Thursday, October 30, 2008

Analyzing the Mortgage "Tax Break"

One of the financial sentiments among most people that just grind my gears is the notion that you should keep a mortgage in order to get a tax break. Hear me clearly...I would not suggest that you make any financial decisions with taxes being the sole motive. While I believe in sound tax planning as a part of your financial plan, I do not believe that there are many, if any, financial decisions that you should make based on taxes alone.

If you had the money available to pay off your mortgage, would you? Many financial advisors say that you should not pay off your mortgage because (1) the interest is low, (2) you will lose the tax break and (3) your money will make more in the market, which has historically averaged 10-12%. We can chat about all three, but I want to chat about #2, with an illustration.

Assume the following:
Mortgage: $100,000
Interest rate: 6%
Tax bracket: 25%

Person A choses to keep the mortgage in order to keep the tax break, therefore at 12/31/20XX , Person A...
  • paid Example Bank $6,000 in interest
  • got a tax break of $1,500 (they are in the 25% tax bracket, so $6,000 * 0.25)
  • overall out of $4,500 (6,000 interest paid - 1,500 tax savings)
Conclusion - Person A sent the bank $6,000 so they could get $1,500 back from the government.

Person B chose to pay off the mortgage and give up the tax break, therefore at 12/31/20XX, Person B....
  • paid Example Bank $0 in interest
  • paid $1,500 in taxes because there was no tax break (6,000 income * .25)
  • overall out of $1,500
Conclusion - Person B has $6,000 more in income because they did not pay interest, which means that the $6,000 is taxable. Since they are in the 25% tax bracket, they had to send the IRS $1,500 but they kept $4,500.

When time meets opportunity, I will be Person B! How about you?


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