WARNING: This post contains math.
“When you have a mortgage, you get a tax deduction for all the mortgage interest you pay. So you shouldn’t pay down your mortgage early, because you’ll lose the tax deduction.”
This is one of the most common reasons people say to not pay down your mortgage.
But this is a good chance to see if you understand the difference between a tax credit and a tax deduction. Or, more pointedly, if you understand the difference between a larger number and a smaller number.
Let’s talk about interest
Every month that you have a mortgage, you will accrue interest that also needs to be paid. The amount of interest you accrue over a given time is dependent on the interest rate and term of the mortgage, and also where you are in your repayment. Toward the beginning of the term, you’ll be paying much more in interest than toward the end of the term.
For a specific example, if you assume a $200,000 mortgage at a 4% interest rate on a 20 year loan, you’ll pay almost $8,000 in mortgage interest during the first year. (As an aside, wow, just think about that.)
Now, since this is a tax deduction (and not a credit), instead of being money you get right back, dollar for dollar, all this does is reduce your taxable income. And to review: the amount saved through a tax deduction is equal to the amount of tax deduction multiplied by your marginal tax rate.
Median income puts most people in the 25% tax bracket. So this means that the amount you save with this tax deduction is: $8,000 × 25% = $2,000.
Let me repeat: You paid $8,000 to get $2,000 back.
Please let me know that you understand this.
Moreover, I didn’t cook the numbers here: There will never be a situation with a tax deduction that you make more money paying more than with paying less. The math doesn’t work.
The politics of mortgage interest
While we’re at it, let’s look at the political implications of this transaction. That $8,000 is going to your mortgage lender. The $2,000 is given to you by the government. I don’t know about you, but that seems wrong to me.
I mean, why would I want to support the mortgage company? I mean, sure, I appreciate that they’re there, but I don’t feel the need to extend this engagement any longer that I have to.
And, I don’t particularly want the government to give me money for this. Say what you will about our government and the way it handles money, but I believe that defunding a mismanaged system is wrong, and certainly not the way to fix it. I can’t guarantee that they’ll use my money in a way that I approve of, but they certainly can’t do anything beneficial with money they don’t have.
A mortgage is almost always a necessity for people in order to make the jump to home ownership. It may not be “good debt“, but it’s as necessary as debt gets.
But many people think that holding on to the mortgage is the most prudent move, to just sit back and get the tax breaks. Unfortunately, the math, like hips, doesn’t lie.
But enough about me. Do you not pay extra on your mortgage if you could? I’d love to hear your story.