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Pay Off Mortgage, Lose Tax Deduction?

I was working with a client a while back who brought up a question that a lot of people ask me and it’s one of the most common questions I get asked. This particular client was interested in paying off his home early and wanted to go over some of the ways that he could do that. Toward the end of the conversation he asked, “But if I pay off my home, won’t I lose my tax deduction?”

The home ownership tax deduction is the biggest and one of the few remaining tax deductions for the middle class American, so it’s not something that’s easy to let go of, but there’s an incredibly simple answer to that question.

If I told you that if you give me a dollar, I’ll give you 33 cents back, would you go for that? If so, give me a call, I’m sure we can work something out ;-). All kidding aside, that’s what the home-ownership tax deduction amounts to.

Let’s say you have $85,000 a year in taxable income; if you’re single that puts you in the 28% tax bracket (see chart).

Marginal Tax Rate

[Taxable Income] Single

Married Filing Jointly

10%

$0-$7,825

$0-$15,650

15%

$7,826-$31,850

$15,651-$63,700

25%

$31,851-$77,100

$63,701-$128,500

28%

$77,101-$160,850

$128,501-$195,850

33%

$160,851-$349,700

$195,851-$349,700

35%

> $349,700

> $349,700

Let’s also say the interest payments on your home are $2,500 a month, $30,000 a year. Since your mortgage interest is tax deductible, you can write off all $30,000, which will give you an $8,400 tax refund.

Now, what if you pay off your home? You don’t get the $8,400 tax deduction, but you also don’t pay the $30,000 in interest in the first place. So, why pay $30,000 to get an $8,400 refund in April?

There Are Benefits to Not Paying Off Your HomePay County Taxes Sign

Don’t get me wrong, I’m not always in favor of paying off your home, in most cases it needs to be a personal choice you make after you’ve looked at all the options. The tax break can be used to your advantage with arbitrage, which basically means you’re borrowing money to invest and earning more on the investment than you’re paying on the loan. For example, if you pay $30,000 a year in interest, that’s equivalent to 6% on a $500,000 loan. If you receive an $8,400 tax refund, your effective interest rate on that loan is only 4.3%, not 6%; so if you can find an investment that pays more than 4.3%, you’ll be better off not paying off your home.

Tags: Taxes & Deductions

8 responses so far ↓

  • 1 Double Glazing // Oct 3, 2007 at 12:17 am

    Don’t get me wrong, I’m not always in favor of paying off your home, in most cases it needs to be a personal choice you make after you’ve looked at all the options.

    I completely agree; selling a home can be a tough decision and a stressful experience; definitely a toll and a personal decision.

    Great post, bookmarked this one for later!

  • 2 Dennis K. // Oct 3, 2007 at 12:35 am

    Hmm…did that guy above even read the post? You don’t even talk about selling the home…I think he’s just trying to bump his website rankings.

  • 3 Wanda Grindstaff // Oct 9, 2007 at 7:46 am

    Thank you Thank you Thank you!!!!!
    Such an excellent point and very well made. It is simple math! The American homeowner has been duped into believing they should never pay off a mortgage and you have clearly expressed why that is a myth. Not to mention of course the equity in the home and the advantages of it in the future and upon retirement.

  • 4 StingRay // Jan 18, 2009 at 6:33 pm

    I agree, paying off your home in this market is a wise choice. My problem is I will need to sell company stock to payoff my house with a sizeable capital gains tax disadvantage. I’m trying to determine what my best course of action is. Our stock gets evaluated 4-times a year and I’m sure it will not be favorable this quarter. My estimated Cost Basis is approx $16 more than the current stock value. I would be looking at capital gains tax on $123,000. AT 15% that $18,500 in Taxes…Ouch!

  • 5 John // Jan 19, 2009 at 6:53 am

    @StingRay: Ouch indeed!

  • 6 Brandon // Feb 19, 2009 at 11:14 am

    you should mention the taxes your have to pay on your “investment”. also, wouldn’t the tax deduction put you in a lower tax bracket?

    Also, just because you are in a higher tax bracket does not mean you will be taxed that actual amount. It is a progressive scale. For Example, the first several thousand of your income is only taxed at 10% or so.

    your marginal tax rate isn’t really your tax rate, people just misunderstand what it means.

  • 7 Michael // Mar 12, 2009 at 9:41 pm

    @Brandon

    Good point on the tax brackets being a progressive scale. It’s pretty simple, but I’m surprised by how many people don’t understand it.

    For those who are not aware, using the table above, a single person making less than $7,825 will pay 10% in taxes. If that person makes more than that they will still only pay 10% on the first $7,825 and then 15% on the portion that exceeds that, up to $31,850.

  • 8 Rick // Sep 13, 2010 at 10:30 am

    Hi,
    If I borrow money from my father and pay say $35000 on the principle in order to reduce my monthly payment would I get taxed a 15% on the $35000 that I paid into my mortgage account or tax does not apply in this case?
    Thanks
    Rick