Pay off your house

In the U.S., you shouldn’t pay off your house early because then you’ll miss out on the tax deduction, right? So it only makes sense to keep a balance on your mortgage as long as you can, right?

The answer might surprise you.

Let’s run an example:
Suppose you have a $100,000 balance on your mortgage loan, at 5% APR.
That means that this year you’ll pay somewhere around $5000 interest to the bank.

Now, if this resulted in a $5000 tax credit, you might say “I’d rather pay $5000 to my bank than to Uncle Sam!” Fair enough. But that is not what you get…

What you get (if you itemize deductions) is a $5000 deduction from your taxable income. How much tax you save depends on your marginal tax bracket — how much you woulda been taxed if this $5000 hadn’t been deductible. If you are in the 40% marginal tax bracket, by having the $5000 mortgage interest be tax-deductible you will save $2000 (40% of $5000) on your taxes next year.

Got that? You’re paying the bank $5000 in interest but only saving $2000 on your taxes. You are in the hole $3000.

You’re saying, “I am so intent on keeping Uncle Sam from getting my $2000 in taxes that I am willing to pay the bank an additional premium of $3000 to make it happen.” Did you mean to say that?

And this is really a best-case scenario — most people aren’t in the 40% marginal tax bracket. If for example you are in the 15% marginal tax bracket, then the tax you would have paid on the $5000 if it weren’t deductible is only $750, and you would be paying the bank $5000 of interest to avoid paying the government a mere $750 in taxes! That’s pretty expensive.

I can’t imagine that most people really intend to pay additional thousands to their bank each year. My guess is that they are thinking of the mortgage interest deduction more as a tax credit and they just didn’t bother to do the math.

So, don’t be shy: pay off that mortgage. There must be a better place to spend all that money than giving it to the bank!