PROBLEM #2: Should I keep paying my mortgage simply to take advantage of a tax break?
I’ve heard that I should not pay my mortgage early because I need it to take the mortgage interest tax deduction. I now have a PROBLEM. Do I heed this advice, or should I pay off my mortgage as soon as I can?
As an engineer, I find it helpful to simplify problems or statements to understand clearly the trade-offs between the two choices.
Let’s explore this mortgage interest deduction for a few moments. What is it? And how does it work? Simply put, You receive a tax deduction based on the amount of interest you pay on your mortgage in a given year. To understand this, we need some numbers to discuss (engineers like numbers).
Let’s say you were in your second year of a $150,000.00 mortgage loan. Let’s also assume an interest rate of 3.875% and a 30 year term (which is the most common). If your mortgage is different – value, interest rate, or term – the numbers will be slightly different, but the conclusions will be the same.
“A deduction, by definition, is deducted from your taxable income. A tax credit is subtracted from your actual tax bill.”
Using the above numbers, you would pay approximately $5,765.00 in interest to the bank in this second year. This is also the same amount of money you would enter on your tax forms as a deduction. Take note – this is not a tax credit, but a deduction. This is an important distinction. A deduction, by definition, is deducted from your taxable income. A tax credit is subtracted from your actual tax bill. Calculate the taxes you save on your bill by taking this deduction by multiplying the amount of the deduction (in this case – interest) by the tax rate. Your tax rate will vary by income. For example: $5,765.00 x 25% = $1,441.25. This is the amount you save on your tax bill.
So in other words – you pay $5,765.00 to the bank to not pay the government $1,441.00. Think about that for a minute: You have to pay one or the other. I suppose you could pay both; but why would you want to? Personally, I would rather pay the smaller amount of $1,441.00 in taxes than the larger amount of interest.
No matter what the numbers of your loan are, the result will always be the same. The tax bill savings is less than amount of interest paid. By all means – deduct your interest, but the bottom-line is: don’t worry about keeping a mortgage around simply to take the tax deduction. Pay off your mortgage off as soon as possible – once your other debts are gone of course.
Don’t worry about keeping a mortgage around simply to take the tax deduction.
So based on the information above, I’ve decided to pay my mortgage off as early as I possibly can, and I think you should too. Let me know if you’ve been able to payoff your mortgage early, or if you are working towards that goal.
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