When you sign and initial the hundred or so times required to purchase a home, chances are good that you wind up with a mortgage to go along with the property. That mortgage has an associated interest rate that is used to calculate how much you're charged each month, but it isn't always an accurate measure of how much you pay, in the end. (The mortgage also has an advertised APR that includes points, lender fees, and any applicable PMI thanks to the Truth in Lending Act. Honestly, I've never found the APR that helpful, and it definitely isn't helpful in this discussion - we need to look at the base interest rate.) The net interest you pay depends on your tax situation, and results in what I call your effective interest rate (not to be confused with the more official effective annual interest rate - new name suggestions are appreciated!).
Mortgage interest is tax deductible, which is great in theory, but it doesn't always help very much, if at all. Individuals get a standard deduction of $5,700, and married couples filing jointly get $11,400. If your mortgage interest isn't greater than whatever standard deduction applies to you, then the mortgage interest deduction doesn't help you on its own. You may have other deductions like qualified medical expenses, 401(k) contributions, charitable giving, and the like. If you have a mortgage, chances are good that you have an income and pay state and/or local income taxes, and chances are even better that you have property and are paying real-estate taxes, both of which are deductible. With these deductions, the mortgage interest deduction can be more beneficial.
My medical expenses are well below 7.5% of my adjusted gross income, so those are not deductible. My 401(k) contributions go into a 401(k) ROTH account, so they are not deductible. I have some donations and the occasional miscellaneous deduction, but my main deductions are the state income and property taxes I pay. In the end, most of my mortgage interest winds up being deductible. That means I pay a lot of state and local taxes, though, so that's not entirely a good thing.... It doesn't apply to me this year, but your deduction can also span tax brackets, making the calculation that much more complicated. Some of the deduction may save you 28%, while some may save you 25%, for example.
The amount actually deducted (we can call it the effective deduction until a better suggestion comes in) affects the effective interest rate you pay. For a 5% mortgage with outstanding principal of $200,000, your interest payments will be around $10,000. Say you contribute to a 401(k) and so can deduct all your interest and are in the 25% tax bracket. You effectively reduced the interest paid by 25% * $10,000 = $2,500. You are now paying a net of $7,500 for an effective interest rate of around 3.75%.
Because I'm such a fan of calculators, I just couldn't resist making another one!
| Interest Rate (%): | |
| Interest Paid ($): | |
| Interest Deducted ($): | |
| Tax Bracket (%): |
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