# Why Paying Down Your Mortgage Might be Bad

Paying down your mortgage can be a great way to build equity, but how exactly do you benefit from paying down your mortgage? Well to answer that question we first have to have a basic understanding of the tax benefits associated with home ownership.

As an taxpayer you are entitled to the GREATER of **EITHER** the standard deduction **or** the itemized deduction for tax purposes. Well the standard deductions for a single individual like myself is $5,800 for 2011, but my itemized deduction was much larger for 2011, therefore I will deduct only my itemized deduction.

What goes into your itemized deduction? Well you might want to take a look at a Schedule A for the complete list and instructions, but the ones to discuss now are:

**Interest you paid**- Taxes you Paid

So let’s say you paid $3000 in taxes and $7000 in interest on your home. As a single individual you would take the **greater of** $5,800 (standard) or $10,000 (3000 + 7000, itemized) and deduct it from your income before multiplying it against your margin rate. So if you had a marginal rate of 25%, your itemized deductions saves you: [** $4,200** (how much larger your itemized is from standard)** * 25%** (marginal rate) ] = **$1050 net savings per year**.

Now back to paying down your mortgage. As your pay down your mortgage, the amount of interest you paid a year is lower, and this reduces the amount of itemized deduction you receive.

If your mortgage gets small enough, **the standard deduction could even be larger **than the itemized. For example you pay off 75% of your entire mortgage and only have $1750 of interest now instead of $7000. You now get a deduction of the greater of: $5,800 (standard) or $4,750 (taxes + interest, itemized deduction).

So what does this all mean?

**If you paying down your mortgage and you are currently itemizing you only save:**Interest Saved * (1 – Marginal Tax Rate)

**If your standard deduction is larger than the itemized deduction, you save:**Interest Saved

So if you have $10,000 to put towards the mortgage principle on a 4% mortgage and you currently are taking an itemized deduction and you are in a 25% marginal tax bracket, you save will:

$10,000 * .04 * (1 – .25) = **$300 net year.** Which is an effective rate of return of 3%

Why is this important? Well if you think 3% return is the best bet, then maybe paying down your mortgage is the best option, but I can promise you this – if you think 3% return is good enough – It’s going to be hard for you to accumulate wealth unless you have a lot of money to invest. Just to illustrate, if inflation is 2% on average for the next 30 years and you invest $10,000 in a 3% return for the next **30 years** – Your investment after removing inflation is: $13,478 (+$3,478). Where will you be in 30 years to spend your extra $3,478?

Did I also mention your payment is still the exactly the same before and after when you prepay your mortgage? The take home message is: The only benefit you are getting from paying down your mortgage if you’re itemizing is:

**Amount Paid Down * (1 – Marginal Tax Rate)**

*Disclaimer: Always consult a tax professional for assistance for tax preparation. EpicFinances.com is not to be used as a source for your personal tax preparation*