Ask anyone what one of the major befits of buying a home is and you’re sure to hear many tout the benefits of the mortgage interest deduction. From your friends and neighbors to the financial gurus on TV, everyone urges you to buy a home for this sweet tax break. They can’t be wrong, can they?
It’s not that they are wrong, but like most financial rules of them, they are simply not universal truths that apply to everyone, or even most people. Unfortunately, this causes people to rush into some financial decisions without being completely informed. And when you’re talking about buying a home, it can be a very costly mistake.
The Actual Value of the Mortgage Deduction
The first mistake many people make is simply assuming they will be getting a big tax break with their new mortgage interest and property tax deductions, but that’s jumping the gun a bit. In reality, the value of the deductions is only the amount that goes above and beyond the standard deduction. You see, even if you’ve never owned a home before, you’ve been getting a pretty hefty standard deduction every year (assuming you don’t itemize). Since claiming the mortgage interest and property tax deduction requires you to itemize deductions instead, you’ll have to ensure your itemized deductions tally up to more than the standard deduction.
As a quick example, let’s say you bought a house and over the course of the year you paid $10,000 in mortgage interest and had a $2,000 property tax bill. Good news, that’s $12,000 in tax deductions right there. But guess what? In 2010 the joint standard deduction was $11,400. Assuming you had no other itemized deductions, your net tax deduction gained by using the mortgage interest and property taxes was just $600. And remember, this is a tax deduction, not a tax credit. So if you’re at the 25% tax rate you’ve only saved $150. Suddenly all of those dreams of a huge tax break go right out the window.
Of course this is just a high level example. You may have other deductions that can be itemized and your tax situation may be different which yields a bigger deduction, but this is to show you how to really place a value on the mortgage deduction. It isn’t the full amount that’s meaningful, but the amount above and beyond the standard deduction.
Why Many Homeowners Don’t Even Qualify
The other realization first time homeowners come to is that it may not even be worth claiming these so-called huge tax breaks. The reality is that you need to carry a mortgage large enough to make the tax deduction even worthwhile. Those who are buying less expensive homes or don’t need to borrow as much may find there’s really no benefit at all.
Another quick example: Let’s say you buy a $150,000 house and put 20% down and finance the rest at 5%. Guess what? In the first year you’ll pay less than $6,000 in mortgage interest. Even if you had a $2,000 property tax bill, a married couple would still fall over $3,000 short of meeting the standard deduction. So, unless you were able to come up with significant itemized deductions elsewhere you’d have no reason to claim any mortgage interest deduction. As you can see, many homeowners who buy modest homes, especially in the low mortgage rate environment we have now, won’t even see the tax benefits that everybody loves to talk about.
The Diminishing Deduction
Even if you do qualify for the mortgage deduction there’s another caveat. Because most mortgages are front-loaded with interest, you’ll pay less and less in interest with each passing year. So, between the standard deduction amount increasing most years and the amount of interest you pay going down each year it isn’t uncommon to find that just a few years into a mortgage it’s no longer beneficial. So, keep that in mind. The deduction will diminish or be gone entirely long before the loan is repaid.
Buying a Home for the Right Reasons
So, is the mortgage deduction worthless? Not at all. The point here is that even though everybody loves to talk about the great tax breaks from owning a home, you have to look at it in context. What seems like a huge benefit is often little more than a few hundred dollars in actual tax savings, if there’s any savings at all.
The real danger is that people who aren’t aware of how this tax deduction actually works may rush into buying a home, or buy more home than they can afford simply because they think it will be offset by big tax savings. This happened a lot in the great real estate bubble. People would justify spending more on a home by talking about a bigger tax break. While on paper that may be true, spending money is spending money no matter how you look at it, and the added costs, either direct or indirect, will far outweigh any tax savings.
This is why it’s important to buy a home for the right reasons. There are many reasons why buying a home is a good idea. But doing it just for a tax break isn’t one of them.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.