Debunking Financial Myths Part 5 – Mortgage Interest Tax Deduction
Our series on myths continues with my personal favorite about taxes. Ready?
“It is worth taking out a home mortgage just to get the tax deduction.”
False. Please stop by my office and I’ll happily trade you a quarter for your dollar . . . because that’s exactly what we are talking about. Under current federal tax laws, the mortgage interest on your primary residence is deductible if you itemize. For example: “Bill” itemizes $10,000 in mortgage interest, in addition to $10,000 in other deductions. If Bill is in the 25% income tax bracket, he will be able to reduce the tax he pays by $2,500 because of the mortgage interest. The net result is that Bill paid $10,000 in interest and got a $2,500 tax break for it, so he still paid $7,500 in after-tax interest. If he only took out the mortgage to get the interest deduction, then Bill traded $10,000 to get $2,500 back (a dollar to get a quarter).
It’s not just about taxes. There can be several considerations when analyzing whether to get, or pay off, a mortgage. The rate of interest to be paid on the mortgage and the rate of interest that can be earned on available cash would be two key factors. For example, if Bill’s mortgage is “interest-only” at a rate of 5% and he owes $200,000, his annual interest would be the aforementioned $10,000. Now, if Bill had $200,000 in cash sitting idle in the bank earning one quarter of 1%, would he be wise to forgo the tax deduction and put the $200,000 toward the mortgage? Even after the tax benefit, Bill’s net interest is still 3.75%, which is 15 times what he is making on his idle cash. Yes, Bill could invest his $200,000 and possibly make more than 3.75%, but I haven’t seen a guaranteed rate that high. By paying off the mortgage, Bill has, in effect, arranged a 3.75% guaranteed return on his money. He doesn’t actually receive cash payments, but not paying 3.75% is the same as earning 3.75% in my book.
To conclude on taxes, here’s one that’s not a myth: Regardless of political persuasion, I haven’t met a person yet who wants to pay more in taxes. They might want you to pay more, but not them! Just know that there’s nothing illegal or unethical about taking steps to minimize your tax obligations. Cheat? No. Minimize? Yes! And, get professional help if your circumstances warrant.