Why the home mortgage interest deduction is a disappointment

UPDATE: I originally made a math error below, and have corrected it. Apologies.

UPDATE #2: I have another take on this.

Oh you’ve got a mortgage now!” goes Conventional Wisdom. “Now your taxes will be lower because you’ll be able to deduct your mortgage interest.

I admit that the idea is appealing. It’s not a reason to purchase a home, of course, but as long as I’m paying interest, I might as well get a tax break on it, right?

But like all too-great-sounding ideas, when you look into the details, it ends up being a little less than thrilling.

What is the home mortgage interest deduction?

Let’s define our terms first. The home mortgage interest deduction (or HMID) is the ability to deduct the interest spent on your mortgage from your taxes. It’s available in the US and a few other countries.

We already know what a tax deduction is, so we know that it’s a way to reduce your total income from which your tax is calculated. It’s not a direct credit against taxes owed. But it’s still a benefit. The problem is that it’s not a benefit to everyone, and not much of a benefit to most people. Let’s see how.

Can you do better than the standard deduction?

In order for you to take advantage of the HMID, you need to itemize deductions. (Well, you need to own a home too, but that should be obvious.) In order for itemizing deductions to make sense for you, the total itemization must exceed the standard deduction. So we need to find more than that amount in deductions. Can we do that?

For the sake of simplification, let’s assume that you have nothing to deduct aside from the HMID. (Which I grant is an oversimplification, since as far as I can tell, most people can deduct state and local taxes too. But I’m trying to keep the conversation simple and less than 1,000 words here.)

For those listed as single in 2015, the standard deduction is $6,300. How does that compare to the home mortgage interest you paid?

Sample solution

There are two variables at play here: your income (which determines your average tax rate) and the amount of mortgage interest you paid. Let’s assume that the tax brackets aren’t going to change anytime soon.

If we assume you have an income of $50,000 (again, not too far away from the median household income) then your marginal tax rate would be 25%.

Let’s assume you have a mortgage of $200,000 at 4%. While the amount of interest you pay will vary over time, if you’re at the beginning, you’ll be paying something in the ballpark of $650 a month in interest, or $7,800 a year.

Now, your mind might jump to the $7,800 – $6,300 = $1,500 calculation and think you’re getting that much back. Unfortunately, no. This is because we’re talking about a tax deduction, not a tax credit.

Any extra deduction just reduces your income from which your tax is calculated. So the taxes still need to be taken off that $1500. That’s $1500 × (1 – 25%) = $1125. So of that $1,500 deduction, this means that you’d get back $1,500 × 25% = $375.

So after spending $7,800 dollars in interest, you’re getting back $1,125 $375. Which, okay, is real money, but not a whole lot considering the sums involved. And certainly not worth paying your mortgage more slowly so as to reap the “tax benefits”.

It gets less impressive

As you pay down your mortgage principal over time, your paid interest will go down too. Which means that the tax savings you receive from the HMID will go down over time as well.

And in fact, for a large portion of the life of the loan, this deduction does you absolutely no good. In the above case, as soon as your monthly interest reaches $525, you’re out of the game (since $525 × 12 = $6,300). So on a 30 year mortgage, you’d only get a benefit for the first 10 years. On a 15 year mortgage, you only get 4 years of benefit!

And in this scenario, if you’re married, forget it, because your standard deduction doubles, so you’d have to effectively double your mortgage to get any benefit at all.

In fact, the benefits of the HMID only seem to come out when you take out larger and larger mortgages. So it’s very easy to misinterpret this deduction as an excuse to get buy a more expensive property. But like all deductions, the amount paid out always lags the amount returned. The house (pun intended) always wins.

What I found

I ran my own numbers for my situation, and found that if I only pay the minimums (which I’m not doing, but still) after the thousands of dollars I’ll be paying in interest each year, I’ll get around a $600 $200 savings the first year (over the standard deduction), with that number going down for six years until it reaches zero. I mean, I’ll take it, but it’s not life-changing.

There are benefits to home ownership, but the home mortgage interest deduction isn’t really one of them.

But enough about me. How is the home mortgage interest deduction working for you?

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