Many people love having a mortgage because they get a tax deduction as a result of the interest they pay. In fact, some people are under the impression that not having a mortgage is actually bad.
The truth is that while you do get a deduction for the interest you pay on your mortgage, you could have a lot more money by not having it. Here is how it works.
The Mortgage Deduction
If you have a $1,400 mortgage payment, $1,000 may go to interest. At the end of the year you will have paid $12,000 to the bank for the privilege of doing business with them.
When you file your taxes, $12,000 will be deducted, meaning that if you were going to be taxed on an income of $40,000-70,000 (15% income tax bracket) you would now be taxed on an income of $28,000-58,000, sparing you from a tax bill of $1,800.
In order to not pay $1,800 to Uncle Sam you paid $12,000 to a bank. While a mortgage is good because it allows you to buy a home much sooner, the better long-term plan is to pay it off, and have all of your own money for the purposes you see fit.
What if I Want the Deduction?
If you pay off your home loan you can still get the deduction people get for having a mortgage, but instead of paying money to a bank, you can give it to a charity or invest it in a retirement account.
Charity: If the same person above making $40,000-70,000 gave $12,000 to her favorite cause, be it a local synagogue, Find a Cure, or an alma mater, she would receive a $1,800 tax reduction on the money. This is not only a great way to get a tax break, but it’s also a fine way to support a cause close to your heart.
Retirement Savings: Money invested into a traditional IRA or 401(k) is tax-deferred, meaning that no taxes are due until funds are withdrawn many years later. However, it’s nearly impossible to save well for retirement when a mortgage is looming over your head. If (when) the mortgage is paid off, the $12,000 that was going toward bank interest can be used to an even greater advantage.
Math on Retirement Savings: We’ve already touched on the tax break, but there’s more going on here. If you paid off your home mortgage with 10 years to go until retirement, and used that time to simply start saving for your golden years in an account averaging gains of 7%, the $120,000 put in, according to this calculator would come out to $177,000.
Now, many people (especially the type who’d be interested in reading an article like this) already have something saved for retirement. According to the US News & World Report, the average 45-49 year old has $69,000 put away. Using the same calculator, 10 years of $1,000 monthly contributions added to that principle just about doubles the money ($69k + $120k added) from $189,000 to $313,000. For those who achieve 10% annual returns, the fund grows to $390,000!
It’s okay if you prefer to get the mortgage interest deduction, but it’s best to know that owing a bank for the rest of your life is not the only way to reduce your taxes or increase your tax return. Additionally, given the choice between paying bills and building your net worth, it seems that the solution is a simple one once you understand the disparity between the two choices.