I wanted to write on this topic because it seems as though MANY people are quite confused on how it works. In the past I’ve been in many debates on whether it was a good financial decision to pay off the mortgage or keep the interest tax deduction. As a matter of fact, just this past weekend I was involved in a conversation covering this very topic. So let’s take a minute to evaluate how this REALLY works…..
First of all, what does it mean to have a tax deduction? It basically means your adjusted gross income is reduced by some cost reducing what you owe in federal taxes. When you have a mortgage you are able to fully deduct the interest portion that you send to the bank (with some exclusions- check out the IRS website for exclusions. http://www.irs.gov/publications/p936/ar02.html). In short, the interest portion from your mortgage that you send to the bank reduces your gross income which, in turn, reduces your income tax liability. Not bad, huh?
Ok, now let’s dig deeper. Let’s say you earn $60,000 per year which would put you in the 25% income tax bracket. That means every year you pay the federal government $15,000.
$60,000 x 25% (or .25) = $15,000
With that income you bought a nice home for the family with a mortgage of $200,000 with an interest rate at 3% (interest rates are GREAT right now!). This means the first year you will pay in the bank $6,000.
$200,000 x 3% (or .03) = $6,000
As I stated above, the interest rate is fully deductible from your gross income. So in our example you would deduct the $6,000 from the $60,000 gross income.
$60,000 – $6,000 = $54,000
So NOW your gross income is $54,000 and not $60,000. The government will then tax the 25% off of the new amount ($54,000) which means you pay $13,500 towards income tax.
$54,000 x 25% (or .25) = $13,500
So instead of paying $15,000 in income tax, you’re now paying $13,500 which is a $1,500 decrease. BUT WAIT!!! Didn’t you still pay the bank $6,000 in interest??? So to save $1,500 in taxes you pay $6,000 in interest to the bank. Does this make sense to you???
If this makes sense, send me $6,000 and once your check clears I’ll send you $1,500. Deal?
Check out other creative ideas on http://www.nerdwallet.com/blog/2012/carnival-personal-finance-invest/. Have FUN!!!!