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 $500,000 house. They put down $100,000 (20%) and take a 30-year fixed loan at 4.5% for the remaining $400,000. 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 $17,867.99 in interest and $5,000 in property taxes.
Their total tax deduction is easy to calculate. They have a total of $17,867.99 + $5,000 in deductions, for a total of $22,867.99. Since they are in the 25% tax bracket they will save $22,867.99 * 25% = $5,717.00 in taxes in the first year, right?
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 2016 for a married couple filing jointly is $12,600. If your total itemized deductions are less than $12,600 then you’re better off just taking the standard deduction. If your itemized deductions are higher than $12,600 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 ($22,867.99 – $12,600) * 25% = $2,567. That’s less than half the originally calculated value.
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 $12,600, 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.
Tax savings from mortgage interest & property taxes
|Marginal tax rate||Mortgage||Interest rate||Interest + property taxes||Tax savings (beyond standard deduction)||Tax savings as percent of interest paid|
If you sort by tax savings by percent (rightmost column) you’ll see that the average taxpayer in the 25% tax bracket with a $300k mortgage (which would imply a $375k house, assuming 20% down) will only get a tax savings of 5% of the total interest plus real estate taxes paid. Even for somebody in the highest tax bracket with a $500k house at a 5% interest rate the tax savings only equal 26.3% of the interest paid.
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.
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 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).
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.