The Mortgage Interest Deduction Myth

Do you know how much money you save through your mortgage interest tax deduction? No? Neither do most Americans. Most of us consider it to be a big deal because we are told by our realtors and mortgage brokers and financial advisors that it is. Unfortunately, none of those groups are doing your taxes for you. And, since many of us (not the Dragon, mind you) use tax preparation software, the true effect is obscured. I am willing to wager that the vast majority of Americans think they are benefiting much more from this deduction than they actually are.

What is it?

The mortgage interest deduction (MID) is exactly what it sounds like; a tax break on the interest you pay on your mortgage. In order to claim this deduction you must itemize on the IRS 1040 Schedule A. So far, so good.

But there are three reasons why this tax break is highly overrated:

  • The marginal impact is very small
  • Many people don’t qualify
  • You are still paying the bank

And there is only one reason why it’s great:

  • It helps you leverage your charitable giving

The marginal impact is very small

The only reason to file a Schedule A is if your itemized deductions exceed the standard deductions for you and your dependents. For an individual in 2016, the standard deduction was $6300. For married persons filing jointly, the standard deduction was $12,600 and for heads of household it was $9,300. For most people, the items claimed on a Schedule A are charitable deductions, mortgage interest (and taxes), and health costs that exceed 10% of their income.

Ignoring health and charity for a moment, this means that in order to claim the MID you must have paid your bank more interest on your loan than your standard deduction. What does that look like in 2016?

The typical APR for a 30 year loan in 2016 was approximately 3.5%. Assuming you and your spouse purchased your home in December 2015 (and are thus paying the maximum interest vs. premium every month in 2016 for the full tax year), and assuming you are deducting $2000/year in property tax, you would START to qualify for the mortgage interest deduction with a loan of $305,000. That means that you are actually realizing no incremental tax gain until you reach this loan value. So in reality, you are paying $10,600 in interest to your bank in 2016 with no tax break. The following year, in this example, you will pay $10,400 in interest to your bank, and the standard deduction will likely have increased with inflation, leaving you with potentially no reason to itemize and certainly no tax deduction. Hm.

So let’s say you and your spouse have an income that puts you in the 28% tax bracket and you have a $350,000 mortgage. In that scenario you pay $12,150 in mortgage interest plus $2,000 in property tax. You itemize a total of $14,150. Your standard deduction is $12,600. Aha! Now you’re saving! Except what you’re really saving is 28% of the difference between the two… or $434.

Wait, what? For the privilege of paying $12,150 to the bank you only get $434 back? Yes. That is a tax break worth a whopping 3%, not the 28% that your mortgage broker led you to believe. Rats.

Most people don’t qualify

As you can infer from my example above, the vast majority of the benefits from this tax break accrue to people who are in very high tax brackets and who own multiple houses, or a very expensive house. With today’s record low interest rates, you have to have a pretty significant mortgage in order to qualify. Furthermore, as you pay down your loan you pay less interest every year, per the amortization schedule. This means that the tax break is the most valuable at the time that you purchase your house and it declines every year. In year 10 of the example above, the couple will pay $9,332 in interest for the year which is well below the standard deduction.

If, as a couple, you earn less than $75,000 and are in the 15% tax bracket, your benefits will be effectively zero regardless of the size of your mortgage (assuming you could qualify for a $500,000 mortgage you would only “save” $1,000).

The math is not that much better for individuals, given that the tax brackets are lower in addition to the standard deduction being lower.

Now, it is true that the value of this deduction will rise when interest rates rise. But at this juncture, it’s just not that important to the vast majority of Americans.

You are still paying the bank

My real problem with the MID is not that the tax break doesn’t work for everyone. It probably does work for many people reading this blog. The biggest flaw is that the marketing hype around it deludes people into thinking they are saving money when in fact they are SPENDING money. The goal of the housing industry is to get you to buy a bigger and/or more expensive house. Many people are tricked into buying more expensive homes because they perceive that they are getting tax savings. But you are still paying the bank! Getting 3% of your interest back is not a good reason to get a bigger loan, just like using a cash back credit card is not a good reason to buy a new flat screen TV.

The bright spot: leveraging your giving

So what does the MID have in its favor? It helps you amplify the effect of your charitable donations. By combining your mortgage interest AND your charitable giving, you can get far above the standard deduction and realize actual savings.

Let’s say the couple above chooses to give $10,000 to charity in 2016. If they are renters and have no mortgage, they would not be able to deduct their charitable contributions (as the value is under their standard deduction). Bummer. But with their $14,150 in mortgage interest and taxes, they are able to deduct a combined $24,150. At a 28% tax rate, that means a tax savings of $3,234! Now we’re talking! That’s a 13% savings on the total deduction, or a 32% savings on your charitable deduction, depending upon how you choose to view it. You will also save more on your state taxes, which ups the leverage of your gift.

On its own, the MID is far less effective than people perceive it to be. But when used in this way, the MID becomes a powerful tool for helping you give more of your hoard. Let’s use it!

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