The Mortgage Deduction Myth
The first bit of sophisticated financial advice I received came from a neighborhood friend’s father in the early 1990s. My parents had provided me with the basics, such as saving for big purchases and an introduction into budgeting, prior to my teenage years, although I had no concept of the differences between a lease and mortgage. At least until one weekend afternoon when my friend and I overheard her father explaining to her mother then need to maintain a mortgage on their current home. Apparently they had the funds to pay down the debt, but he had no desire in doing so due to the tax deduction involved. In his opinion, getting the tax break in April offset the value in paying the mortgage off and losing the deduction.
The mother nodded her head in agreement, prompting the daughter and me to take his words as gospel. After all, here was a successful businessman in his mid-40s with a full-time job, a nice house and two cars in the driveway. Our level of ignorance that afternoon can be explained away as 13-year-olds soaking in every bit of detail possible from their surroundings without any gauge of right and wrong. Unfortunately, a similar explanation applies for adults who lack the knowledge needed in any given circumstance to reach well-thought-out, reasoned conclusions. When we are unsure of something, we become more likely to accept any number of explanations, ranging from rational to ridiculous.
History books are chock full of conclusions humans accepted for centuries that seem asinine in retrospect. Humans believed in geocentrism – the belief that the sun, planets and stars revolve around the Earth – until the 17th century. Even now nearly a quarter of Americans are apparently confused about that fact.
The concept of spontaneous generation – meats producing maggots, rats growing from dirty rags, etc. – was accepted as true until 1859 (the Greek philosopher Aristotle advanced the idea of spontaneous generation some 2,200 years earlier). Accepting truths without verifying them has been an evolutionary trait dating back thousands, if not hundreds of thousands, of years. Science and math, however, have provided road maps to debunking these false conclusions over the last 400 years, but they are only a tool and have yet to cure our ingrained thought processes that seek immediate resolution instead of taking the time to figure out the answers. Doing so is not only time-consuming, but it’s also daunting and at times terrifying. Because of that, we are far too willing to let our guard down and trust individuals that either don’t have our best interests at heart or are simply ignorant.
Two topics I will address in later blogs are car financing and whole life insurance policies. It’s difficult to imagine someone with a keen knowledge of the financial math involved willingly taking out a car loan or purchasing a whole life insurance policy. In very rare circumstances does it ever make sense to utilize one of those financial vehicles. And because of the potential profits involved, those industries are overrun with unscrupulous salesmen trying to fatten their wallets at the expense of your bank account. That’s not to say that all car salesmen or insurance salesmen are crooks. They are not, yet when you take the time to educate yourself on the finances instead of being hooked by a low interest rate, a snazzy commercial, or a smile and a cup of coffee, you find those deals hurt your finances more than help.
In most situations, I fear, the problem resides with men (or women) of ignorance and their willingness to share that ignorance with family and friends. That’s clearly the case of my friend’s father, whose advice remained cemented in my head for nearly two decades. First things first about the mortgage interest tax deduction: you only qualify if you itemize your deductions, and the 2015 standard deduction is $6,300 for singles, $12,600 for married filing jointly and $9,250 for head of household. That’s a hefty deduction total to eclipse before even considering itemizing, which only then would bring the mortgage deduction into play. Secondly, the mortgage deduction is not a tax credit. There is no dollar-for-dollar reduction in taxes owed. Instead, the mortgage interest you pay in a given year is multiplied by your tax rate.
For example, let’s say you own a home with a $200,000 mortgage at 5 percent. Your income puts you in the 25 percent tax bracket. Your mortgage interest for the year in question is $10,000. When factoring in your 25 percent tax bracket, your deduction becomes $2,500. In effect, you paid the bank $10,000 and the government cut you a 25 percent discount. If you had already paid off the mortgage, you would no longer receive the $2,500 deduction from the government, but you also would not be giving the bank $10,000 in interest each year, either.
In the early 1990s, the average mortgage rate in the U.S. ranged between 7-9 percent, more than double and nearly triple our recent rates, so the savings differential was even more dramatic when my friend’s father was sharing his financial intellect. The amount of money he cost his family by making a silly argument when a calculator could have proven his belief wrong in a matter of seconds is troubling.
With mortgage rates so low in the current economic climate – a 30-year fixed rate is hovering around 4 percent – it’s possible to make the case that the mortgage deduction reduces tax implications enough to match inflation rates and therefore neutralize the potential risk involved. I’m more inclined to advocate for a debt-free lifestyle, but at least that argument is based in logic and understanding of the economy. That, more than anything, is all I ask when making financial decisions. Just avoid making arguments from ignorance.