Advice: Calculate Mortgage Tax Savings
Peter McDougall
06/23/08 - 10:34 AM EDT
The decision about when to buy a home is based on factors including interest rates, home prices and your financial situation. One important part of the financial calculation that is frequently forgotten, however, is the tax benefit of paying mortgage interest.
Mortgage interest payments (along with any points paid at closing) are tax deductible if you itemize your deductions on Schedule A of Form 1040.
The IRS defines mortgage interest in
Publication 936 as "any interest you pay on a loan secured by your home (main home or second home). The loan may be a mortgage to buy your home, a second mortgage, a line of credit or a home equity loan."
In order to deduct the interest legitimately, you need to be legally responsible for the loan -- meaning, you can't deduct interest you're paying on someone else's loan. Your loan also has to be considered secured debt, meaning that your home serves as collateral for the loan (as is the case for most mortgages and home equity loans).
If you know your federal tax bracket, then the calculation of how much you'd save on taxes can be relatively easy: multiply the amount of mortgage interest you paid this year by your tax rate and that gives you your savings. But that figure doesn't give you the complete picture.
That's because, in addition to a number of other
itemized deductions available on your federal return, you can deduct your state income taxes. The
Mortgage Tax Savings calculator from BankingMyWay.com makes these calculations simple.
The calculator requires you to enter details about your loan: the loan amount, the term, the interest rate and the closing costs. You also need to know your federal and state tax rates. The calculator then determines your effective tax rate by taking into account how much your overall tax liability is lowered by deducting your state taxes.
If your tax rates are 25% for federal and 8% for state, the calculator determines that your effective tax rate is 31%. This figure comes from taking your total tax rate of 33% (25% federal + 8% state) and subtracting the amount of the state tax liability you recoup by deducting your state taxes on Schedule A (25% x 8% = 2%). You are therefore left paying an effective rate of 31% (33% - 2%).
On a 30-year mortgage for $200,000 with a fixed rate of 6.32%, your monthly payments would be $1,240.55. By the end of the first year, you would have paid $12,573.78 in interest. Provided your loan qualifies for the mortgage interest deduction, you stand to lower your taxes by $3,897.87 ($12,573.78 x 31%).
Say you had to pay a point at closing. When you take that into consideration (points are also deductible in the first year) you end up lowering your taxes by another $620 ($2,000 x 31%), for a total tax savings of $4,517.87 in the first year.
In the second year, your interest payments are slightly lower, as more of your monthly payments go toward paying down the principal of your loan. Even so, your interest payments in year two are $12,423.29, which translates into a tax savings of $3,851.22 (assuming you remain at the same tax rate next year).
You shouldn't decide to buy a house solely on the basis of the potential tax savings, but you should be aware of some of the benefits that decision can have for your financial situation.
