Calculating the Mortgage Interest Tax Deduction

The mortgage interest tax deduction is one of the most cherished American tax breaks. Realtors, homeowners, would-be homeowners and even tax accountants tout its value. In truth, the myth is often better than the reality.

The Tax Cuts and Jobs Act (TCJA), passed in December 2017, changed everything. Prior to its passage, 54% of taxpayers who paid interest on their mortgages received a tax benefit. Even then, a hefty 46% of homeowners paying interest received no benefit at all. With the passage of the TCJA, a 2017 White House commissioned study predicted that nine out of 10 people would opt for the standard deduction, forgoing use of the mortgage interest tax deduction entirely. That means 90% of homeowners paying interest would receive no benefit at all. Furthermore, even those who do receive a benefit would get far less than they expect.

The mortgage interest tax deduction is perhaps the most misunderstood aspect of home ownership. It has taken on near-mythical status, to the point where many would-be homeowners are sold on the benefits before they even examine the math to determine their eligibility. Underlying the myth are two primary misconceptions: The first is the mistaken idea that every homeowner gets a tax break. The second is that every dollar paid in mortgage interest results in a dollar-for-dollar reduction in income tax liability.

Misconception 1: You Will Get a Tax Break

Despite the hype, the overwhelming majority of homeowners receive no tax break at all from the mortgage interest tax deduction. Keep in mind that in order to even qualify for the deduction, homeowners must itemize their deductions when determining their income tax liability. Itemizing provides an opportunity to account for specific expenses, including mortgage interest, property taxes and medical expenses. As mortgage interest is often the largest expense a taxpayer faces, deducting it is often cited as a financial incentive to buy a home.

Once again, while an attractive idea in theory, the reality is that passage of the TCJA means that itemizing deductions no longer makes sense for most people. Using 2018 data as an example, for taxpayers who are single or married but filing separately, the standard deduction is $12,000. For heads of households it is $18,000, and for married couples who file joint returns the standard deduction is $24,000.

Taxpayers who do not have deductions that add up to more than the standard deduction amounts do not get to itemize. Taxpayers who do not have enough deductions to qualify for itemization get no benefit from paying interest on their mortgages. Don’t forget that the government estimates that 90% of homeowners with mortgages fall into this category.

Misconception 2: It Will Be a Hefty Deduction

Even for homeowners who itemize their taxes and qualify for the mortgage interest tax deduction, the amount of the deduction is a mere fraction of the amount of interest paid on the mortgage. Once again, a little number crunching is required to fully comprehend the situation, because the deduction is not a tax credit. You don't get a $1 tax break for every dollar spent; you get pennies on the dollar. Unlike a credit, which provides a dollar-for-dollar reduction on actual tax amounts owed, the mortgage interest deduction reduces the amount of income subject to tax owed based on the taxpayer’s tax bracket.

For example, a taxpayer spending $12,000 on mortgage interest and paying taxes at an individual income tax rate of 24% would be permitted to exclude $12,000 from income tax liability, resulting in a savings of $2,800. In effect, the homeowner paid $12,000 to the bank in interest in order get less than a fourth of that amount excluded from taxation.

Spending $12,000 to reduce the amount of money you will pay taxes on by $2,800 simply makes no sense. Worse yet, an honest assessment of the actual bottom-line savings should factor out the value of the standard deduction. The table below provides a comparison.

Using our $12,000 mortgage interest example, a married couple in the 24% tax bracket would get a $24,000 standard deduction, which is worth $5,760 in reduced tax payments. If the couple itemized their deductions on Schedule A, the mortgage deduction would come to $2,880. The couple would get the standard deduction amount even if they do not have a mortgage. The difference between the two – the tax break gained by paying $12,000 real dollars to the bank in mortgage interest – would be a loss of $2,880. Taking the standard deduction would be the far wiser course of action.

Even taxpayers in higher tax brackets would get no benefit. A taxpayer spending $12,000 on mortgage interest and paying taxes at an individual income tax rate of 35% would receive only a $4,200 tax deduction. That’s the same amount the taxpayer would receive from taking the standard deduction. The “benefit” of the mortgage interest deduction is shown on the table below.

Putting the numbers in greater context, the Tax Policy Center report characterizes the mortgage interest tax deduction as “irrelevant for all but a small fraction of homeowners” and notes that “the implied tax subsidy rate for those who can claim the mortgage interest deduction…would be zero for the 90+ percent of those households that would not itemize.”

Simply put, the data shows that a tax deduction arguably put in place to encourage home purchases is used most by taxpayers who itemize, who tend to be in higher-income households.

Rather than spending large amounts of money on interest for little in return, you will be far better off paying cash for your new house. A cash purchase will save you tens of thousands of dollars because you will not be paying interest.

Of course, there’s always the argument that you could make more money by paying the interest and investing the rest of your money in the stock market. It seems like a great strategy when the market is going up, but prognosticators giving that advice are nowhere to be seen when the stock market drops by 40%, home values fall by 40% and their investment advice leaves homeowners owing more on their mortgages than the home is worth.

As there is no investment out there that will guarantee better returns than the amount you would save by avoiding interest payments altogether, the conservative choice is clear. Avoid making interest payments if you can. Pay off the house quickly if you cannot.