First let me say if you have an existing mortgage with eligible interest payments and you qualify to itemize your deductions, then by all means you should go ahead and take advantage of that deduction.
What I take exception to are those financial advisors who suggest that you should not pay off your mortgage early because if you do you will lose the tax deduction. This is pretty common “wisdom”. You will hear many people give this advice.
Why this is a deduction you ought to really want to lose
The problem is when you logically look at the math, keeping your mortgage so as not to lose the tax deduction is actually kind of ridiculous.
Let’s take an example. We’ll use round numbers to make the math fairly easy.
Let’s say James has a mortgage on his house for $200,000. The interest rate on the mortgage is 5%. That means that this year he will pay approximately $10,000 in interest.
Now let’s also say this year James made $75,000. That puts him squarely in the 25% tax bracket. However, since he paid $10,000 in interest he can deduct that on his taxes so that means he’ll be paying 25% on $65,000 instead of $75,ooo. 25% of that $10,000 difference is $2,500. So by having the mortgage deduction available his total tax bill will be $2,500 less than it would have been otherwise.
If James had paid off his mortgage early then he wouldn’t have that deduction available and would have to pay taxes on the full $75,000. That means he’d be stuck paying the IRS that extra $2,500. Who wants their tax bll to be $2,500 more than it needs to be so therefore it’s a bad financial move to pay that mortgage off early. Right? That’s what the financial experts will tell you.
But wait a minute. As Lee Corso is fond of saying on ESPN’s College Gameday. “Not so fast my friend.”
In order to save $2,500 you had to pay a total interest bill of $10,000. So you are telling me that it is smart to send the bank an extra $10,000 in order to keep from sending the IRS $2,500?
Really? How again is this a good financial move?
A better alternative.
So if you really want to get that $10,000 deduction, here is a better idea. Go ahead and pay off your mortgage. Now give your church or your favorite charitable organization a $10,000 donation. Charitable giving and mortgage interest both come off the same Schedule on your taxes. So the end result is exactly the same from a tax standpoint and you have the peace and freedom that comes from knowing your home is paid for.
Now let me state one more time. If you still have a mortgage and aren’t close yet to being able to pay it off, then take advantage of the deduction. You should never cheat on your taxes and you should pay what taxes you have due. But by the same token you should never pay more taxes than you are required to by law. This is good stewardship of your money. As long as the government allows you take the mortgage interest deduction and you have mortgage interest you have paid then take advantage of the tax savings that provides.
What I am saying though is “keeping your tax deduction” is never a good reason to hold on to your mortgage. It is simply bad math. I chose round numbers for the sake of the example but the ratios are the same no matter what your numbers are. You will always have to pay the bank more in interest than the tax savings you get. And if you really want the tax deduction there are much better ways to get it – like charitable giving. Your tax deduction is always a bad excuse for not trying to pay off your mortgage.