Why You Shouldn’t Keep a Mortgage Just for the Tax Deduction
Published on - March 10th, 2009 (by J.D. Roth) This is a guest post from CJ at WiseMoneyMatters.com. This post represents CJ’s viewpoints, which are not necessarily my viewpoints. (Although I, too, hope to pay off my mortgage early.)
The other day, I was telling my wife’s grandmother that we had sold our house. We are downsizing in order to eliminate our mortgage more quickly. It looks like we will have our mortgage completely paid off in three to five years, depending on when kids enter the scene. She gave me a speech about how our house is one of the only tax deductions we have, and how most accountants recommend you keep a mortgage payment for that reason.
I think this logic is misguided. Let me show you why.
The standard deduction
The 2009 standard deduction for married couples will be $11,400. That means in order to gain any benefit from tax deductions, your interest paid must exceed this number. In other words, you would have to pay $950 per month in mortgage interest (not principal) in order to see any tax benefit from your mortgage payment.
If you had a mortgage on a $200,000 house at 6.25%, you would be barely exceeding the standard deduction for the first few years, assuming the deduction never increases (which it usually does). After that, you would be better off taking the standard deduction assuming you receive no other deductions.
So, in reality, such a tax deduction would only be helpful in house purchases in which your mortgage is $200,000 or more. Anything else and it’s almost pointless.
He also added: “You should not look at the tax savings as the reason to purchase a home. It is only one component, and a minor one at that.” Basically, he agrees with CJ.
A poor trade
If you do itemize deductions, you’re still paying more in interest than you’ll save on taxes. This is the second thing that people overlook.
If you are paying over $11,400 in interest, that does not mean that you are paying $11,400 less in taxes. It means that $11,400 of your income is not counted as taxable income.
Let’s say you’re in the 25% tax bracket. If you pay $20,000 in mortgage interest, it will save you $5,000 in taxes. $20,000 of your income does not count towards taxes. Effectively, you are paying $15,000 to get your tax deduction. This is not the most financially sound advice I’ve ever heard. If you take such advice, I’ve got a really good deal. I will pay you $33 in exchange for $100. That’s the same type of financial advice as someone telling you that keeping a mortgage is a good thing for tax reasons.
The risk factor
The final benefit to paying off your mortgage is that it reduces financial risk to yourself.
Keeping a mortgage payment (and especially a high mortgage payment) is risky. In the unfortunate circumstance that you lose your primary source of income, your largest “asset” can quickly turn into your largest liability. This is a big reason why so many people are facing foreclosure these days. They got into a mortgage payment they couldn’t afford (or could barely afford) and all of a sudden when a small hiccup comes up in life, they are living on the street. Emergency funds are important to help offset these risks, but to truly eliminate the risk, you should pay off your mortgage.
I’ve heard of people who took out mortgages on their homes during the housing bubble so that they could invest the money in stocks. They argued that you get the tax benefit and stocks appreciate quicker than a house. As we can see now, this is an unwise financial decision. Sure, you could make lots of money. You could also make lots of money by winning the lottery, but that doesn’t make it a wise retirement plan.
When it comes down to it, I would rather have the safety of knowing that if the economy crashed and I had to work at McDonald’s for the rest of my life, I could still survive just fine with my current lifestyle.
Final thoughts
While I know there are a lot of variables and other tax deductions I didn’t cover here, I think it’s safe to say that the old notion that keeping a mortgage simply for its tax benefits is not the best advice you can get. When it comes down to it, get the financial advice of a professional regarding your individual situation but don’t simply take their word for it. Have them show you the numbers before you start throwing your money away. I’d argue that even if the numbers are close, the risk factor puts paying off the mortgage in a slightly better position than not.
I’d love to hear some comments or scenarios where keeping a mortgage is better than taking the standard deduction.
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This article is about Choices, House and Home, Taxes
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“Put simply, if you pay off $100 on your mortgage you save $6 in interest, but you would have got $1.50 of that back on your taxes. So your effective savings is only $4.50 or 4.5% of your $100.”
Let’s see if you can follow me here.
At the beginning of the year, we each have a $100.00 mortgage at 6%, and $100.00 cash.
I said that the rate of return on paying down your principal is exactly equal to your mortgage interest rate, and you say no.
So let’s say I pay off my mortgage, and you invest your $100.00 and get a rate of return exactly equal to the mortgage interest rate. At the end of the year, I have no mortgage, paid no interest, and paid no tax.
You make 6% on your $100, but you had to pay 6% on your mortgage. Plus, you had to pay $1.50 in income tax, but you got a $1.50 mortgage interest deduction.
Here we are, at the end of the year. My balance is zero. You still have your $100, but you still owe $100, so your balance is zero, too. You made 6 bucks, but you had to pay 6 bucks interest; you had $1.50 in income tax, but it was wiped out by the $1.50 deduction.
So we are exactly equal. The only difference is that you think the mortgage interest deduction saved you $1.50, and you’ve spent the year telling everyone so writing comments on blogs.
Further, for many married homeowners the standard deduction is so high that the savings from the mortgage interest deduction is worthless, or worth little.
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“So we are exactly equal.”
Only if the return on my investments is only 6%. If they are 8%, I will pay $6 in interest, make $8 on my investments and pay $2 in taxes and save $1.50. I am ahead by $1.50.
But we were talking about YOUR return, which is still 4.5%. The actual return on alternative investments depends on a a variety of circumstances.
If I make tax exempt investments, I won’t pay any taxes at all. If I invest in stock, I won’t have to pay anything on the return until I actually sell it. At that point, I will be paying the capital gains rate on the appreciation not my income tax rate.
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Like most other readers, I completely agree with the premise that the tax benefits alone are not a good reason to avoid paying off the mortgage or to purchase a home.
Regarding this same issue, I created a simple table that helps illustrate the extent of the tax benefits at http://www.yourtwobits.com. For those who are visual people, it may help.
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@Michael C:
Great insight on your post…it does make the whole thing easy to understand.
Like you, I’ll gladly send my .28 to the IRS and pocket the .72 instead of paying $1 to the bank and saving .28 in taxes.
If someone really wants to avoid paying the IRS extra money though, contributions to a church or charity are every bit as deductible as mortgage interest. At least then the person can choose where they want their money to go instead of having the decision made for them.
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It’s not a good idea to ask the professionals. Too many of them are simply ignorant.
Financial planners don’t know how to handle bear markets and their advice iks worthless.
Stockbrokers don’t know what to buy or sell – if they did, they would not be salesmen – they’d be wealthy and retired.
I think many can figure this out for themselves.
But there’s one more important factor. Comfort. If you feel better with no mortgage, that’s worth a great deal in leading a satisfied life. If it turns out that it costs a few dollars to make this choice, it’s well worth it.
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Man, I almost wish my mortgage was higher. I don’t really have an incentive to pay my mortgage off early b/c my mortgage is about as much as most people’s car payment ($320).
And being only 25 there are more things I’d rather spend my money on today although I do have a couple investment accounts (well actually only my 401K and Roth IRA)and at least 2 months of emergency funds (which I am actively growing ASAP to at least 6 months)–I had financial issues recently that included buying a house, needing a new car, and being laid off, then hired at a higher salary…all in the last few months; so my savings has suffered, going from 20k to about 2k.
Hunkering down to pay off my 63k 30 year mortgage just isn’t that motivating especially since my mortgage is already lower that virtually all rent in my area, and barely makes a dent in my monthly expenses.
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