Homeownership provides a variety of benefits. A place to call your own, long term appreciation and a sense of security. There’s also one more benefit that owners enjoy that renters do not: the ability to deduct the mortgage interest from taxable income, reducing an owner’s tax bite. What’s the real impact?
How Much Interest is Paid per Year?
First, understand that this is not tax advice but simply an example of the impact the mortgage interest deduction may have. For tax advice, you need to seek the counsel of a licensed tax professional. That said, as a borrower makes a payment each month to their lender, a portion of the payment is principle, and a portion is interest. The interest portion is typically tax deductible, if it’s a mortgage for a primary residence.
For example, a 30 year mortgage rate of 6% on a $400,000 loan will have a monthly payment of $2,398, not including taxes, insurance, or other housing costs. Of that, there is $23,866 in interest paid to the lender in the very first year.
That $23,866 may be tax deductible, and it could equal a big discount on your tax bill.
Different interest rates will affect the amount of interest paid. For example, a 3% rate on the same scenario provides a $1,686 monthly payment with $11,885 in interest accruing over the first year, a much smaller deduction. Also, the loan amount will also affect interest paid per year. A 3%, 30 year rate on a $100,000 loan results in $2,971 of interest over the first year.
Still, any mortgage interest tax deduction can be a significant tax savings.
Deduction vs. Credit
Before we get too far, let’s first understand what a tax deduction is compared to a tax credit, as both terms are sometimes confused with one another. A tax deduction is an amount subtracted from overall income before income tax calculations are applied.
For example, if someone makes $50,000 and there’s an $11,900 deduction available, income tax will be calculated on $38,100, not $50,000.
A tax credit on the other hand, is subtracted from the final amount of taxes owed. For instance, if you owe $1000 in taxes and you have a $500 credit available, your final tax bill will be only $500. Tax returns can have both deductions and credits at the same time.
Mortgage interest is a deduction; not a credit.
The Impact of the Mortgage Interest Deduction
Now let’s look at a few examples of how the mortgage interest deduction affects someone’s income tax liability. Note, these are general examples only and will not address every factor that can affect an individual tax obligation but will illuminate the impact of the interest deduction.
Income tax rates vary based upon how much someone makes each year and their filing status. The more someone makes, the higher the income tax rate. The 2013 tax brackets for a married couple filing jointly look like this:
|$0 – $12,399||10%|
|$12,400 – $47,349||15%|
|$47,350 – $122,299||25%|
|$122,300 – $198,049||28%|
|$198,050 – $388,349||33%|
The table is relatively clear, but someone making $12,399 is taxed at 10 percent and someone making more than $388,350 or more is taxed at a 35 percent rate. Income tax is applied to a filer’s adjusted gross income, which is the income after all allowable deductions are taken.
Say that a couple’s income is $200,000. The federal income tax liability is 33 percent of $200,000, or $66,000 without a mortgage interest deduction. Now let’s subtract the interest paid on a $400,000 loan with a 30 year fixed rate at 6.00 percent, drawn from the example previously given. The interest is $23,866.
Now let’s look at the tax bite after mortgage interest is subtracted from taxable income. $200,000 – $23,866 = $176,134. The tax rate at $176,134 is 28 percent. That’s quite a bit lower than the 33 percent rate applied to earners making $200,000 per year. The estimated income tax is now $49,317.
The mortgage interest deduction in this example reduces the couple’s tax liability by $16,683! In other words, this couple gets to keep $16,683 more of their money because they have this mortgage.
Rent vs. Buy
It’s easy to see the advantage to owning rather than renting. If this couple were renting the same home for say, $2000 per month, their actual cost to rent should take into consideration the extra income taxes due. Taking $16,683 divided by 12 months, that’s an additional $1390 per month they would be paying in taxes because they don’t have the mortgage.
How does the final cost of renting compare with buying? Assuming the couple pays $2398 per month in principle and interest, plus $420 per month in property taxes and homeowner’s insurance, their full mortgage payment would be $2818 per month to own the home. On the surface, that’s much higher than their $2000 rent payment.
But, adding the $2000 rent and the $1390 in additional income taxes paid, the couple is paying $3390 to rent in real costs. The couple saves $572 per month by owning the home – and they’re building equity for the future.
Will the Mortgage Interest Deduction Last Forever?
Now you see why the mortgage interest deduction is such an attractive feature of homeownership. Around 34 million taxpayers currently take advantage of the mortgage interest deduction. And there’s little doubt that this factor plays into people’s decision to buy a home.
Will the mortgage interest deduction survive? With the “fiscal cliff,” a sluggish economy and increasing deficits, the government is looking for money. Some in government and even various pundits outside the state and federal government realm are suggesting the mortgage interest deduction should be eliminated.
Some say the mortgage interest deduction doesn’t spur home ownership and it’s an unfair tax benefit carved out for those fortunate enough to own their own home. There are various estimates but eliminating the mortgage interest deduction would transfer just under $70 billion from taxpayers to the Treasury.
Others argue that in fact the mortgage interest deduction does enhance home ownership and it should be left alone. Most who own homes or plan to buy a home in the near future agree.
Whatever the outcome of that debate, today it’s still crystal clear: the mortgage interest deduction has a tremendous impact on the real costs of housing. This generous tax rule allows homeowners to keep more of what they earn.