Uncle Sam wants you – to be a homeowner. The proof is in the tax consequences of mortgage interest. For decades, the IRS has allowed mortgage and other associated costs to be deducted from your income. This is a massive financial advantage over renting. Every homeowner needs to understand this tax law, and take full advantage of it.
The most important part of this tax windfall is the interest tax deduction, which allows most mortgage holders to deduct all the interest they pay each year. The deduction applies to people with just one mortgage on a primary residence, as well as those with a combination of loans. When buying a home, you can take out a loan for up to $1 million and deduct the interest. For most homeowners, you claim this deduction on Schedule A Itemized Deductions.
How much is this deduction? Well, consider these numbers off a fairly typical mortgage:
30-year, fixed rate mortgage:
$300,000 loan amount
$1,945.79 Monthly Payment
$258.29 Principal Paid 1st payment
$1,687.50 Interest Paid 1st payment
$1,945.79 total monthly payment
So on your first payment of this mortgage, almost 87% of your payment goes towards interest to the bank only about 13% actually goes to paying down the balance. Every penny of the interest paid gets deducted from your income. Of course, the ratios of your payment slowly change each month, with a slightly greater percentage of your payment going towards principal.
Even so, in the first year on this loan example, you would have paid $23,489.98 in interest. If you are in the 28% tax bracket that means you potentially saved $6,577.19 just by paying a mortgage instead of renting. Of course, this doesn’t even take into consideration other deductions you may have for paying taxes and insurance for your home.
In fact, the tax deduction can be a reason that makes doing a refinance on your mortgage a bad idea. If you are simply refinancing to lower your interest rate, you may not be saving as much as you thought. Consider that the mortgage deduction reduces the effective, or after-tax, rate of a 7 percent loan to around 5 percent for somebody in the 28 percent tax bracket. If you are paying less of an interest rate you get a smaller tax deduction. You may need a larger difference in interest to make the refinance worthwhile.
Making extra mortgage payments can also be less of a good thing then you first think. Someone who makes extra mortgage payments ahead of time would be saving only the 5 percent interest by prepaying. You can often do much better than that by paying off your credit cards or making some intelligent investments.
Most importantly, the mortgage tax deduction is a powerful incentive to stop renting and start owning. Many renters are worried about a greater expense when paying a mortgage. When you look at the tax advantages, though, in the right situation a homeowner can buy a home and pay less. You simply have your employer increase your payroll deductions to reflect your homeownership. You can bring more money home more than enough to pay the mortgage.
So knowing the tax consequences of mortgage payments is important to owners and renters. Find out how you might take full advantage of Uncle Sam’s generosity. Paying interest to the bank does have good aspects!