Last week on the Debt Free Living podcast I had the pleasure of interviewing Crystal from Budgetinginthefunstuff.com on the show. If you missed it, I recommend you check it out as there were a lot of nice tips. The one thing that stuck out to me was when she told people they were going to pay off their house early and people told them that was crazy because they would lose the tax deduction of having a mortgage. I have written before about the mortgage interest myth but today I would like to write more in detail about Crystal’s specific situation and why the tax advantages of having a mortgage did not apply.
Currently on your taxes, you are allowed to deduct from your taxable income the greater of the standard deduction or your itemized deductions. Your itemized deductions are primarily made up of interest paid on your mortgage, property taxes, local income tax paid, state income tax paid, certain medical expenses, and charitable contributions. In 2012 the standard deduction is $11,900 for married couples filing jointly, which means to itemize your deductions you would have to have over $11,900 in itemized deduction costs.
In our example let us assume a couple pays $3,000 a year in state and local taxes, paid property taxes of $2,500, have $1,000 in charitable contributions, and have a $125,000 mortgage at 4.25% percent. That means they would pay approximately $5,300 in mortgage interest for the year. Add that to their other itemized deductions and they would come up with $11,800 in itemized deductions for the year, which is short of the standard deduction amount of $11,900. In other words, there really is no tax advantage in owning a home for this couple because they do not even have enough itemized deductions!
But let’s say, for another example, that our couple made $3,000 in charitable contributions for the year and not $1,000 in our original example. They would then use their itemized deductions on their taxes because their total would be $13,800, which is greater than the standard deduction. However, in reality the tax advantage of having a mortgage is really only worth a deduction of $1,900 off your taxable income ($13,800 itemized deduction less $11,900 standard deduction). At a 25% tax rate the tax savings in itemizing are $475, which is nice, but not a reason to keep paying $5,300 a year in interest to the bank!
Now I am all for you saving on taxes and paying the minimum amount that you legally owe. But with that being said, you need to look at how much the tax advantages are in having a mortgage. In our first example, there was none and in the second example it was negligible. I feel like these examples are more common than we think and by keeping your mortgage you might not be saving as much in taxes as you think. Now, not everyone can pay off their mortgage just like that, but by getting out of other debt first, building an emergency fund, and then paying a little bit extra each month on your mortgage, your mortgage balance will be chipped away and one day you will look up and your mortgage will be paid off! So make it a goal to eventually pay off your mortgage and do not use the tax savings as a reason to delay paying it off because as we showed up above, you might not even have any tax savings currently!
What about you? Do you currently have a mortgage but are unable to itemize the interest on your taxes because it is not more than the standard deduction?