Are the tax advantages of carrying a mortgage really worth it?
In a recent post titled: “Reducing Mortgage Debt: Paying down mortgages faster . . .” I discussed one way to pay down your mortgage faster. However, many you may be asking, “Isn’t it a good thing to have a mortgage? Doesn’t carrying a large mortgage allow me to reduce my overall tax liability by deducting my interest payments?” According to Harj Gill, founder of the Speed Equity System and author of the book, How to Own Your Home Years Sooner! Without Making Extra Interest Payments, carrying a large mortgage is actually “one of the greatest and most tragic fallacies affecting millions of Americans.”
The hypothetical example below is outlined in Harj Gill’s book and uses data from the Tax Rate Schedule in the IRS 2002-1040 booklet. Ms. Jones no longer has a mortgage (she made every effort to pay it off as early as possible) and Mr. Smith still does. The outline below displays the taxable and disposable income each person has before and after taxes.
|
|
Ms. Jones |
Mr. Smith |
|
Gross Income |
$65,000 |
$65,000 |
|
Mortgage |
No |
Yes |
|
Interest on Mortgage |
None |
$11,567 |
|
Taxable Income |
$65,000 |
$53,433 |
|
Total Tax Paid |
$13,896 |
$10,773 |
|
Difference in taxes paid |
+$3,123 |
|
|
Total Disposable Income |
$51,104 |
$42,660 |
|
Monetary Advantage |
+8,4444 |
|
From the above example, you can see that Ms. Jones paid $3,123 more in taxes than Mr. Smith, but still had $8,444 ($51,104 - $42,660) more in her pocket than her counterpart who has a mortgage and who received a “tax benefit” of $11,567. Basically, to save an extra $3,123 in taxes, he had to pay $11,567 in interest.
The real difference is that for every dollar Mr. Smith paid to the bank in interest, he received 27 cents back in tax savings. Alternatively, Ms. Jones who doesn’t have a mortgage and didn’t have any interest to claim as a deduction, still had the $11,567 as part of her taxable income.
Ms. Jones then paid 27 cents on the dollar to the government on this amount instead and kept the remainder. The end result is that she had $8,444 more to spend than Mr. Smith. So the bottom line is would you rather pay 27 cents for every dollar you have, or get back 27 cents for every dollar you spend? Check out Harj’s web site at www.mortgagefreeusa.com for more information about his products.
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The analysis is way too simplistic to be meaningful. What is Ms. Jones’ rent payment as compared to the principal portion of Mr Smith’s mortgage payment? Those two differences should be factored in, as should Mr. Smith’s increased burden of property taxes and homeowners’ insurance. Then you can meaningfully compare disposable income after all costs relating to providing shelter for yourself are covered.
His analysis also overlooks the fact that after 10 years, despite some of the initial cash outlay, Mr. Smith will likely have a significantly higher net worth than Ms. Jones, who will probably not have the discipline to save all that extra disposable income. This observation would of course be true even if the genders were reversed.
Comparing rates of return on home equity vs. unspent disposable income is a topic for another comment….
Thanks for the comment. The example however, which should have been clearer (my fault), was based on both parties being home owners rather than one being a renter. As a result, both should have the ongoing advantages of property tax deduction and increased net worth based on the value of the home. The only difference is that one home owner will save much more money in the long run by paying off the mortgage earlier than the other one keeping their mortgage for as long as possible. Thanks to your post, I have tried to make the example above a little clearer.
I think the key is what does “she made every effort to pay it off as early as possible” entail? Given that they both have the same gross income, their spending is the other variable. If she racked up a ton of credit card debt while paying off her mortgage, or he took the cash he didn’t spend on his mortgage and invested in Google stock, he might end up in the better position. But I think the point is to remind people that you shouldn’t incur costs (in this case mortgage interest) for the sole purpose of getting a tax break. Rather, it should be factored into an overall financial plan.
Please keep these excellent posts coming