The home mortgage deduction is one of the few tax write-offs available to the middle class, and it reduces the cost of home ownership. For that reason, it has become a “sacred cow” to many people.
While popular and worthwhile, the perceived value of the home mortgage deduction may be greater than its actual value. Let’s break down the home mortgage deduction and see what it is and what it is it not.
Tax Credit vs Tax Deduction
You need to understand the difference between a tax DEDUCTION and a tax CREDIT. A deduction reduces the amount of your income tax that is subject to taxes, and a credit directly reduces your tax bill. Say you are in the 25% federal income tax bracket. For every $1000 in mortgage interest you pay (over the standard deduction), your tax bill will be reduced by $250. In contrast, a $1000 tax credit would reduce your total tax bill by $1000.
To take advantage of the home mortgage deduction, you must itemize your deductions. To be eligible to itemize deductions, the dollar value of your itemized deductions must exceed the value of the standard deduction, which was $11,900 for married joint filers in 2012.
If you have a $193,000 loan that is five years old, you will pay $8,104 in interest. So you need $3,796 more deductions before you can itemize and take the home mortgage deduction. If you don’t, then you have to take the standard deduction and you cannot take advantage of the home mortgage deduction.
According to USA Today, only about 25% of tax payers are able to itemize deductions and take advantage of home mortgage deductions. Most of these tax payers are in high cost of housing states, such as California, Hawaii, Washington, Virginia, Maryland and Nevada.
Amortization and Interest
Another concept you need to understand is amortization. It’s the mathematical system that banks use to calculate the payback schedule of interest and principle. In general, the early years of the loan are heavily weighted to paying interest and light on principle. Latter years of the loan are light on interest and heavy on principle.
Using the $193,000 loan example, in the second year your interest payments are $8,562.49 and principle payment are $3,172.35. In the 16th year of the loan you pay $5,785.42 in interest and $5,949.42 in principle, about even. By the 30th year of the loan, the interest payments are $577.30 and the principle payments are $11,157.53.
As the years go by, the value of the home interest deduction diminishes because it gets harder to beat the standard deduction.
Early Loan Payoff
At some point, you may find yourself in position to pay off your loan early. No mortgage payment sounds great, but people worry about the trade-off of losing their home mortgage deduction. There are three things to consider.
1. What is your tax bracket? From our tax deduction example, we know that if your tax bracket is 25%, you get about .25 in benefit for every $1 in tax you pay. So in essence, you are spending a dollar to save a quarter. On the other hand, without a mortgage payment, you’d pay .25 to the IRS and keep .75 for yourself.
2. How many years do you have left on your loan? From our amortization example, we know that if you are past the mid-point of your loan you pay less interest and more principle every year. Therefore there’s less and less interest to deduct as time goes on. Most people in position to pay off mortgages are past the mid-point of their loan.
3. Do your take standard or itemized deductions? If you don’t have enough deductions to itemize, then you can’t take advantage of the home mortgage deduction anyway. So why keep paying interest to the bank?
Did you know that on a $193,000 30-year loan, you will end up paying $159,044.95 in interest! By shaving five years off the loan you’ll save at least $5266 in interest, which goes directly into your pocket. The deduction on that interest: only $1316 (assuming a 25% tax bracket).
The home mortgage tax deduction is a great thing; if you have to have a mortgage you might as well get to write off the interest. However, talk to your CPA and financial advisor to decide if the deduction is a good financial tool for you.