Calculating The Mortgage Interest Tax Deduction

By Lisa Smith AAA

The mortgage interest tax deduction is one of the most cherished American tax breaks. Realtors, homeowners, would-be homeowners and even tax accountants tout its value. In truth, the myth is often better than the reality.

TUTORIAL: Personal Income Tax Guide

Many Homeowners Get Nothing
According to data compiled by the 2005 President's advisory panel on federal tax reform, only 54% of taxpayers who pay interest on their mortgages receive a tax benefit. That leaves a hefty 46% of homeowners paying interest, but receiving no benefit at all. Even those who do receive a benefit are likely to receive far less than they expect.

The mortgage interest tax deduction is perhaps the most misunderstood aspect of homeownership. It has taken on near-mythical status to the point where many would-be homeowners are sold on the benefits before they even examine the underlying math to determine their eligibility. Underlying the myth are two primary misconceptions. The first is the mistaken idea that every homeowner gets a tax break. The second is that every dollar paid in mortgage interest results in a dollar-for-dollar reduction in income tax liability. (If you're a homeowner, this is one item you want to understand and use on your return. See Tax Deductions On Mortgage Interest.)

Misconception 1
Despite the pre-sale hype, there are a significant number of homeowners who receive no tax break at all from the mortgage interest tax deduction. Keep in mind that, in order to even qualify for the deduction, homeowners must itemize their deductions when determining their income tax liability. Itemizing provides an opportunity to account for specific expenses, including mortgage interest, property taxes and medical expenses. Since mortgage interest is often the largest expense a taxpayer faces, deducting it is often cited as a financial incentive to buy a home.

Once again, while an attractive idea in theory, the reality is that itemizing deductions doesn't make sense for everybody. First, the standard deduction amount is based on your tax filing status. Using 2011 data as an example, taxpayers who are single or married but filing separately, the standard deduction is $5,800. For heads of households, it is $8,500, and for married couples who file joint returns, the standard deduction is $11,600.

Taxpayers that do not have deductions that add up to more than the standard deduction amounts do not get to itemize their deductions. Taxpayers who do not have enough deductions to qualify for itemization get no benefit from paying interest on their mortgages. Don't forget - nearly half of all homeowners with mortgages fall into this category.

Misconception 2
Even for homeowners who itemize their taxes and qualify for the mortgage interest tax deduction, the amount of the deduction is a mere fraction of the amount of interest paid on the mortgage. Once again, a little number crunching is required to fully comprehend the situation because the deduction is not a tax credit - you don't get a $1 tax break for every dollar spent; you get pennies on the dollar. Unlike a credit, which provides a dollar-for-dollar reduction on actual tax amounts owed, the mortgage interest deduction reduces the amount of income subject to tax owed based on the taxpayer's tax bracket. (From community-based services to free software, there are many free resources to help with your taxes, read 6 Sources For Free Tax Help.)

For example, a taxpayer spending $12,000 on mortgage interest and paying taxes at an individual income tax rate of 35% would be permitted to exclude $12,000 from income tax liability, resulting in a savings of $4,200. So, the homeowner paid $12,000 to the bank in interest in order get a third of that amount excluded from taxation.

Mathematically, spending $12,000 to reduce the amount of money you will pay taxes on by $4,200 simply makes no sense. Worse yet, an honest assessment of the actual bottom-line savings should factor out the value of the standard deduction. The table below provides a comparison.

Tax Payer Status Standard Deduction Value of Standard Deduction in 35% Tax Bracket Value of

Mortgage Deduction on $12,000 in Interest

Bottom Line Difference

Between Standard Deduction and Mortgage Deduction

Single $5,800 $2,030 $4,200 $2,170
Head of Household $8,500 $2,975 $4,200 $1,225
Married $11,600 $4,060 $4,200 $140

Using our $12,000 mortgage interest example, a married couple in the 35% tax bracket would get an $11,600 standard deduction, which is worth $4,060 in reduced tax payments. If the couple itemized their deductions on Schedule A, the mortgage deduction would come to $4,200. Even without a mortgage interest deduction the taxpayer would get the standard deduction amount. The difference between the two - the value added by paying $12,000 real dollars to the bank in mortgage interest - is $140. (Not taking the standard deduction this year could save you hundreds of dollars. Check out An Overview Of Itemized Deductions for more.)

Taxpayers in lower tax brackets get an even smaller benefit. A taxpayer spending $12,000 on mortgage interest and paying taxes at an individual income tax rate of 25% would receive only a $3,000 tax deduction. The "benefit" of the mortgage interest deduction is shown on the table below.

Tax Payer Status Standard Deduction Value of Standard Deduction in 25% Tax Bracket Value of

Mortgage Deduction on $12,000 in Interest

Bottom Line Difference

Between Standard Deduction and Mortgage Deduction

Single $5,800 $1,450 $3,000 $1,550
Head of Household $8,500 $2,125 $3,000 $875
Married $11,600 $2,900 $3,000 $100

Putting the numbers in greater context, The Tax Policy Center reports that, "The average value of the MID (mortgage interest deduction) rises steadily with income from $91, for those with annual incomes less than $40,000, to $5,459, for those making more than $250,000." The data shows that a tax deduction arguably put in place to encourage home purchases does not encourage the individuals on the margin between renting and owning. Instead, it is used most by taxpayers that itemize, which tend to be higher-income households. (Read about the political parties' differences in tax ideology, and how it can affect your paycheck. See Parties For Taxes: Republicans Vs. Democrats.)

A Better Way
Rather than spending large amounts of money on interest for little in return, you will be far better off paying cash for your new house. A cash purchase will save you tens of thousands of dollars because you will not be paying interest. (This may be the biggest debt you'll ever incur. Learn why you should retire it sooner rather than later, in Paying Off Your Mortgage.)

Of course, there's always the argument that you could make more money by paying the interest and investing the rest of your money in the stock market. It seems like a great strategy when the market is going up, but prognosticators giving that advice are nowhere to be seen when the stock market drops 40%, home values fall 40%, and their investment advice leaves homeowners owing more on their mortgages than the home is worth.

Since there is no investment out there that will guarantee better returns than the amount you would save by avoiding interest payments altogether, the conservative choice is clear. Avoid making interest payments if you can. Pay the house off quickly if you cannot.

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