One of the biggest reasons people give for buying a home is the mortgage interest deduction. While the deduction is a bonus, I think using the tax benefits of the deduction alone is a bad reason to buy a home.
Why is it a bad idea? Basically because you should not buy a home for a tax deduction. To get a descent deduction, you will need a big loan. This equates to a big home and larger property tax and home maintenance expenditures. Plus the deduction diminishes over the life of the loan. We will cover more about deductions below but first what are some good and bad reasons given to buy a home?
Good reasons other people give to buy a home:
- A place to live (Ok a valid reason but you could rent.)
- Equity in a home/property (Automatic savings? )
- The likelihood it will increase in value (An appreciating asset. While this may be true, there is no guarantee. Expect to live in the home for at least 5 years to see any sort of return on investment,)
- The American Dream (Whose? Your’s? Mine? My grandfather’s?)
- AND TO GET A BIG FAT TAX DEDUCTION! (To be discussed more down below)
Bad reasons I give to buy a home:
- It’s a home. It is super illiquid.
- Stuff breaks. I mean lots of stuff. So basically Maintenance
- Lawn care
- It makes it hard to move, especially within the first 5 years if you want to reap any profits.
- You are in debt. You own a home with a mortgage on it.
- AND TO GET A BIG FAT TAX DEDUCTION (To be discussed more down below).
Okay, so that is my rant, but what about this BIG FAT TAX DEDUCTION. Honestly, the tax deduction can be pretty sweet if you are in a high tax bracket and buy a big home. Otherwise it is a wash, BUT DON’T BUY A HOME TO GET A TAX DEDUCTION.
Why not? Well if you own a home, then you have a mortgage. Most banks are happy to give buyers more then they should spend on a home (remember the Great Recession of 2008). This leads to many people taking more money than they really should to buy more home than they really need.
But there is a deduction
True. The government is kind enough to let us deduct interest paid on that home loan (i.e. mortgage) on our income tax returns. They also let us deduct money spent on buying points to lower your interest rates. Here is a good article on Points from Bank of America (no affiliation here, just a simple article). The home has to be either the primary or secondary residence/home.
So let’s talk about the deduction real quick:
- It must be a primary or secondary home.
- Deductions must be itemized. So the itemized deduction must be higher than the standard deduction ($12,700 for a married couple filing jointly in 2017).
- It is only good for the first $1 million dollars of debt. This is probably less of an issue for most FIRE types, but since there are doctors and other high earners, this applies to you.
- If deducting home equity debt, that is only good for the first $100,000 for a deduction.
Interestingly before 1986 all interest was deductible. That included credit cards, student loans, home loans, and your car. Pretty amazing. After 1986, the government eliminated this deduction but maintained a home mortgage deduction. Some (particularly realtors) argue it would encourage home ownership. I am not sure how that panned out, but home ownership still remains part of the American dream, though that may be changing.
So how does the deduction work? Well it is a deduction from your gross income and thus lowers your adjusted gross income. Here is a chart of what taxes are typically due in 2017 for various incomes from Forbes.com. It is a good way to assess your federal tax levels and how deductions might lower your tax bracket.
Mortgage interest deduction
Now how about mortgage interest deduction? That is what we are here for right?
Let’s use some examples. For the following examples I used the calculator found here.
Caveats: All of these examples assume that it is a 30 year mortgage with a fixed rate of 4%. We assume the individuals below are not taking other itemized deductions (in which case a mortgage interest deduction may make sense).
To calculate the tax savings for 30 years of standard deductions I used to formula of $12,700 x 30 years x tax bracket. Of course all of these things are likely to change in the future including standard deduction amounts and tax brackets, but I found this exercise to be interesting and hopefully it will be helpful to you.
Example 1: Dr. Sensible
Dr. Sensible has taken out a $300,000 mortgage on a 30 year fixed rate of 4%. Tax assessments are for a married couple filing jointly.
As you can see from the table. For every tax bracket, the standard deduction is higher than the mortgage interest deduction. If Dr. Sensible was going to file taxes and not deduct other things (charitable givings, business expenses, etc.) then the standard deduction will give more tax savings then deducting mortgage interest deduction.
In this case buying a home does not provide any real tax savings and should not be used as an excuse to by a home.
Next up. Example 2 Dr. Rich
Dr. Rich has taken out a $600,000 mortgage on a 30 year fixed rate of 4%. Tax assessments are for a married couple filing jointly.
In this case, due to the higher mortgage amount Dr. Rich will be paying more in interest. Therefore, for each tax bracket she will have a higher tax deduction. In her case the mortgage interest deduction is higher (almost double) from her standard deduction. If she decides to add charitable giving, etc. then she will come out with more tax savings.
Still, even in this case, at the highest tax bracket Dr. Rich is only saving $4,399 (Mortgage interest deduction savings – standard deduction savings). She has to determine that the $4,399 outweighs the other costs of the home including property taxes, insurance, maintenance, and realtor commissions is she ever wishes to sell the home.
Interestingly, over the life of the loan she still comes out ahead with more savings using a mortgage interest deduction then the standard deduction. Tough choice but a case for having the mortgage deduction.
Finding an flex point. Example 3. Dr. Flex
Dr. Flex really wants a home but is not convinced to buy one just for mortgage interest deductions. She wants to determine where the tax benefits start. So she runs her numbers through the calculator to determine at what price point mortgage interest deductions beat standard deductions. She determines it is at a mortgage of $320,000 for a 30 year loan at 4%.
This is her flex point. Buying a house for cheaper then this will not gain her substantial tax benefits. Buying a house for more than this will provide tax savings but at a higher total cost (home price, insurance, maintenance, etc.). She has a decision to make but at least knows where the flex point purchase price is when she buys a home.
It is important to point out that even at this flex point, over the course of the 30 year life of the loan, she will gain more tax benefits from standard deductions by almost $60,000. The tax deductions from the mortgage interest are biggest early on when the principal is larger. As the years progress, the interest paid becomes less and the deduction diminishes.
What to do with this information? Well I am not advocating for buying or not buying a home. Just know what you are getting into.
If you have a ton of itemized deductions (charitable giving, business expenses, etc.) then you will be able to maximize them with your home mortgage interest deduction. If you have no other itemized deductions, then buying a home for tax savings is kind of silly.
The reality is the tax savings are higher early on and lower near the end of your term because you are paying less in interest. So over the 30 years, the standard deduction may win out in some cases.
Finally, you need to spend more money or have less favorable rates to be paying large amounts in interest. In fact you have to pay over $12,700 in interest to get a benefit from the deduction. Do you really want to pay that much in interest?
For me, I have an expensive mortgage at a good rate (2.8%) and yet I still was shocked to see how much interest I paid in the first year. My tax savings will be approximately $11,000 on my federal tax filing (not to mention potential state taxes), but I am paying more than that in property taxes. Will I get a good tax deduction? Yes, but at the end it is a wash if you count property taxes I am paying.
Additionally, I calculated that at 20 years into the loan the standard deduction will surpass my itemized interest deduction.
Is it worth paying the bank that much money to avoid paying the government some? No. Honestly I would rather give the government my money over the banks. As inefficient as they may be, I have to assume they are working for us. The banks don’t have that mandate.
What are your thoughts? Have you ever calculated your flex point?
Also published on Medium.