Tax deductible mortgage interest doesn’t always save money

The interest is tax deductible, but other deductions may get in the way

In years past, buying a home was a difficult prospect that few could undertake. The most limiting part of the process was the large down payment involved when applying for a mortgage. Recent mortgage innovations that require smaller down payments have allowed more people than ever to afford a home. In fact, home ownership in the United States is nearing 70% of the populace. All in all, that’s good; we’d all rather live in our own home than rent one or live on the street. Still, owning a home usually requires a loan, since few of us can afford to pay cash. Cash is best if you can afford it; there is a lot less paperwork to be filed and once you’re paid the bill, you’re done. Not so with a mortgage, which requires payments every month, usually for 30 years. Worse, with the interest added to the payments, the price of the home often triples. Many buyers don’t realize this until the numbers are spelled out for them at closing, but a $150,000 home, with interest, can easily reach $500,000, or one half of a million dollars, by the time it has been completely paid for.

When buyers gasp at the sight of those large numbers on the contract, the lender usually points out that the “interest is tax deductible.” That comment is intended to soothe the buyer into thinking that they don’t really have to pay all of that interest. Well, what’s the story on the tax deductible interest? Does the tax relief lower the price of the home or help in any way?

The benefits of the tax deductible interest on a personal mortgage are largely overstated. Yes, the interest on the mortgage for a homeowner’s primary residence is tax deductible on home loans of up to one million dollars. But how does this help the buyer? Most Americans are taxed in the 28% bracket; they pay 28 cents on every taxable dollar earned. By deducting the interest on their mortgage, the homeowner is permitted to subtract the amount of interest paid in a calendar year from his or her taxable income. If you earned $60,000 and paid $15,000 in interest, your taxable income is effectively reduced to $45,000. This reduces your income tax by some $4200. That’s good, but you had to spend $15,000 in interest to get that $4200. So, you’re still out $10,800 in interest payments.

Worse, taxpayers are entitled to something called a “standard deduction.” That standard deduction is currently $10,000 for a married couple. With the standard deduction, the homeowner is only allowed to deduct the portion of his or her interest that exceeds $10,000. In the scenario above, that would be $5000.

Most Americans don’t pay that much in interest, and more than two thirds aren’t able to deduct any interest at all from their Federal taxes. That being the case, the benefits of the tax deductible interest are largely mythical. That doesn’t mean that no one benefits. Those homeowners with high incomes that are taxed at higher rates and/or those with larger mortgages can benefit. But for the most part, the mortgage interest deduction isn’t all it’s cracked up to be, and buyers shouldn’t consider it at all when deciding how to pay for a home.