The Overrated Mortgage Interest Deduction

As I write this, another tax filing season just finished up.  I recently spoke with someone who does some work on the side helping people prepare their tax filings.  Most of her clients are not simply filing a 1040EZ form or even a simple 1040 form.  They tend to be investors, or small business owners, or have rental real estate, or some combination.  In other words, her clients aren’t generally people making a low income.

I asked her specifically about the mortgage interest deduction.  She said that a sizable majority of her clients do not qualify for the deduction.

While we hear about the great benefits of being able to deduct the mortgage interest on your primary residence, it is highly overrated for most people.  The fact is that the standard deduction for 2016 was $6,300 for singles and $12,600 for married couples filing jointly.  For a married couple, you will need a lot of mortgage interest and other deductions to qualify.

She said that a few people have mistakenly believed that you can deduct your mortgage payments.  But when you make a mortgage payment, a portion is going to interest and a portion is going to pay down the principal.  In many cases, people also have taxes and insurance included as part of their mortgage payment.  They may also pay private mortgage insurance (PMI).  You can only deduct the interest portion.

For somebody who just bought a house, the interest portion will make up a large portion of the mortgage at the beginning of the loan.  As time goes on with each payment, the amount going to interest decreases each month, while the amount going towards principal increases.  She said that many of her clients had owned their house for several years and therefore did not pay nearly as much in interest as when they first bought.

This is a generalization, but people who own a house with a significant mortgage tend to be married.  To qualify for the mortgage interest deduction as a married couple, the interest alone, combined with other deductions, will have to exceed $12,600 to get any benefit.

The people who will mainly benefit from this deduction are those who live in areas with high housing prices and those who donate a lot of money.

If you have a married couple earning $100,000 per year and they donate $10,000 per year to their church, then they might easily get a tax benefit from their mortgage interest.

If you live in San Francisco or New York City (or any high-priced city in the U.S.), then you may benefit from the mortgage interest deduction if you have a large mortgage.  Of course, I would much rather live in a normal place and pay $200,000 for a house and not get the deduction than to live in a place where you pay $800,000 for the same-sized house and get the deduction.

Here is one other important thing to consider.  Let’s say that a married couple does have enough mortgage interest and charitable contributions in order to itemize.  They have $13,000 combined, which exceeds the $12,600 standard deduction.  If this couple is in the 25% tax bracket, then they will save a whopping $100.  The difference between itemizing and taking the standard deduction is $400 ($13,000 – $12,600).  But that is not a tax credit.  It is just a deduction.  At 25% of $400, congratulations on that great mortgage deduction that saved you $100 for the year.  I hope your $2,000 per month mortgage payment was worth it.

Of course, some people benefit far more than this.  But the reality is that it just does not benefit that many people.  And for those who do benefit, the actual dollar amount is usually far lower than they would estimate.

According to the Tax Foundation website, 30.1 percent of households chose to itemize their deductions in 2013.  But this doesn’t tell us how much they benefitted by itemizing.  Again, think about the $100 benefit from the example above.

You should never pay more for a house with the rationale that you can deduct the mortgage interest.  That is a terrible reason (justification) to buy an expensive house.  You should buy a house as a consumer good.  If you are buying a house for investment purposes to rent it out, then this situation doesn’t apply to you anyway, as rental real estate is handled separately and does not impact whether or not your itemize your deductions.

Buy a house because you think it is a good decision.  But I would suggest not factoring the mortgage interest deduction in this decision.

One thought on “The Overrated Mortgage Interest Deduction”

  1. I live in the state that benefits the greatest from the deduction. High state income tax plus high property taxes mean I’m almost at the standard deduction amount before I even get to mortgage interest. It may be overrated for many, but not all.

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