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!