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.
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:
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