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Most people assume their home is a great investment. I know I did when I bought my first home. Through homeownership, you can build wealth and best of all, lower your taxes substantially through the mortgage interest tax deduction, right?
Not necessarily. In actuality, the mortgage interest tax deduction may be one of the most misunderstood tax deductions on the books today.
A Little History
In 1913, interest deductions were first introduced into the tax code. All interest, not just mortgage interest, was deductible on tax returns starting that year. This included interest on personal loans such as credit card debt. However, the deduction excluded the first $3,000 of income for singles and $4,000 of income for married couples. Thus, the deduction affected less than 1% of the population at that time.
A little over 30 years ago, the Tax Reform Act of 1986 limited the interest deductions to just mortgage interest. The hope was that it would spur homeownership.
Mortgage Interest Tax Deduction
The mortgage interest tax deduction allows taxpayers to deduct interest paid on their mortgage up to $1 million in principal on their home. If your mortgage is $2 million, only the interest on the first $1 million of principal is tax-deductible. In addition, you can also deduct the interest of up to $100,000 of home equity debt.
Most people qualify for the mortgage interest tax deduction as they don’t come anywhere near the $1 million principal limit.
Additionally, the interest deduction only applies to one’s first and second homes. Thus there is no tax incentive to buy a third home. However, this could change according to whatever tax plan is passed later this year.
More Limitations
To qualify for a mortgage deduction, you must itemize your taxes when you file. You would also need to forgo the standard deduction. As of 2017, the standard deductions are: $6,350 for single people, $9,350 for “head of households”, and $12,700 for married couples filing jointly.
In order for the mortgage interest deduction to help your tax situation, the deductions on your Schedule A must exceed the standard deduction. Otherwise, you can only take the standard deduction and will not receive any additional tax benefit.
An Example
Let’s say you and your spouse paid $14,000 in mortgage interest on your home in 2017. You would receive a $1,300 benefit over the standard deduction of $12,700. If you are in the 20% tax bracket, you could only claim $260 in tax benefit.
That hardly seems worth it if you paid $14,000 in mortgage interest.
Average Savings of Mortgage Interest Deductions
The average savings in 2016 was $1,918. However, those with incomes over $200,000 saved $4,149. Meanwhile, the average American family, who earns less than $75,000 per year, saved less than $700.
| Mortgage Interest Deduction | ||
| Returns in thousands, Money amounts in millions of dollars | ||
| Income Class | Returns | Amount |
| Below $10,000 | 6 | $2 |
| $10,000 to $20,000 | 138 | $40 |
| $20,000 to $30,000 | 350 | $132 |
| $30,000 to $40,000 | 668 | $337 |
| $40,000 to $50,000 | 1,153 | $602 |
| $50,000 to $75,000 | 4,692 | $3,650 |
| $75,000 to $100,000 | 5,074 | $5,538 |
| $100,000 to $200,000 | 14,597 | $24,853 |
| $200,000 and over | 7,178 | $29,782 |
| Total | 33,856 | $64,936 |
Source: The Joint Committee on Taxation
Source: The Joint Committee on Taxation
As you can see, the real winners are those who earn $200,000 and over. Although you may have heard that the mortgage interest tax deduction is a great benefit, it appears that it really only greatly benefits the wealthy.
Home Size & Homeownership
According to the Wall Street Journal, the average house size in the Washington, D.C area would be almost 1,400 square feet smaller if the mortgage interest tax deduction did not exist. After all, the mortgage interest deduction was first enacted to promote home ownership.
However, although the deduction has increased the size of housing, it has done very little to encourage people to buy homes. In fact, US homeownership rates are similar to that of Canada and Australia, but neither Canada nor Australia offer mortgage tax deductions.
So, the next time someone tells you to obtain or keep your mortgage because of the wonderful tax benefits, you should take their advice with a grain of salt.
As a fairly high earner in a high income tax state the deduction from my homes interest and property taxes is significant. I’m getting anxious to potentially lose these deductions if the new proposed tax plan goes through. It will definetly hurt my savings rate.
Jason@WinningPersonalFinance recently posted…Stop Giving Interest Free Loans
Thanks for sharing Jason!!! From what I read I thought it was only suppose to impact new mortgages and I hadn’t heard that it was suppose affect old mortgages but these tax plans get muddled all the time.
I don’t really think about our mortgage interest deductions. It does save us several thousand a year in taxes, yes, but I’m much more interested in the over $6000 we’d save in interest payments were we to pay it off. We have a fifteen year mortgage and have paid half off, so we’ll have less and less mortgage interest over the coming years as our payment on principal increases. I think most people miss the forest for the trees with this tax deduction, frankly. They justify taking out a 30-year mortgage and paying thousands more per year in interest for a rather small tax deduction. So I’m with you here!
High earner here who has 5 years left on a 7 year ARM. I chose the mortgage type based on lowest rates and my ability to pay it off FAST. That said, I really appreciate the deduction and am sad to see it possibly going away. I think the real takeaway here is that FIRE principles are critical to people like me where someone else thinks I am “wealthy” but I don’t necessarily feel that way. I live by choice and force in expensive city and paid for an education that allowed me to get a high paying job. Each of these choices has brought more income, but at a higher up front cost. By slashing where I can and lobbying for tax treatment that benefits me, I can maintain my status as a high earner without it costing so much.
Heather @ bizewife recently posted…DIY Design Hacks: Crafting a Custom Closet on a Budget
Thanks for sharing Heather!!! I definitely understand not feeling that well off especially in expensive cities. It would be interesting to see what would happen if taxes were applied against the median income of each city/state 🙂
I definitely agree with you Laurie!!! Too often I don’t think people realize that the benefit may be smaller than they actually think.
Interesting article, many people I know who are younger in age use the investment line as the reason they buy their home.
I don’t find anything wrong with buying a home at an early age if you are ready and your financial situation can afford it. Many people fail to see the maintenance cost, insurance cost, and the mortgage interest in their estimates of “investment.” The charts show another way they could miscalculate the benefit of having the house as well.
Thanks for shring !
Chris @ Duke of Dollars recently posted…Health Insurance Wasteland – 2018 Individual Plans Suck
Thanks for sharing Chris!!! I definitely agree homeownership isn’t for everyone. Especially if you’re young and not sure you want to settle down. Why buy something before you’re ready?
Thanks for writing up the history of the mortgage interest deduction. And it’s very insightful how you compared household incomes versus how much in savings they get from the deduction.
Personally, we itemize our deductions and have saved quite a bit in taxes over the last few years versus taking just the standard deduction.
Definitely take the advice of it being a great deduction with a grain of salt. A person must analyze their own personal income and taxes to see if it’s worthwhile. Never make a home purchase because of the deduction!
Thanks for sharing Lena!!! I definitely agree every person’s situation is slightly different. So analysis definitely has to be done. It’s too easy to fall into the trap of not fully investigating something.
After my wife and I got married, we were able to pool resources and eliminate our mortgage on our small and modest house pretty quickly. I was never overly enticed by the mortgage deduction. For example, if you have to spend $3 in interest to save $1 on taxes, I thought it better just to save the $3 upfront and forget about the tax deduction. I know their is an opportunity cost on using one’s money this way, but I liked the sure thing. Tom
Tom recently posted…Why Your Investment Portfolio Is Like a Garden
I’m like you Tom!!! I definitely was willing to forgo some of the opportunity cost to get rid of my mortgage. Definitely helps me sleep a lot better at night 🙂
As a high earner this is one of the only deductions we qualify for. Most everything else phases out. This is one of the reasons we don’t mind carrying a mortgage. If this disappears through tax reform, we will likely pay off the mortgage. For now, with the tax break and the interest rate so low, we’d rather keep the funds invested elsewhere.
Turning Point Money recently posted…Time for Tax Loss Havesting
Thanks for sharing Turning Point Money!!! I definitely understand the point of view of investing in other things especially in this environment. I’m a bit more conservative so I like paying off my mortgage but I definitely understand why you would keep your mortgage 🙂
Agree.
The benefits of mortgage interest deductions are overblown. I have seen my fellow high-earning physicians get suckered into buying way too much house in an effort to benefit from this mysterious tax benefit.
Thanks for stopping by WealthyDoc!!! Like you I have definitely seen a ton of people buy way too much house and justify by getting a tax break…
I couldn’t agree more. I think we give too much Creedance to the tax deduction. It does not make that huge if a difference for most people.
Thanks for stopping by DDD!!! I definitely think people need to investigate how much tax benefit they are really getting.
People have told me to not pay off the mortgage to take advantage of the tax benefits. But as Dave Ramsey said, you would have to pay $1,000 a year, for example, to get $300 back, which does’t make much sense.
Mr. FAF and I are trying to pay off our mortgage. We’ve slowed down our progress a bit because we’re maxing out our 401(k) and saving for other future expenses. But I’m with you on this topic.
It’s the opportunity cost that kills you though: a 200k mortgage at 4% over 30 years will cost ~$350k total. If you invest that 200k and get 7% return, you’ll get 1.3 million in gains which is still quite a lot more than the 100-150k you pay in net interest.
Even at 5%, a delta of 1% over a 4% mortgage rate, you get $650k in gains on that $200k over 30 years. Take away 10% for tax, deduct the $150k you pay in interest, and you’re still up $435K. The mortgage interest benefit might improve this number a bit, but we don’t even really need to consider it.
These numbers are when you have the cash to potentially pay off the house up front. However, the math is the math… the compounding over time of even a small difference in interest rate yields a large difference in gains regardless if the money is available on day 1 or day 5475 of the mortgage. These crazy low interest rates are a much bigger gift that any mortgage interest deduction will ever be.
Of course, it only applies to folks who can save that money and leave it alone. That seems to be a small portion of the population overall, but hopefully most of us reading the blog. 🙂
Thanks for sharing Mikes!!! Great analysis!!! I think if you can save the difference that it is definitely the way to go. Most people I’ve found don’t save the difference and unfortunately buy a bigger house than they can afford. But if they can apply the difference…the math is the math 🙂
Thanks for sharing Ms. FAF!!! Maxing out your 401k and savings makes a ton of sense. Especially since you know you’re keeping those tax benefits for sure 🙂
Yes I always heard about these mythical tax advantages of having a mortgage. They almost made it sound like you wanted a higher interest rate so you can deduct more. Then I got a mortgage but still filed a standard deduction.
I bet a lot of people are filing a standard deduction and don’t even know it.
Grant @ Life Prep Couple recently posted…You Don’t Have To Be Frugal To Be Good With Money
I tend to agree with you Grant!!! I think people would be amazed if they did the analysis to see how little they actually save.
It’s sad when you sit down and see how much you’re paying in interest VS the tax benefit. If I could I’d definitely pay off my mortgage in order to save all the money in interest. I’m thinking about taking a big chunk of the tax return this year and just applying it towards principal.
SMM recently posted…Make Personal Finance Great
Thanks for sharing SMM!!! You bring up a great point about all the interest that you actually pay. When I was paying off my mortgage I essentially looked at it as a bond which diversified my stock risk 🙂
In Canada, we don’t get to deduct the mortgage interest to lower our income tax on our principal home. However, there are a couple of methods that would allow us to deduct the mortgage interest.
If we rent out part of our home, then a percentage of our mortgage interest can be deducted, but we will also have to report the rental income. If we buy an investment property, and we rent it out completely, then all the mortgage interest is deductible and there is no limit on the number of mortgages that you can deduct from.
For our principal home, if we don’t rent it out, when we sell, we don’t have to pay capital gain tax on it. For rental properties, we’ll have to pay capital gain tax when we sell.
For me personally, the real estate market had been a blessing as the home price in the area that I lived in more than doubled within the last ten years.
Leo T. Ly @ isaved5k.com recently posted…The Stepping Stone To Building Wealth
Thanks for sharing Leo!!! It’s interesting to hear your perspective from up North. I think if mortgage interest deductions were to be phased out that people would freak out even though people still buy homes even if you don’t have the benefit 🙂
I fall into AMT (Alternative Minimum Tax) and I’m so deep in the AMT that for me the entire mortgage interest expense is effectively deductible at a marginal rate of 35% federal (=28% rate times 1.25 due to phase-out of exemption) plus state tax. Over 40% combined! No constraint from the standard deduction! So, for me personally, the mortgage interest deduction is quite useful. Until next year when we (hopefully) get tax reform and get rid of the AMT. But that’s when I retire! 🙂
EarlyRetirementNow recently posted…Ask Big Ern: A Safe Withdrawal Rate Case Study for “Ms. Almost FI”
Thanks for sharing ERN!!! You always bring a unique perspective and I definitely should have considered the AMT aspect in my analysis. Thanks for stopping by!!!
We’re now at a point where it makes sense to itemize every other year (big property tax bill we can time 2x in same year), so the mortgage interest deduction really starts to lose its appeal. I’ll be interested to see what happens if the standard deduction goes up – housing may be hurt, but perhaps we should stop incenting home ownership anyway?
Paul recently posted…TGIF: The Woody Rule
Thanks for sharing Paul!!! I’d be surprised if people stop buying homes if homes aren’t discounted by mortgage interest deductions. I could be off but based on some of the other statistics I doubt it 🙂
I’m glad you did the calculations on this. I have met many people who say the mortgage interest deduction is one of the key tax reasons to own a house. I think this is crazy and often wonder how many people are depending on this deduction or if they simply do not understand the tax code.
Thanks for sharing Jeff!!! I definitely agree that it’s a shortcut to say you save money without doing the analysis. It may save you money or if you still have a standard deduction it won’t 🙂
Nice write up and a good look at the “other side” of the equation regarding mortgages. I for one will continue to pay down my mortgage at a faster pace. The tax savings are not what I am after, it’s the peace of mind of no longer having a payment. There are pros and cons to both side, it really is what you want to do.
FIbythecommonguy recently posted…Net Worth #7 – Oct ’17
I’m with you, the peace of mind of not having a mortgage is well worth it to me!!!
You touched on the biggest misconception I run across. People take their marginal tax rate times their mortgage interest payments to see the tax benefit. However, that ignores the standard deduction hurdle. $14,000 in mortgage interest x 20% = $2800 tax decrease. However, if they had no mortgage, they would still get the standard deduction of $12,700. $12,700 x 20% = $2540. The $14,000 mortgage interest payments yields a $260 incremental tax benefit or 260/14000 = 1.85% or stated otherwise every $100 of mortgage interest reduces your taxes by $1.85 compared to the standard deduction.
Great analysis Dan!!! I definitely agree that people forget about the threshold. It will be really interesting if the standard deduction doubles in the future how long the misconception will last.
When I was a mortgage sales assistant we were sold this Koolaid big time and proceeded to sell it to clients as well. About half way through my 5 year career in that field, I realized what a bunch of hoohaa it was and started advising clients to pay off their mortgage and give that money to their fave charity instead. Same discount, better impact on the world. Great post, Rob!
Thanks for stopping by Laurie!!! I love hearing your unique perspective from the inside. I am definitely going to borrow your line about paying off the mortgage and share with their favorite charity 🙂
I’ve always found it interesting that we Americans tend to justify spending more if we thinking there is a deduction involved…
The money is still being spent!
Wes recently posted…October 2017 Blog Numbers
Great observation Wes!!! I never understood when marketers would say Save 30% off any purchase. I want to scream Save 100% by not spending the money!!!
Great topic! There are a lot of misconceptions about the true impact of this deduction.
Personally I don’t think about it anymore – since I paid off the house three years ago. Lately I take the standard deductions and it works really well for me!
Brad – MaximizeYourMoney.com recently posted…Highest Paying Jobs Without A College Degree – 2017
Hahahaha….thanks for sharing Brad!!! I too have paid off my house but still have been able to utilize the itemized deduction due to SALT 🙁
This really depends where you live. Here in NY, it’s a big deal, esp when coupled w/ not being able to deduct real estate taxes and/or state taxes both of which are very high here.
In my county, the median is $650,000 for a house and $800,000 for average. Sales tax is higher here vs most other states and in my county, you would gasp when you heard some of the real estate taxes.
So, this whole tax thing is not a decrease, but rather an increase here…at least in it’s current state. I hope that they would make cost of living adjustments.
As you mentioned, it all depends on your situation and can vary based on married vs single, etc. But, this has been a big deduction for me for the last 11 years. I did not realize about the cap of $100,000 home HELO. I had to do that to avoid jumbo loan rate.
All that aside, of course you need to look at your interest rates, etc and your situation And, if you are in a situation to pay down the mortgage to avoid the interest, you could do so…but, it is still an opportunity cost of where you put your money. Sometimes it’s good to use OPM and have leverage while you invest elsewhere. And, diversification of assets is good too. To each their own. What good for one person isn’t necessarily good for another…or at different stages of their life.
Thanks for sharing Debbie!!! You are absolutely right that it will affect those in higher priced areas. It would be interesting to see if federal income tax rates were based the locale that you lived in. I would think it would be a bit more equitable 🙂
I agree. While the mortgage interest deduction is great if you can get it, it’s nowhere near as great as not having a mortgage in the first place.
Hahaha…paying off my mortgage was by far the best thing that I did 🙂