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.
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 Home
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.