Here’s a look at how the mortgage deduction can affect your taxes. The table below assumes the following:

Using the numbers for the 2006 tax year.

Family of 4, which represents 4 exemptions at $3,300 each.

$100,000 income with $10,000 going into a 401(k) with no other adjustments to income.

$200,000 mortgage with $15,170 in annual payments and $13,000 in interest paid.

$3,000 in annual property taxes.

$16,000 in itemized deductions and $10,300 for the standard deduction.

Keep in mind that I had no other itemized deductions besides mortgage interest and property taxes. In reality, most people would also deduct charitable contributions and either state income tax or sales taxes. It’s also possible that some families could deduct medical expenses but only the amount that EXCEEDS 7.5% of their adjusted gross income (for this example, they would have to exceed $6,750). I included property taxes in the calculation because they are a significant expense for most families. I didn’t include property tax on the non-mortgage side because they would not have been enough to itemize. So, if you remove the property tax deduction, the tax savings would be $675.

I’ll try to come up with some kind of calculator so that you can play with the numbers yourself. I’ll hopefully have it posted later today.

Right now, I would like you to weigh in on this example. **Was I fair and balanced?** My goal for this blog is to offer the rational side of personal finance and leave the emotional stuff to you.

You did it right and you should include the property tax on the left hand side.

You see from this example, the $13,000 mortgage interest resulted in only $5,700 extra deduction, i.e. reduced the taxable income from $66,500 to $60,800. The other $7,300 in interest, representing 56% of interest paid, is effectively non-deductible. As time moves on, standard deduction increases, mortgage interest decreases, the percentage of deductible interest, currently at 44%, goes lower and lower.

If you make a calculator, please include a calculation for this “what percentage of your mortgage is really deductible” number. My gut feeling is that this number is smaller than most people think.

Boy I remember going through these calculations when I was buying our house. There’s certainly some benefit there no doubt about that.

The government is talking about getting rid of this deduction which is kinda scary. I know a lot of people look forward to big tax return because of all the interest they’re paying.

They are “selling it” by saying they will discount other taxes and make it more fair to everyone. But we know how that will end up right? We’ll end up loosing the mortgage deduction and still paying all the other taxes.

Good post. People should consider this when buying a house.

– Bryan

http://www.BryanCFleming.com

So by paying $13000 in interest (to a bank), I can avoid paying $1400 in taxes (to the government)?

And if sometime in the future, the tax laws change so that I can’t deduct that interest then the tax savings go away but the interest doesn’t….

I’m personally debating whether or not I should pay my mortgage off and the more I consider all the variables the better off I think I am paying it off.

Rich,

I think you have to look at the BIG PICTURE here. Don’t forget the fact that you are paying 6.5% in interest, which is relatively low compared to past interest rates. So sure, $13,000 seems like a lot to pay in interest, but you are building wealth in the process.

Totally right JLP. From what I have researched about the withdrawal of the mortgage deductions, they will be implementing new tax deductions for everyone instead of just homeowners (don’t agree, but w/e). I wish they just introduced Fair Tax and eliminate all this worry.

RichSlick:

I am considering paying my mortgage off as well but I decided to leave the cash in CDs for now (maybe bonds later). It just seems to make more sense to me as long as I have a substantial income. I get the deduction. I am earning a better rate on CDs that I pay on the mortgage and the CDs are essentialy risk free. I can pay off anytime I want.

Same here Don but what has me tipping in favor of paying it off, in part, is because of the new bankruptcy laws. You can shield wealth from bankruptcy (and lawsuits) if you pour your wealth into your home. Prior to bankruptcy law, there were no limits or time frames but with the new law there are limits and you must live in your home for at least 41 months in order to shield the home equity (wealth) you’ve built up.

No, I’m not planning on filing for bankruptcy nor am I planning on being sued but it’s a nice precaution to have in worst case scenarios. I could always tap the home equity via home equity loan.

Yes, the interest rates on HELOCs are higher than a fixed but aren’t we just discussing here how great a tax write off home interest loans are?

This doesn’t add up to me. I pay out $13,000 in interest in order to get back $1,375 in tax savings? So if I don’t pay the interest and don’t get the tax break then I come out with $11,625 (13000-1375) to save/investest, spend, etc.

I only say this to point out that having a mortgage just for the tax break doesn’t make sense.

Walter,

I’m not advocating that a person have a mortgage just so they can get a tax break. Rather, the tax break is just a benefit of having the mortgage as it reduces the cost of the mortgage.

Other than the fact that the term “fair and balanced” makes my eyes roll out of my head – 🙂 – I think it’s a great post. Many pf bloggers talk too much in generalities, but you’re good at breaking down the numbers.

Just an aside that I’ve mentioned in previous posts: itemized deductions start to phase out at higher income levels…3% of adjusted gross income exceeding $145,950 (or thereabouts…I haven’t looked lately) for married couples is subtracted from your itemized deductions. Of course, there’s no reduction if you simply take the standard deduction. So, for high-earners, mortgage interest deduction (and charitable, RET, state taxes, etc.) may be reduced.

I would point out that in the example you’ve given, only $5700 of the mortgage interest is really reducing your taxable income. The $5700 is the difference between $16000 and the standard deduction of $10300.

Once the mortgage balance is paid down and the mortgage interest drops, and the standard deduction increases with inflation, mortgage interest will not reduce the tax bill.

Please Advise!

I want to buy a car and remodel my home. I will need $120,000 to buy the car and remodel. For tax deduction purposes, should I get the entire amount as a home loan? Or should I break it down and get separate loans? Which would be more adventageous?

Car loan = 4.25% rate verses home loan = 6.5%