Don't Go Crazy Just Because Mortgage Interest Deduction Was Saved

NEW YORK ( BankingMyWay) -- Now that we've dodged the bullet and the fiscal cliff debate is behind us, it's time to think seriously about that new home you've wanted.

The deal approved this week leaves intact the homeowner's mortgage interest deduction, which makes a home purchase more affordable. There had been some talk of modifying or eliminating that tax break for homeowners, and though the idea never got a lot of traction it was enough to make a prospective homebuyer hesitate.

So, to be clear, here's how the deduction works: You can subtract from your taxable income the interest paid on up to $1 million in mortgage debt. That maximum applies to the total amount of debt on a first and second home. Had there been a change, the deduction on a second home seemed particularly vulnerable, and there was some talk of reducing that $1 million limit.

This good news comes on top of a series of positive reports about the health of the housing market. Prices have been rising, more homes are being built and the prospects for a new plunge in home values are diminishing by the day. With the uncertainty over tax rates resolved for the long term, it's much safer for homeowners, builders, employers and lenders to place their bets. That could propel improvements in the broad economy that would reduce the risk of a home purchase.

But let's not go overboard. You won't find any experts predicting a home-price boom like the one in the middle of the last decade. While there may be hot markets here and there, it's just not possible for home prices to rise faster than incomes indefinitely, because at some point there are not enough people who can afford those pricy homes. Many of the people who ignored this fact and bought at the peak a few years ago are still deep underwater, owing more than their homes are worth after prices collapsed.

Over the long run, home prices rise at about the inflation rate, which averages around 3% a year. Add interest charges, taxes, maintenance, insurance and other costs of ownership and a home is likely to be a money loser. Even if it does turn out to be a profitable asset, it's unlikely to beat alternatives such as stocks over the long term.

Buying a home does make sense because you need a place to live, and owning can be less expensive over the long term than renting. But from a purely financial perspective it pays to buy the cheapest home that fills your needs rather than the most expensive one you can afford. Savings on the cheaper home can then be invested more profitably.

The mortgage interest deduction, while valuable, is not as valuable as many think. It offers tax savings only to those who have enough deductions to justify itemizing them on the federal return. Homeowners who don't itemize get nothing from the mortgage interest deduction, despite paying lots of interest.

And even those homeowners who do itemize benefit only if the interest deduction pushes their total deductions higher than the "standard deduction" available to everyone. For 2013, the standard deduction, which the IRS will announce soon, is expected to be $6,100 for individuals and $12,200 for married taxpayers filing a joint return.

In other words, a married couple with no other deductions would benefit from the mortgage interest deduction only if their interest payments exceeded $12,200, because they'd be entitled to the $12,200 standard deduction anyway if they did not itemize.

If they paid $15,000 in interest, the mortgage deduction would garner them an additional deduction of only $2,800. That would save them just $700 in taxes if they were in the 25% tax bracket, not the $3,750 they might expect for paying $15,000 in interest. They'd save the full $3,750 only if their other deductions totaled at least $12,200, making the entire mortgage interest payment deductible.

This isn't to say that the mortgage interest deduction isn't worth having. It's just that, in itself, it's not a good reason to take out a larger mortgage. After all, even if the entire interest payment is deductible, it doesn't make sense to pay an additional $1 in interest just to save 2 cents in taxes.

Happily, there are other reasons to buy a home, and the risk seems to be diminishing as the market improves and Washington finally resolves the uncertainty surrounding taxes.