The Mortgage Interest Tax Deduction: Spending $10 to Save $3
Figures Don't Lie
The idea of a tax deduction excites even the least of the financially savvy. However, a deduction is simply not worth making continued mortgage payments, particularly when the funds are available to pay off a mortgage balance early. To help this examply along, let's use some real numbers. Joe and Sally recently took out a $200,000 mortgage loan to finance their new home at a 6% interest rate, and are paying $1,200 a month (not including taxes and insurance). They had some recent success in the stock market, and Sally received an inheritance they could use to pay cash for the house. Joe's friend, a CPA, tells Joe he would be crazy to pass up the mortgage deduction.
A quick look at an amortization schedule shows the total of Joe and Sally's first year's interest payments is roughly $12,000. Joe is a modest income earner with a taxable income of $70,000 a year. According to the latest tax table, Joe and Sally will owe $10,621 in federal taxes. Deducting $12,000 worth of interest payments brings down their taxable income to $58,000 and at this new income level Joe and Sally will owe $7,949 in taxes. Carrying a mortgage and making interest payments will save Joe and Sally about $2,672 in tax liability. But at what cost? The annual cost of continuing those $1,200 monthly payments is $14,400. Effectively, the advice from Joe's CPA is to send the mortgage company $14,400 in payments to save $2,672 in taxes. Sounds like Joe needs a new financial planner.
Find a Better Deduction
Tax deductions are a useful tax planning tool to take advantage of if you have a legitimate reason to offset taxable gains. However, you can generate the same tax savings by adding $1,000 to a money market savings account throughout the year and making an annual donation of $12,000 to charity. With this plan you are making payments to yourself while earning interest on your money, and still saving considerable money on taxes for your noble efforts.
Published by Tyler Foster
I am a 30 year old husband and father of two working in software development for money, but writing for fulfillment. View profile
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- Total Annual Mortgage Payments = $14,400
- Total Tax Savings = $2600
14 Comments
Post a CommentIf you can't find an investment vehicle that earns greater than 4.1% annually (after tax rate equivalent) then you should put on your hockey helment and payoff the mortgage. Otherwise invest the $200K and make something of your life. Everyone who said nice article but did not ask themself this question while reading, sorry that the short bus pulled away on you.
Does this scenario consider the fact that if even if they do pay off the mortgage - maybe they will be taking the Standard Deduction instead of Itemizing? The standard deduction for a married couple is $10,500. Makes an even better case for paying off the mortgage.
linda you're lucky, not many people can say that until they're 50+
So complicated. Glad I don't have a mortgage on my home.
Good job, my friend!
Great article. As an accounting major I deal with these issues everyday. I have to try to explain this logic to family and friends.
Yes, I understand the wash out effects on what you are saying regarding deductions. I just wanted to make sure your readers understood that there are circumstances that would effect it and not be a good idea. See I have 2 homes, one paid off and the other one I don't want to pay off because my interest is so low 5 1/4% and we need to keep the tax brake. Combining that with what one is now getting in the bank, for me it would be foolish to pay it off. That's what I meant. I appreciate your comments. Enough said. Thanks
Irene, I concede on the math issue. I was simply trying to make the point that one could gain the same tax deduction by giving $10,000 to a charity or $10,000 to a bank in mortgage interest. When factoring in risk, owning a home, and especially a second home, introduces additional risk that must be measured against any potential tax advantages. Having said all that - I appreciate you taking the time to read the article and comment.
Well, I guess we hit a nerve on this article. I know 5.25% is not equal to 5.25% in an account. Sorry,I should have clarified that with combining the tax bracket of ones adjusted gross income puts it not in an advantageous position to pay off. That's what I meant about agreeing with Pete. I totally agree with what Pete said on this, using his example,you can get more for that money elsewhere if the interest rate on your mortgage is lower or even slightly higher than a money market, etc...depending on one's tax bracket (as I was saying in my case with my vacation home). Your article makes things cut and dry and it is not like that. Many things need to be taken in consideration. I'm sorry if you disagree, but those are the facts. Just do the numbers and you will see what we are talking about using this scenario.
Irene, what makes you "foolish" by wanting to payoff your mortgage and eliminate risk from your financial life? To me, risk aversion is worth at least 3 or 4 percentage points when comparing interest rates. So, for me a 5.25% leveraged rate (mortgage) is not equal to a 5.25% rate on a pile of money in a savings account. One is frought with risk and fees, the other is not.