Author Bio: The following is a guest post by YFS from yourfinancessimplified.com. If you want relevant, witty and easy to follow financial guidance visit him at his website or subscribe to his newsletter by clicking here!
It may be interesting to realize that the government is putting out all sorts of schemes and incentives just to get the average American interested in acquiring property. Most of the time these perks come in the form of tax deductions. Sometimes however, we tend to get carried away with such treats that we don’t even realize the real danger of what we’re getting into.
Take for example, mortgage deduction. Many Americans get so thrilled by the fact that the government is allowing a deduction on their taxable income. This totals to the amount of interest paid on the loan on their home residence. Initially if you think about this, if you were paying $1,200/month in mortgage interest for a year, then some quick math will tell you that you’ll get about a $15,000 deduction. But is this really the case?
The Standard Deduction
For those who are still unaware, the government actually allows a standard deduction. For married couples, this is deduction is $11,400. The thing is, you will only get a tax deduction from the difference between your mortgage deduction and the standard deduction. So if you were entitled to a $15,000 deduction on mortgage, then in fact, you will only be getting a measly $3,600.
To put it in a more general sense, you would have to pay at least $950 per month in mortgage interest (remember, just interest and not including the principal), in order to actually realize any tax benefit from your mortgage payment. In reality this tax deduction would only be helpful if your mortgage was $200,000 or more. Any amount less than that would be almost pointless.
Analysis
Now if we really think about what’s happening here, you’re actually paying more in interest than what you’ll save on taxes. This is what some people don’t really seem to realize. Let’s say you’re entitled to a $15,000 tax deduction. This does not mean that you will be paying $15,000 less on taxes. Instead, this amount will be deducted from your taxable income.
For example, you’re in the 25% tax bracket. If you’re paying $20,000 in mortgage interest, you will get a savings of $5,000 in taxes. It seems as if that you are actually paying $15,000 just so you will be eligible to get a tax deduction of $5,000. This of course isn’t so smart now that we see the numbers.
Realizing the Risk
Unless you can really afford the home, trying to keep a mortgage payment that you can hardly afford is very risky. In the unfortunate event that you lose your primary source of income, what you would normally consider as your greatest asset can in fact turn on you to become a liability. This is especially true when the housing bubble collapsed in 2007. Many people were forced to foreclosure and out of their homes because they couldn’t keep up with the high mortgage payments.
One sign that people aren’t ready to buy a home is when they try to scrimp and save on every dollar while rationalizing why owning a home would be reasonable even if they know they can’t really afford it. A mortgage deduction is hardly a good reason to get yourself into a mortgage, and in fact, you’ll end up paying more than what you hoped to save in the first place.
Mortgage deductions can be a great thing, don’t get me wrong. But it is only good for those who really have the intention to buy a home in the first place, and for those who really have the money to afford home ownership plus all the hidden expenses associated with it.
What other bad reasons are there for purchasing a home?
retirebyforty> Mortgage interest deduction is a great thing for home owners, but it shouldn’t be THE incentive to buy a home. A home is a place to live in and build a family and that should be the main focus. Another bad reason to buy a home is for “investment,” but that will take a whole post to write about.
Passive income is the key to early retirement. This year, Joe is investing in commercial real estate with CrowdStreet. They have many projects across the USA so check them out!
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Boy oh boy. I can just see the look on the faces of all the real estate hacks in the great state of california during the long long decline in the price of real estate in the golden state.. Contrary to popular belief that a large decline in the price of real estate is a bad thing. Those who profited most from the meteoric rise in the price of real estate in california over the last twenty years are now the ones suffering the most. First time buyers with good credit can now qualify for a thirty year mortgage at a interest rate of just four percent. Or think about this the young couple with fairly good credit but not quite perfect credit making a reasonable down payment of ten percent’ they have been waiting for the so called chance of a lifetime to appear and wanting to seize the opportunity to buy that dream house at a rock bottom price. Having picked out their dream house made the deposit. Than nervously waiting for two whole weeks to see if they qualify for their thirty year fixed rate mortgage at 3.99 percent. Than only to hear back from their banker. Im sorry but you just don’t qualify for the thirty year fixed rate mortgage.
I’m always amazed by how many people (especially during the boom) mention the mortgage deduction as a justification for buying a home. If you want to be a homeowner and can benefit financially from owning, all the better. In fact, even if you don’t benefit financially but like the idea of owning, I can get on board. But people clearly don’t understand taxes well enough to make intelligent decisions based on tax planning. If you pay H&R Block to do your taxes, I don’t know why you’d expect to be an expert on the subject.
Suffice it to say, I’ve seen several friends conveniently forget about the standard deduction when determining the tax savings of home ownership. In one unfortunate case, due to the lower interest rate afforded by an ARM loan, the total deductions didn’t even add up to a single friend of mine’s standard deduction amount.
You’re right about standard deduction. The mortgage deduction only makes sense if you have other deductions as well.
Mortgage deduction should be the last thing on anyone’s mind when buying a house.
Another thing people should consider before buying a home are the extra costs (other than the mortgage payment). Heating and Cooling a home, HOA fees, homeowners insurance, and property taxes can really add up and make a house unaffordable.
Great minds think alike. I have a post up at my website now title “8 hidden home ownership cost” Get out my head!!!!
I am 48-years-old and do not own a home. As a public school teacher, I have no guarentee that my contract will be renewed each year. Therefore, not owning a home at least gives me the freedom to pick up and move on in the event I should lose my job. Any thoughts on this?
Having flexibility is one reason to not own a home. But, you need to apply that logic to your situation. How long have you worked in the same school district or lived in the same location?
I think you are doing the right thing in your situation. Usually owning a home is more expensive overall than renting anyway so you are not losing anything. If your job become more secure later, you can always buy a house then. Good luck!
Joe what do you mean by this: “Usually owning a home is more expensive overall than renting anyway”
Are you standing by this statement for all lengths of ownership?
When contemplating the standard deduction you ALREADY get without buying a home, this makes the case even less compelling to buy a home just for the deduction. You should buy a home because you think you’re going to be in the area for a while and don’t want to pay a landlord but instead build some equity (and possibly, capital appreciation but never bank on that over a 5-10 year period). One would have to be quite naive to focus on just the tax deduction since it’s not significant when all other factors are considered (closing costs alone would consume several years of the tax benefit).
Great observation but a sucker is born every minute. A lot of people use the mortgage interest deduction to anchor their argument on buying vs renting.
Very good information – Price reduction on a house doesn’t always mean you getting a great deal.
I take a price reduction over a mortgage reduction 🙂
The mortgage deduction is awful and should be eliminated. I don’t think people buy a home because of it, but I do think that people are given incentive to buy more home than they need.
It’s one of the last substantial deductions left that hasn’t been taken away or marginalized by the ‘tax the rich’ crowd. So, if you are a high earner you have a lot of incentive.
Great observation. The deduction really makes since for high earners/high tax bracket people. I also believe it makes people buy more house than they need. All for the sake of the deduction.
In a similar vein, I can’t tell you how many people I’ve heard say that they don’t want to pay down their mortgage because they’ll lose the tax deduction. The next question out of my mouth is usually “Oh do you itemize?” — and I get a blank look or a no. (So what tax deduction?)
Jackie yea this is really silly. Most people do not have enough deductions to even claim the mortgage interest deductions or even know what itemized deductions are! A lot of people like to simply repeat key words they hear over the years about finances.
Hey, you guys are lucky you get to deduct your mortgage interest in the states 🙂 We don’t have such a thing.
Though if you use a HELOC and invest that money you can offset some of your mortgage interest, or if you use your home for a business you can deduct it, but otherwise, no dice.
Great post!
It evens out. We also pay a premium for real estate because of the deductions. Real estate is a subsidies industry in the U.S which leads to bubbles and often times economic disaster.
Since you get to deduct HELOC interest does it make you want to take a HELOC on your home?
I think using HELOC to invest the money is a bad idea. What happens if that account goes down? You could lose the house right?
You can only lose your home if you fail to pay the HELOC. Also, the HELOC will most likely be in the 2nd position with the Mortgage being first.
For example.
Home Value = 500k
Mortgage = 400k
HELOC = 100k
If you do not pay the HELOC your credit will be impacted but you cannot lose your home unless the HELOC owner pays 400k to the Mortgage provider.
YFS-
I agree that it’s never wise to let the ‘tax tail wag the dog’. In other words, if your primary reason for investing in or purchasing something is for tax reasons, you might want to reconsider.
In most cases this is like paying a dollar to save 25 cents… it doesn’t make sense. So if I find myself using this type of reasoning, I’ve programmed my brain such that a red flag begins flashing immediately.
I believe that keeping risk as close to zero through education and understanding strong financial principles will help you produce enough wealth that you’ll find yourself in the place where you’re getting deductions for things you were ALREADY going to do (such as buying a house, investing in your business, etc.) and that you don’t need to tax advantages to make something worth while.
I agree. Nothing wrong with getting a deduction for something you were going to do anyway. Tax advantages come second to proper planning
So true, everyone always talks about that mortgage deduction, but you can save even more money and have more financial security in your life if you dont have a mortgage.
KC what makes you think you can save more money and have more financial security without a mortgage?
The mortgage interest deduction definitely isn’t as great as many people think it it. My mom was only able to take the deduction for a few years before her itemized deductions ended up being smaller than her standard deduction. That was with a 20 year loan and giving 10% to her church to beef up her deductions. Real estate is cheap where she lives.
What another great catch Andy.. Often times the mortgage deduction + property taxes are not more than the standard deduction. Especially if you’re married. Most people don’t realize this.
There is no better alternative to buying home with cash. I trained myself not to believe that no incentive is better option than avoiding paying interest.
What about the opportunity cost of using cash. If you can get a 400k mortgage at 3.25%, and you know you can make at least 8% else where doesn’t it make since to take a mortgage and invest the funds?
We were eligible for a first time home buyers tax deduction when we bought our house but that was not why we bought it. It was definitely a bonus. We had been saving for house and it was in our plans not only as an investment but as a place to have a family in.
that’s good for you Miss T! is the first time home buyers tax credit still available this year or not anymore? do you know?
smart momma
Nice.. this was definitely a bonus for you especially since you could already afford your home.
The mortgage deduction has never been a reason for buying a house for me. It doesn’t effect most peoples bottom line. It’s just a small way to shelter part of your income from taxes. If it ever went away it wouldn’t be problem for most people.
I think people would have a fit!
I agree with Joe. But I personally know people (no, not me!) who bought a house just to get a deduction. They are miserable right now.
Tell me about it. They get a deduction but they lost a ton of home value.
I agree. I completely share Joe’s sentiments as well. The math and the logic simply don’t add up.
I bet a real estate agent will disagree with you 🙂
Good post. Whenever anyone talks about a tax deduction as being a major reason for buying a home, I immediately wonder about the person’s finance acumen and why they feel the need to talk authoritatively. May sound a bit harsh, but it’s just one of those things. So needless to say, I agree with the post!
You and me both. I usually say.
“For every dollar you give me, I will give you 25 cents. Do you think that is a good deal?”
When they say “No”
I then say “Well that’s what your mortgage deduction is”
Tax break such as the mortgage deductible is only provided to aide the taxpayers but it should not be used solely as a reason to purchase a home. This article is very eye opening. Thanks!
smart momma
No problem 🙂
Thanks to IRS regulations, the government subsidizes mortgages! You still have to pay the lions share of the bill despite the subsidy. Don’t take on too much house or you will end up losing it.
I couldn’t agree more.
I hear the mortgage deduction tax benefit thrown around all the time as a great reason to be paying a mortgage instead of paying rent. Seems like there’s even less truth to it after reading this article. I’m also not a big believer in doing things solely or partially for a tax break because it’s probably going to cost you more anyway.
There are a lot of hidden home ownership costs or myths in owning a home. I believe it comes down to a personal preference in the end. There really isn’t a right or wrong answer.
That’s true. Owning a home is usually much more expensive than renting at least in the short term.
You did not include other deductions available once you start itemizing. Ie Medical, taxes, charities, work expenses, tax prep etc. Your analysis is too basic and not an honest look at tax advantage of home ownership.
This article was written from the perspective of a person who buys their home exclusively for a tax deduction. No matter how you cut it If you are in the 35% tax bracket and pay 1 dollar in interest you only get 35 cents back.
When is this ever a good deal?
It’s even worse if you’re in a low tax bracket like many people are.
Also, medical deductions only come into play once your medical expenses exceed 7.5% of your AGI.. Then you only get to deduct your amount over that amount. Work expenses must be over 2% of AGI and only if you do not get reimbursed.
I agree there is an advantage to owning a home but the mortgage deduction should not be an incentive to buy a home. Heck, some would say because a person gets a mortgage deduction home prices are inflated a bit.
I own a home and if you really want to talk tax advantages deductions are not the answer. Your best bet would be to incorporate and ensure those your expenses are business expenses.
For example when you specified medical expenses. When you file your tax return your expenses have to exceed 7.5% of AGI. A married couple with a 200k income would need their medical expenses to exceed 15k before they could start taking a deduction. This is the reality for a lot of my friends. They have medical expenses but not enough to deduct. Also certain medical expenses are not tax deductible i.e. Cosmetic surgery.
But, if you’re say an actress and have a corporation you can deduct your legitimate medical expenses from your corporation’s profits dollar for dollar. (Above the line)This even includes cosmetic surgery. The key word here is “Legitimate business expenses”
But then again this isn’t a tax planning article exclusively 🙂
Great guest post YFS (I kept waiting for you to guest post on Joe’s site – haha)! I never would have considered buying a home for the tax benefits, but then again, I’m not like most people. Good to know about the tax regulations. I will keep that in mind for the future.
This is my second post for Joe :-). Mortgage deductions is one of the dumb reasons people buy a house. I had a friend once tell me they bought their home because of it. I was pissed!
There needs to be more of an incentive to purchase a home. For me, my motivation is to have a place paid for by retirement. Renting just doesn’t cut it in this scenario.
The incentive for a lot of people is locking in the cost of housing. What additional incentives do you need to purchase a home?
If people on the edge about whether to buy a home, a mortgage deduction certainly shouldn’t be what helps make their decision. If the only way you can afford a home is with the tax incentives, then you probably shouldn’t be buying it!
I agree. Do not buy a home until you’re ready
The same reason home buyer credits shouldn’t be a reason to buy homes! I agree with Joe’s thoughts and thanks for a very informative post.
Exactly! Buy a home when you can afford it without credits or deductions. Credits/deductions should be an after thought.
I plan on holding off on purchasing a house for awhile. Thinking about credits/deductions will be the furthest thing from my mind. There are too many other important factors to be considering.