by TSR » Mon Apr 07, 2014 12:58 pm
Friends,
This post was inspired by numerous recent threads about paying off one's mortgage, as well as my anxiety that we may be collectively over-selling the benefits of the mortgage-interest deduction.
It appears that the short-hand on this board for how to view the benefit of the mortgage-interest deduction is to subtract one percentage point from your interest rate (assuming that rate is somewhere near 4% and that your marginal tax rate is somewhere near 25%). That is, if your interest rate is 4.0% then the mortgage-interest deduction will make it more like 3.0%. From that, one can presumably then calculate, for example, whether it is better off to pay off a mortgage or to invest elsewhere, setting aside all the other psychological/emotional merits of that argument.
But other threads I've seen remind us that the above assumption is wrong for many (most?) people because it may fail to take the standard deduction into account. For example, if one's total annual mortgage interest were barely above the standard deduction, and one did not have many other deductions, one could easily derive essentially NO benefit from from the mortgage-interest deduction, despite the fact that the deduction (just barely) pushed you into itemizing teritory.
Questions:
1. Is there an equation one can use to reach the actual value of the mortgage-interest deduction, expressed as a (reduced) percentage of one's mortgage rate? I am assuming that this would involve many, many variables, and would essentially require redoing one's entire tax return, but maybe it's less complicated?
2. Is there a better approximation that we could use on these boards than the "subtract 1%" strategy without getting too deep into each poster's personal situation? Or even some general criteria? (E.g., "people making between $50K and $200K annually typically only derive x% reduction in their mortgage rate from the deduction," or "people with a mortgage of more than $x typically derive x% reduction in their mortgage rate"?)
(Please forgive me if the assumptions behind these questions are wrong -- I was an English major back in the day and really have no math skills to speak of. I appreciate your thoughts.)
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Re: Calculate effect of mortgage-interest deduction
by DSInvestor » Mon Apr 07, 2014 1:11 pm
If your deductions excluding the mortgage interest are sufficient to itemize deductions, then you receive a tax benefit for every dollar of mortgage interest paid. In this case, the after tax mortgage rate is Rate X ( 1 - your marginal tax rate). You'd need to add up your property tax, state/local income taxes paid or sales tax paid/table , charitable donations, medical expenses etc.
If your deductions without the mortgage interest is not sufficient to itemize, then the amount of your total deductions above your standard deduction receives the tax benefit.
You don't have to redo the tax return to see the effect of the mortgage interest. Enter everything but the mortgage interest in your tax return and see what the total Fed and State tax is, then add the mortgage interest. Note the changes in tax liability.
If you've already completed your tax return, you know your fed and state tax liability with mortgage interest. Save the file to another name, and then go into the return and zero out the mortgage interest. How did the tax liability change? If you removed 10K of mortgage interest from your tax return and saw your tax liability go up $2500, you received a 25% tax break. If your mortgage rate was 6%, your after tax equivalent rate would be 4.5%. If you removed 10K of mortgage interest and saw your fed tax liability go up $100, you didn't get much tax benefit.
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Re: Calculate effect of mortgage-interest deduction
by kenyan » Mon Apr 07, 2014 1:25 pm
If the taxpayer would itemize deductions with or without mortgage interest, then he/she is getting the benefit that everyone assumes. This is a relatively small fraction of people. The fraction of people who would itemize without either mortgage interest or property taxes (the relevant number when discussing rent-versus-buy) is smaller yet.
Many people who receive some tax benefit, aside from those in high-tax states with high income, will be itemizing only because they purchased a house, and thus receive less of a tax benefit than the full marginal rate. I fall into this category. As noted, there is no quick-and-dirty formula, but it needs to be tailored to the individual.
I don't know the exact statistics, but I recall that in the neighborhood of 50% of people with mortgages in the country receive no tax benefit from them. I would be willing to bet that a significant fraction of those people are unaware of this (I've spoken to some).
Retirement investing is a marathon.
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Re: Calculate effect of mortgage-interest deduction
by Kosmo » Mon Apr 07, 2014 1:29 pm
In reverse order:
TSR wrote:2. Is there a better approximation that we could use on these boards than the "subtract 1%" strategy without getting too deep into each poster's personal situation? Or even some general criteria? (E.g., "people making between $50K and $200K annually typically only derive x% reduction in their mortgage rate from the deduction," or "people with a mortgage of more than $x typically derive x% reduction in their mortgage rate"?)
Effective interest rate = interest rate x (1-marginal tax rate). You deduct the interest paid from the top of your earnings, so you use the tax bracket you're in. A 4% mortgage in the 25% tax bracket is 4% x (1-.25) = 3%. That's the exact answer. Size of the mortgage, term, income, make no difference. But this assumes you itemize deductions, which brings us to...
TSR wrote:1. Is there an equation one can use to reach the actual value of the mortgage-interest deduction, expressed as a (reduced) percentage of one's mortgage rate? I am assuming that this would involve many, many variables, and would essentially require redoing one's entire tax return, but maybe it's less complicated?
You need to determine if itemizing deductions is appropriate. Essentially, fill out a schedule A for your tax return and see how that total stacks up to the standard deduction. If it's higher, use it. If not, use the standard deduction. The end result of the "value" of interest deduction if the different in tax owed between the standard and itemized deductions.
A little twist (if you can call it that) is the actual benefit of the itemized deductions compared to the standard deduction. Or in other words, how far above the standard deduction are the itemized deductions. You could think of it as interest is deductible to the extent greater than the standard deduction. If the standard deduction is $12,500 and your itemized deductions are $15,000, then you have an extra $2500 of deductions. So effectively $2500 of your mortgage interest is deductible (because you're going to get the $12,500 deduction no matter what). The math on this gets a little more complicated to determine the effective interest rate.
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Re: Calculate effect of mortgage-interest deduction
by Twins Fan » Mon Apr 07, 2014 1:51 pm
If you believe there is a benefit to paying interest to someone to get a tax break rather than keeping your money and paying taxes on it, you're over-selling it. 
As mentioned, it is very situational. For high income/high mortgage types paying yearly interest that is twice the standard deduction, sure there's some benefit... and quite a nice one for them as they probably have a low interest rate and the effective rate really lowers for them. For many of us though, myself included, the mortgage interest benefit is little to none. My yearly interest paid is below the standard deduction. I do itemize though, but even with that I'm only slightly over the standard deduction. I get the "benefit" on a couple thousand a year. Better than nothing, but not much to write home about either. 
Someone said the 50% number earlier get no benefit group. I read an article recently about the mortgage interest deduction, and I think the number was even higher than that for the folks getting no real benefit from it. Of course numbers can be arranged to fit the author's needs. But, I do think the mortgage interest deduction gets far too much weighting in many discussions about it... My take on it anyway.
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Re: Calculate effect of mortgage-interest deduction
by TSR » Mon Apr 07, 2014 2:12 pm
Kosmo wrote:In reverse order:
TSR wrote:2. Is there a better approximation that we could use on these boards than the "subtract 1%" strategy without getting too deep into each poster's personal situation? Or even some general criteria? (E.g., "people making between $50K and $200K annually typically only derive x% reduction in their mortgage rate from the deduction," or "people with a mortgage of more than $x typically derive x% reduction in their mortgage rate"?)
Effective interest rate = interest rate x (1-marginal tax rate). You deduct the interest paid from the top of your earnings, so you use the tax bracket you're in. A 4% mortgage in the 25% tax bracket is 4% x (1-.25) = 3%. That's the exact answer. Size of the mortgage, term, income, make no difference. But this assumes you itemize deductions, which brings us to...
TSR wrote:1. Is there an equation one can use to reach the actual value of the mortgage-interest deduction, expressed as a (reduced) percentage of one's mortgage rate? I am assuming that this would involve many, many variables, and would essentially require redoing one's entire tax return, but maybe it's less complicated?
You need to determine if itemizing deductions is appropriate. Essentially, fill out a schedule A for your tax return and see how that total stacks up to the standard deduction. If it's higher, use it. If not, use the standard deduction. The end result of the "value" of interest deduction if the different in tax owed between the standard and itemized deductions.
A little twist (if you can call it that) is the actual benefit of the itemized deductions compared to the standard deduction. Or in other words, how far above the standard deduction are the itemized deductions. You could think of it as interest is deductible to the extent greater than the standard deduction. If the standard deduction is $12,500 and your itemized deductions are $15,000, then you have an extra $2500 of deductions. So effectively $2500 of your mortgage interest is deductible (because you're going to get the $12,500 deduction no matter what). The math on this gets a little more complicated to determine the effective interest rate.
Thanks. I guess my question was more aimed at your "little twist" at the end -- there's not much benefit to having a mortgage if EVERYONE (homeowners and non-homeowners alike) gets the benefit of the first $12,500 in deductions. That would necessarily mean that saying "you have a 4% mortgage and it's 3% after the deduction" is very frequently wrong. The "real" effective interest rate of your mortgage after the deduction is what I'm looking for.
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Re: Calculate effect of mortgage-interest deduction
by TSR » Mon Apr 07, 2014 2:18 pm
Twins Fan wrote:If you believe there is a benefit to paying interest to someone to get a tax break rather than keeping your money and paying taxes on it, you're over-selling it. 
As mentioned, it is very situational. For high income/high mortgage types paying yearly interest that is twice the standard deduction, sure there's some benefit... and quite a nice one for them as they probably have a low interest rate and the effective rate really lowers for them. For many of us though, myself included, the mortgage interest benefit is little to none. My yearly interest paid is below the standard deduction. I do itemize though, but even with that I'm only slightly over the standard deduction. I get the "benefit" on a couple thousand a year. Better than nothing, but not much to write home about either. 
Someone said the 50% number earlier get no benefit group. I read an article recently about the mortgage interest deduction, and I think the number was even higher than that for the folks getting no real benefit from it. Of course numbers can be arranged to fit the author's needs. But, I do think the mortgage interest deduction gets far too much weighting in many discussions about it... My take on it anyway.
Right. I agree with the suggestion in your post that this deduction is not a good reason to purchase a home. There is SOME benefit, but it's DEFINITELY overstating that benefit if you just subtract 1% and assume that's the effective rate of your mortgage. And yet a lot of folks here do that. This is especially tricky now because you really can envision a world where someone is wondering whether to pay off their mortgage or invest the money and earning over 3% in the market seems like almost a sure thing (of course it's not actually a sure thing), but they might think differently if faced with the idea that in fact their effective rate after the deduction is essentially identical to their mortgage rate of 4%.
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Re: Calculate effect of mortgage-interest deduction
by an_asker » Mon Apr 07, 2014 2:18 pm
kenyan wrote:If the taxpayer would itemize deductions with or without mortgage interest, then he/she is getting the benefit that everyone assumes. This is a relatively small fraction of people. The fraction of people who would itemize without either mortgage interest or property taxes (the relevant number when discussing rent-versus-buy) is smaller yet.
Many people who receive some tax benefit, aside from those in high-tax states with high income, will be itemizing only because they purchased a house, and thus receive less of a tax benefit than the full marginal rate. I fall into this category. As noted, there is no quick-and-dirty formula, but it needs to be tailored to the individual.
I don't know the exact statistics, but I recall that in the neighborhood of 50% of people with mortgages in the country receive no tax benefit from them. I would be willing to bet that a significant fraction of those people are unaware of this (I've spoken to some).
+1!
It is also ironic that this benefit helps those who are non-Bogleheadish and spend way more than they should for their house, as their mortgage interest is much more.
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Re: Calculate effect of mortgage-interest deduction
by jsl11 » Mon Apr 07, 2014 2:21 pm
There is an additional complication in trying to figure the tax benefit of a mortgage. If your itemized deductions are near the standard deduction, either a little more or less, then you can gain by bunching your deductions into alternate years. There is not too much you can do with the mortgage payments. You may be able to make 13 payments one year, and 11 the next. However, you may be able to shift all of your real estate taxes into alternate years. If you do this, you would also try to shift as many other deductible items as possible into those years. All of this makes your calculation more complicated.
Jeff
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