the mortgage interest deduction. Living in NYC, we were both paying enough in state and city income take to itemize in the years prior to buying the house, so anything on top of that is “gravy”.

    With that said, I still the consider mortgage interest deduction it a terrible argument FOR buying a house. Instead of paying a $1 to save $0.25, I’d rather just pay the $0.25 and keep the other $0.75 I would have spent.

  8. Anonymous

    I remember one time I heard a couple fretting over their taxes because they had paid off their mortgage and wouldn’t have that tax deduction anymore. I remember thinking that they had been saving money all year not having to pay a mortgage. I’m happy to read some validation that this couple was looking at their situation all wrong.

  9. Anonymous

    We don’t have income tax here in Florida, but there is a deduction for sales tax instead of income taxes depending on your situation. Getting back to the main point, however, it is a very good deduction for those who do have relatively high mortgages, but doesn’t benefit those who are either at the end of their amortization life or as Jim said, you don’t have an ability to itemize. Unfortunately, that’s just how the code is written: some people get lucky with deductions and credits and others don’t.

  10. Kathy: I left out state taxes on both sides of the coin — both in terms of the additional tax savings when deducting your mortgage interest and in terms of using it as an additional deduction on your federal return — because state taxes are so variable. In fact, some states don’t even have an income tax. But you are correct that any additional federal income tax deductions would increase the benefit up to a maximum of your marginal rate.

  11. Anonymous

    I often hear people who are adamant about buying a house in order to get the mortgage interest deduction. That’s like buying a $100 item to get a $20 rebate. It only makes sense if you’re willing to pay $80 for that item (with no rebate). But many people feel like they’re missing on free money by passing up that $20 rebate.

  12. Anonymous

    THis is a good point Nickel. I think people overestimate the amount their mortgage deduction actually gives them. A couple years ago I looked at this and one point I found is that while there were about 48M people with mortgages at the time, there were only 38M people itemizing deductions and claiming mortgage interest. So that meant that a full 20% of people with morgages were not itemizing and claiming a deduction and therefore getting no tax benefit from the mortgage interest deduction. That can easily happen with someone who’s mortgage has a relatively low balance. e.g. if your home is $150k at 5% and your property taxes are $1500 and you’re married then the $7500 in interest adn $1500 in property tax alone isn’t enough to beat the standard deduction.

  13. Anonymous

    Seems like I just read about this same issue on another financial blog and I made a similar comment as below.

    Don’t forget that when you itemize your deductions, you can also deduct your state income tax and your property tax. My state income tax of about $5000 per year and annual property tax of about $2500 per year automatically put me over the $5800 standard deduction for a single person. So for me, any interest mortgage deduction saves me 25% of the interest.

    But I agree don’t use the interest tax deduction alone as a way to justify not paying the mortgage off early.

  14. Anonymous

    I agree. The mortgage interest deduction is a plus for people who would have a mortgage regardless, but it is nowhere near good enough to be a driving decision for one to get a (new) mortgage, or to avoid paying off an existing mortgage early.

    Basically it boils down to this: you are paying the bank $1, to avoid giving the government $0.25 (in taxes). You are better off just paying the government $0.25 (in taxes), and keep the other $0.75 for yourself.

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