Bad Advice: Keep Your Home Mortgage to Get the Tax Deduction

Bad Advice: Keep Your Home Mortgage to Get the Tax Deduction

I’d like to start a new series of blog posts called Bad Advice.  Too often people give us financial tips and tricks that we just assume is good advice.  Now, I don’t think those giving us this advice are giving it maliciously, or have ill intent.  I just think they don’t really understand what they are saying.  They’re probably just propagating something someone else told them and they believed.

With that in mind, I’d like to start this series today with a piece of advice I tend to hear all of the time, especially around tax time, and it is just plain wrong:

Don’t pay off your home mortgage so you can get the tax deduction.

How many times have you heard this before, or some variation of it?  This is something I have personally heard for years and years.  And I just assumed it was correct . . . until I started to increase my own financial literacy.  

This is something you might actually believe.  It might be something you are actually doing.  Maybe someone you trust gave you this advice.  Maybe your parents had this philosophy.  

Well, today is the day to bust this myth.  We’ll look at some real numbers in a hypothetical example and really break this down.

Our Example

Let’s say we have a married couple filing jointly, since this is the scenario that applies to the largest number of my readers.  We’ll call them Jack and Jill.  Now let’s make some assumptions about their finances:

First, Jack and Jill have an adjusted gross income (AGI) of $125,000.  This means that we have already accounted for retirement account contributions, student loan interest paid, and other adjustments to their gross income to arrive at this number. 

Second, Jack and Jill have a 4% fixed rate 30 year mortgage of $250,000, a pretty average amount in the United States.  So in a one year period of time they would owe 0.04 x 250,000 = $10,000 in mortgage interest that is paid to their lender.  (I know that with each monthly payment it would chip away at the principal amount of the loan a little bit, thereby decreasing the amount they owe in interest each month, but let’s keep this really simple.)

Third, Jack and Jill have an effective tax rate of 4% for their state income tax, which is about average.  Thus, this year they owe $5,000 in state income tax, assuming their state also uses their AGI on their federal income tax return.

Fourth, Jack and Jill paid $2,500 in property tax on their home last year, which is about the United States average for the value of home they own.

Fifth, last year Jack and Jill made $15,000 in charitable contributions through tithes to their church and to other good causes.

Now that we have established the assumptions for our example case, let’s discuss the two main reasons it is bad advice to keep your home mortgage to get the tax deduction.  

#1 Most people don’t itemize their taxes

Whenever someone drops this line, “don’t pay off your home mortgage or you’ll lose the tax deduction” it seems to somehow be accepted as a universal truth that applies to everyone.  No matter what your situation, this is a golden rule of taxes you don’t want to break.  Of course this is completely wrong.

The reality is much different.  The vast majority of Americans do not itemize their taxes, and thus they likely never have and likely never will claim this tax deduction, so this advice DOESN’T EVEN APPLY TO THEM.

In order to understand this point, you have to understand the process for claiming mortgage interest as a tax deduction, which really comes down to taking the standard deduction vs. itemizing your deductions.  I’m going to use a few tax terms here.  If they are unfamiliar to you, then I recommend you check out my post on The Top Ten Terms You Should Know About Taxes before moving on.

When determining your taxable income, you start with your gross income as the beginning dollar amount. Then, you make certain adjustments to your gross income called allowances (aka above the line deductions) to arrive at your adjusted gross income (AGI). Next, you reduce your AGI further by either taking the standard deduction or itemizing your deductions (aka below the line deductions).  This is basically the amount of money you subtract from your AGI to make the final determination of how much you owe in federal income tax, so you always take the greater of the two to owe the least amount in taxes.  

The standard deduction is a fixed amount based on your filing status for a given year.  For a married couple filing jointly just before the Tax Cuts and Jobs Act of 2017 it was $13,000.  After this law was passed there was a near doubling of the standard deduction.  In 2019 it is $24,400 for a married couple filing jointly.  

If you choose to itemize your taxes, you add up the amount of the individual deductions and subtract this from your AGI.  Three of the most common itemized deductions are the amount you pay in mortgage interest, charitable contributions, and state and local taxes (the SALT deduction).  After the Tax Cuts and Jobs Act of 2017 the SALT deduction is limited to $10,000.

What does this all mean and how does it relate to keeping my home mortgage for the tax deduction?  In a sentence, if you take the standard deduction, then there is absolutely NO TAX BENEFIT to paying any mortgage interest.  

Before the Tax Cuts and Jobs Act of 2017, it is estimated that only 30% of people itemized their deductions on their tax return.  So this widely held belief of keeping your home mortgage for the tax deduction DID NOT apply to 70% of people before the tax laws changed.  In 2019 it is estimated that only 10% of people will itemize their taxes, meaning that 90% of people will get no tax benefit at all for any mortgage interest they paid.  

So let me be clear on this point.  The statement that “you should keep your home mortgage to get the tax deduction” does not apply to 90% of taxpayers because they take the standard deduction and do not itemize their taxes.

Back To Our Example

Now, let’s go back to our example and look at some real numbers.  Jack and Jill have an AGI of $125,000 in 2019.  They are going to have to decide if it is better for them to take the standard deduction of $24,400 or to itemize their deductions.  We will assume they only have the itemized deductions listed above.  

If we add up their mortgage interest payments ($10,000), state income tax ($5,000), property taxes ($2,500), and charitable contributions ($15,000), the total amount is $32,500.  So, in their situation it actually does make more sense to itemize their deductions than to take the standard deduction of $24,400.   They fall into that ~10% of Americans who should itemize their taxes.

This means their taxable income will be $125,000 (AGI) – $32,500 (itemized deductions) = $92,500.  This puts them in the 22% marginal tax bracket (see the chart below), which will be important moving forward as we debunk the rest of the myth.  

#2 Don’t spend a dollar to save a quarter

At this point we’ve established that Jack and Jill fall within the 10% minority of Americans that will get a tax benefit by itemizing their taxes and claiming the amount that they paid in mortgage interest as a deduction.  Isn’t that a good thing?  Yes, it is a good thing that this can reduce their tax bill this year, and they should take the deduction.  But it most certainly DOES NOT mean they should avoid paying off their home mortgage more aggressively to keep this tax deduction.  

Let’s explore what this tax deduction means.  Remember, a tax deduction is not a tax credit.  They don’t get to reduce their tax bill by $10,000 because they paid that much in mortgage interest.  A deduction means they get to reduce their taxable income by that $10,000.  

Remember that their taxable income based on the calculation above is $92,500.  For a married coupled filing jointly in 2019, this puts them in the 22% marginal tax bracket.  Without deducting this $10,000 tax deduction, their taxable income would be $102,500.  How does this translate to real dollars?  This $10,000 tax deduction saves them the amount of money that they would owe in this tax bracket, which would be 0.22 x $10,000 = $2,200.

Let’s think about what this means.  In 2019, Jack and Jill paid $10,000 in interest to their mortgage lender.  Given their 22% marginal tax bracket, this saves them $2,200 on their tax bill.  THEY HAD TO SPEND $10,000 TO SAVE $2,200.  Does that seem like a good deal to you?  Does this seem like a winning financial strategy?  It doesn’t to me either.  In the words of Dave Ramsey, who has spoken extensively on this topic, “Don’t spend a dollar to save a quarter!”  I would rather pay an extra $2,200 in taxes than pay $10,000 in interest to the bank so I could save paying that $2,200 in taxes.

So, let’s be clear about this.  If you keep your home mortgage so you don’t lose the tax deduction, every year you are paying thousands of dollars in interest to the bank so you can save a fraction of that on your tax bill.  

If you didn’t have the home mortgage, would you pay more in taxes?  Yes, assuming you still itemized your deductions.  But you would be saving so much more money by not having to pay interest on your mortgage.  

Let’s look at this one more way for clarity and simplicity:  how much money leaves your pockets.  If you pay $10,000 in mortgage interest over the course of the year, $10,000 leaves your pocket and goes to your lender.  As we’ve established in the above scenario, this will reduce your tax bill by $2,200, so $2,200 stays in your pocket that would have otherwise gone to taxes.  That still means that you had to pay $7,800 out of pocket.  Conversely, if you didn’t have the home mortgage or had paid it off you wouldn’t have this tax deduction.  So you would have to pay that $2,200 more in taxes, meaning $2,200 total left your pockets.  But $0 would leave your pockets because you no longer are paying any mortgage interest. I’m not sure about you, but I’d rather only have $2,200 leave my pockets, compared to $7,800.  

What We’re Doing and What I Recommend

Going back to the original piece of advice we are trying to debunk:  keep your home mortgage to get the tax deduction.  Hopefully I have demonstrated why this is bad advice.  

First, it only applies to the 10% of people for which it makes sense to itemize their taxes.  So for this group (90% of Americans), you get NO TAX BENEFIT to having a home mortgage.  Thus, it should be part of your financial strategy to pay off your home mortgage sooner rather than later because this is just another form of debt resulting in you losing money with every interest payment you make to your lender.    

Second, for the 10% of Americans who do itemize their taxes, while it certainly does make sense to take this deduction while you have a mortgage and are paying interest on it, it IS NOT wise to avoid paying off your mortgage just to keep this tax deduction.  This is because you are spending significantly more in mortgage interest than you are saving on your tax bill.  

Do my wife and I deduct mortgage interest on our taxes?  Yes.  For us it makes much more financial sense to itemize our taxes rather than take the standard deduction.  And because we have a mortgage on our house and pay mortgage interest, we take that deduction.  But that DOES NOT mean we are avoiding paying off our mortgage early just so we can keep this tax deduction, for reason #2 discussed above.  

One of our next financial goals is to work aggressively to pay off our home mortgage early, and I’ll be writing about this soon.  I guess it comes down to your personal financial philosophy about debt.  I really hate debt.  I don’t like the feeling of owing anyone anything.  It restricts your freedom.  Freedom to live the kind of life that you want to live.  And for me, that is the whole purpose of working towards financial independence and writing this blog.  Freedom.

While many financial experts will talk about “good debt” and “bad debt,” I really look at it as just different degrees of bad.  Because the bottom line is that when you are in debt, you are paying interest to someone else and making them money.  That means you are losing money.  And that is money you could have put to work for yourself earning interest, bringing you closer to your own financial independence (opportunity cost).

Here is my advice.  If you don’t itemize your taxes, there is no tax benefit to having a home mortgage.  So make it a part of your financial plan to pay off your home mortgage early as part of your broader financial strategy.  If you do itemize your taxes, take the mortgage interest deduction while you still have a home mortgage.  But don’t let that be a reason to not work aggressively to pay off that home mortgage.

Conclusion

Today we have discussed why it is bad advice to keep your home mortgage just to get the tax deduction.  This false financial doctrine somehow seems to be an ingrained part our collective financial psyche.  So much so that when you try to explain why this is a bad financial strategy, people may argue with you or brush you off and go on in their financially ignorant ways.  To keep it simple, just remember these key take home points:

• ~90% of Americans don’t itemize their taxes, so they get no tax benefit for having a home mortgage.

• For those that do itemize their taxes, you are only saving a fraction of what you pay in mortgage interest on your taxes, resulting in a net loss.

• Thus, in either situation, you would save more money by paying off your home mortgage early, rather than dragging it on for years for some mythical tax benefit.

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

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