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.