Buy a House for the Mortgage Tax Deduction? Not so Fast
At some point every single one of us has heard the advice, “Buy a home, so you can get the tax deduction.”
The reality is that this piece of advice being a financially smart move is not a universal truth. It’s anything but that.
Before I get into number crunching, I want to clarify the basics of what the mortgage tax deduction is and when you could claim it.
What is a Mortgage Tax Deduction?
When you get a mortgage, you are often paying insane amounts of interest in that mortgage, particularly in the beginning. Banks front load the mortgage with higher interest amounts in the beginning of the mortgage which taper off over the years. They do this so they can get more money out of each mortgage in the event the debtor were to pay off the loan early.
On the mortgages I’ve held, almost two-thirds of the total payment in the first 5 or more years of the loan were interest payments. The other third actually went to paying down the principal (what you actually owe) on the house. It’s highway robbery (but that’s a different story for a different day). Ask your bank for an amortization schedule if you want to see what you’d be paying in interest vs. principal.
There is also the difference between a tax credit and a tax deduction. A credit is getting the full dollar amount of taxes owed returned to you. A deduction is subtraction from your taxable income (what you actually end up being taxed on based on your tax bracket). Mortgage interest is tax deductible, not a tax credit.
To sum it up, a mortgage tax deduction is the amount of interest you pay on your mortgage, which you then can deduct from your taxable income total.
The Standard Deduction
It’s important to note that you can only claim the mortgage tax deduction if you itemize your taxes (in reality, only about 35% of taxpayers do). If you’re like the other 65% of the population that claims the standard deduction, you cannot additionally claim the mortgage tax deduction. In some cases, you’ll actually be able to pay less in taxes if you opt for the standard deduction.
The 2012 standard deductions are as follows:
- $5,950 for single filers & married filing separately (up from $5,800)
- $11,900 for married filers (up from $11,600)
- $8,700 for head of household (up from $8,500)
- $950 for dependents (same as 2011)
The standard tax deduction changes annually usually and is based on inflation. So while it will generally go up over the years, your itemized tax deduction will decline as your interest payments on your mortgage do too.
Running the Numbers on the Mortgage Tax Deduction Benefit
Let’s take a hypothetical situation to crunch some numbers. We’ll assume:
- You take out a $200K mortgage @ 4.5% interest over 30 years.
- In your first full year, you’d be paying about $8,873 in interest and $3,287 in principal.
- You have property taxes of $3,000 per year.
- You’re married.
Your two biggest itemized deductions would likely be your mortgage interest and your property taxes. This would equate to a total deduction of $11,873. If you had no other deductions, you’d only gain a total of $273 in tax deductions. If you were in the 15% tax bracket, this would equate to a whopping annual tax savings equal to $41 (15% x $273).
In the process, you’ve paid $11,873 (mortgage interest + property taxes) that you’ll never get back to get that $41 in tax deductions.
Still think your buddy’s advice is so great?
This is just one scenario – your benefit may vary dramatically. It does highlight the importance of running the numbers for your own situation before buying a home. You may find that unless you buy a very pricey home, the tax benefit for you is going to be minimal, potentially even negative compared to the standard deduction.
There has even been discussion of the mortgage tax deduction being eliminated. Imagine buying a home under the guise of huge tax savings only to the deduction be wiped out by legislators in desperate need of generating new revenue.
What Should you Consider When Buying a Home?
There are some other things that I would recommend considering above any tax deduction benefit possibilities. They include:
- How long do you plan on staying in the home? If less than 5 years, it probably doesn’t make sense. Don’t forget that there are closing costs and realtor fees involved in buying and selling a home. And houses are not easy to sell in this market, so it may just sit there as a burden.
- Are you ready to make that kind of expense commitment? It will create a lack of freedom to invest that money elsewhere.
- What does the mortage-rent ratio look like in the area you are living or moving to? Some places offering a compelling reason to buy. Others are very risky.
- Do you need a home to live the lifestyle you feel like you need to live?
I’m a happy homeowner myself, but buying a home is not a decision that should be based off of generalized advice that might actually be wrong.
Mortgage Deduction Discussion:
- Have you heard the advice of buying a home for the mortgage tax deduction?
- Have you bought a home based on this advice?
- What factors would you recommend when considering whether to buy a home?
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I am G.E. Miller, & 
Banks charge the same amount of interest every year. It’s more money at the beginning because you have more of the banks money. It’s just like a savings account. If you put $1,000 in a savings account, you get interest based on what you have in the account each month. Not just new money.
Therefore as your mortgage balance goes down, so does the interest you have to pay to hold on to the bank’s money.
A good rule of thumb is that you will get back 33% of the mortgage you pay. I may be off by 5% or so depending on your income but that makes it easy to figure out if buying a house is a good idea. Ignore the principal you pay since you’ll get that back when you sell. The PMI + Interest is what you’re out. Just like renting, you have a landlord. It’s just the bank instead of some random person.
Take the PMI+Interest and multiply by .66. That is the amount you are paying each month. If that’s about the same as renting, you’d be crazy not to rent since you get the same benefit with none of the liabilities.
Oh, the new rule is no longer 5 years. It’s now 7 years you should consider staying in a house before selling. This is because the risk of your house value dropping and expected time on the market has increased.
I agree with most of what you said, but you are leaving out maintenance and property taxes. There is also the reality that historically speaking (I’m not just including recent history here, i.e. the recent housing crash) investing in the market is a far better return than investing in a home. Unless the home ownership market in your area is exceptionally low in cost, or you are extremely knowledgeable in real estate investment, renting is often the better financial choice.
One thing to think about is your tax situation before buying. I was already itemizing my taxes before because of charitable giving. I know that this is a wealth building forum, but I believe that part of that is giving some away. Choose your cause: disaster relief/Red Cross, kids in Africa, Goodwill, a church. (A class in my senior year as an engineer advised-and drilled-a few points about money: giving is an important part of getting, you’ve never made as much in your life as you do when you become a full time Chem. Eng., and living at your means is a road to failure.) As a single person, I was giving money and donating (household goods and clothing) above the $5,500 standard deduction, so the mortgage interest deduction was just frosting on the cake.
The comment about how the interest is charged doesn’t make sense to me mathmatically. Your house payment is the amount of interest built during the month plus a portion (small at first) of principal. As you pay off a little more principal, the interest gets lower so you can pay off more principal. If you were to go to an equal principle/interest payment month to month, there would be a huge amount of interest that would have to be paid off if you did a lump sum payment within the first half of pay-off; otherwise, wants the point of charging an agreed upon interest rate if you’re not really paying it. If you want to pay off principal with the current “pay the interest now” standard, pre-pay the mortgage. But that’s just my two cents.
I agree that using the argument that you should buy a house because of the tax deduction doesn’t make mathematical sense… but sometimes buying a house doesn’t make mathematical sense. Like you mentioned some markets are better than others for home ownership, and there are disadvantages to owning a home.
I even read an article on MSN.com a few years ago (before the housing crash) that showed that in most cases renting is a better financial decision because if you invest in the stock market you will get a better average rate of return (based on the historical average of 9%) on your money in comparison to owning a home, plus you will not have to pay for maintenance, taxes, and other additional costs for home ownership.
I am not against owning a home many people do this to build wealth…if done properly this is a great option. I’m glad that you are attacking fallacies that get people into trouble!
I saw “mortgage” pop up in the title in this in my Google Reader and immediately clicked past it, but then I remembered I am in escrow and this stuff actually matters to me now! A tax break was not at the top of my list of reasons to buy, but everyone I spoke to along the way mentioned it to me. I considered more heavily the monthly cost (savings to me v. renting) and the likelihood of renting it out and/or making a profit when I eventually sell.
Interesting reading as always.
One should never make financial life choices based on taxes- they should decide what they want, and then figure out the most tax-effective ways for that to happen.
At the very least, one should keep in mind that the tax deduction, like any other, is assuredly not written in stone. It’s all too easy to envision a Monkeys Paw scenario of someone settling for a new home he’s perhaps not too happy with just to get the break because he loves it so- only to close on the loan a month before it blinks into nonexistence following this or that political game of Chicken.