Americans love the home mortgage interest deduction. It’s frequently cited when extolling the benefits of home ownership. It’s an important factor in increasing home ownership rates in the US. It’s considered so valuable that the National Association of Realtors asserts that removing the home mortgage interest deduction could cause housing prices to fall 11%.
But here’s the thing – almost every analysis of the home mortgage interest deduction dramatically overstates its value.
The value of the home mortgage deduction
On its face, the value of the mortgage deduction seems easy to calculate. Let’s take a simple example.
A married couple buys a $650,000 house. They put down $130,000 (20%) and take a 30-year fixed loan at 4.5% for the remaining $520,000. Their marginal tax rate is 25% and they have no other deductions. Property taxes are 1% of the value of the house.
In the first year they will pay $23,228.38 in interest and $6,500 in property taxes.
Their total tax deduction is easy to calculate. They have a total of $23228.38 + $6,500 in deductions, for a total of $29,728.38. Since they are in the 25% tax bracket they will save $29,728.38 * 25% = $7,432.10 in taxes in the first year, right?
Wrong.
The standard deduction
The problem with this calculation is that it ignores the presence of the standard deduction. A quick refresher – when you pay your taxes you choose to either itemize deductions or take the standard deduction. Itemized deductions include charitable giving, state and property taxes, medical expenses (once they exceed 10% of AGI), and others.
The standard deduction in 2018 for a married couple filing jointly is $24,000. If your total itemized deductions are less than $24,000 then you’re better off just taking the standard deduction. If your itemized deductions are higher than $24,000 then you’re better off itemizing your deductions.
This means that your itemized deductions are only valuable to the extent they exceed the standard deduction. In the example above that means the real value of the itemized deductions is ($29,728.38 – $24,000) * 25% = $1,432.10. That’s 19% the originally calculated value.
The implications
One implication is that the home mortgage interest deduction is worthless for all low-income and most middle-income taxpayers. The average home price in the US as of November, 2016 was $234,900. Here are the tax implications (assuming 5% interest, 80% loan-to-value, and 1% property taxes):
- Year 1 mortgage interest = $9,333.04
- Year 1 real estate taxes = $2,350.00
- Total deduction = $11,683.04
Actual value of tax deduction = $0 (the total is less than the standard deduction of $24,000, so there’s no value to these itemized deductions).
It’s clear that for a person buying the average house the home mortgage deduction will likely have no value to the taxpayer. Let’s look at the value of a mortgage (interest deduction + real estate tax) for various mortgage balances, interest rates, and marginal tax rates.
A few things stand out in the table. First, with a $300,000 house, nobody, not even taxpayers in the highest tax bracket, gets a deduction under the new tax law. To get any sort of deduction on a $450,000 loan you’ll need a mortgage with an interest rate in the 5% range.
And even those taxpayers in the highest tax bracket (37%) who own a $600,000 loan financed at 5% only get a deduction worth 13.32% of the interest that they paid (rather than 37%, as you’d expect).
What percentage of taxpayers itemize their deductions? Well, as of 2013 (the most recent year the data was available) only 30.1% of taxpayers itemized their deduction. That same year 64.5% of Americans owned their own home. That means that less than 1/2 of homeowners realized no tax deduction from their mortgage interest.
With the tax reform passed in 2017 the number of taxpayers who itemize is expected to drop to 5%.
This is exactly what we’d expect from the calculations above.
Why you should pay down your mortgage
Given the high valuations in the stock market and low-interest rates today I think that for most people paying down your mortgage will likely provide a better return in the near and medium term.
In the past, when the market is 20% overvalued it has posted an average -0.3% return over the next 5 years. I recently calculated that the S&P is approximately 60% overvalued. Given the high valuations, I would expect the S&P to produce an annualized negative inflation adjusted return over the next 5 years. In contrast, paying down a mortgage at with a 4.5% interest rate results in a guaranteed 4.5% return. Not only that, but it also dramatically improves your financial position.
Why does paying your mortgage down improve your financial position more than just investing the money? After all, you’re just moving money from one pocket to the other, right?
Well, think of it this way – which of these 2 people has a stronger balance sheet:
- Person A – $5M in assets, $4m in debt
- Person B – $1M in assets, no debt
They both have a net worth of $1M, but Person B is clearly in a stronger financial position. They can easily borrow money if needed and they have no debt to service. If the value of their assets drops by 25% they will still have a net worth of $750k. If Person A has his assets decrease in value by 25% he will suddenly have net worth of -$250,000 (yes, negative net worth).
Conclusion
For the average person who owns the average house the home mortgage interest deduction has no value. By almost any metric, the stock market is overvalued and will likely have a negative return over the next 5 years. Compared to the guaranteed return from paying down your mortgage the choice is easy.
Note that this isn’t always the case. The expected return from the market over any 5-10 year period depends largely on the starting valuation. If the market was cheaper the expected return would be higher. In that case it would make much more sense to invest your money rather than pay down your mortgage.
Nothing is guaranteed in investing and finances, but the way to get rich is to invest only when the odds are in your favor.
Updated in 2018 to reflect the changes from 2017 tax reform
I totally agree with this analysis and your sentiment on the market being overvalued. That is exactly why my wife and I are working to have our 30-year mortgage paid off in 7 years or less. We are already into year 3 of our original 7 year plan.
We have taken advantage of the really low rates to complete several refinances over the past 2 years working our interest rate down from 3.75% with 1.35% PMI to our most recent 3/1 ARM loan at 2.25%. We bought the house for $370K with about 5.5% down (original loan amount of $355K) and after 3 years (in February-2017) our loan balance is down to $300K.
We are actually ahead of our payoff schedule due to the last cash-in refinance we completed in 2016.
The plan has us paying down the loan with extra principal payments to the following amounts by year:
2017 : ~$273K
2018: ~$225K
2019: ~$167K
2020: ~$105K
2021: $0
I will be honest that I actually made the mistake of over valuing the interest deduction when I first performed my analysis 2 years ago. When we first put this plan together our income was half as much as it is today, so we are already talking about expediting the plan and shooting for a more aggressive 5 year pay off (having it paid off by end of 2019.
Cheers
I love the plan. I’m very impressed that you’ll be able to pay $105k of your mortgage off in 1 year (2020-2021).
Assuming that my big deal closes in the next few months I expect to completely pay off our second mortgage (~200k). I’m considering paying off our primary as well, but it’s quite a bit larger (~$575k). The improvement in our cash flow would be substantial (approximately $5k/month), which should allow us to supercharge our saving/investing down the road.
Thanks for the detailed commentary!
Great analysis, but you assume that the couple has no other itemized deductions. I’ve been itemizing for several years even without a mortgage, it’s not too difficult to get past the standard deduction, especially if you’re single.
Absolutely – this analysis is just looking at the mortgage interest deduction. Other common deductions include state income taxes and contributions to charity. And a single person has a much lower standard deduction, which makes itemized deductions comparatively more useful/valuable.
This is very situational. If you live in a state with high state income taxes, such as New York or California, you are already itemizing deductions based the amount of state income taxes you’re paying. Thus, every single incremental dollar of mortgage interest or property taxes paid results in a tax benefit at your graduated rate (potentially providing both a federal and state income tax benefit).
My situation when I lived in New York City was such that it made a heckuva lot of sense to buy an apartment. Now that I live in Seattle where there I pay no state income tax, my situation is different and I will have a tough time getting over the standardized deduction threshold.
That’s absolutely true – depending on the value of your other itemized deductions it’s possible that you’re already above the standard deduction.
However, it’s very likely that that part of this years tax reform bill will be a massive increase in the standard deductions. The numbers being thrown around are in the $30,000 for a couple. At that level it’s unlikely that most people would ever itemize. There are also discussions about removing the deductibility of state taxes, which would further reduce the value of the mortgage deduction (for the inverse of the reasons you mention above.)