Myth: Keeping a Mortgage Will Save Money
The Word on the Street
This is one of the big myths of our day. The myth holds that keeping a mortgage to its full term, rather then paying it down early, is wise because the homeowner can deduct the interest payments from his/her federal taxes.
Keeping a mortgage (or any other loan for that matter) for a longer period of time will always end up making the homeowner pay more in interest than can be saved in taxes.
Doubt me? Let’s run the numbers on three different size mortgages and see if I am right.
A Simple Truth
It always amazes me to think that there are professors and other people with PhD’s who cannot decide if this myth is true or not. I have crunched the numbers on dozens of different mortgages with a range of interest rates and tax brackets, and I have never found a mortgage for which this theory holds true.
In fact, when you look at it a different way, you can see that it is impossible for the tax savings on a mortgage to save you money while the mortgage is in force. It really boils down to a very simple truth about taxes.
Depending on your income, the government takes a percentage of your income as taxes. The higher your income, the higher the percentage they take in taxes. The idea behind the tax deduction is that you reduce how much of your income that the government taxes. So, if you pay 40% in taxes and you make $100,000 in a year, the government will take 40,000 in taxes. If, however, you have a mortgage and you deduct $10,000 worth of interest, then the government only takes 40% of $90,000, which is $36,000, a tax savings of $4,000.
But think with me now. In order to get the deduction you must pay interest. In the example above, the person paid $10,000 in interest, but only save $4,000 in taxes! This is the simple truth: in order to save $.40 on taxes, you must spend $1.00 in interest. The interest will always exceed the tax saving! To put it mathematically:
Tax Savings = Tax percentage * Interest Paid
And since the tax percentage is always less than 1, the tax savings is always less than the interest paid.
An Example The following tables analyze a $200,000, a $300,000, and a $400,000 mortgage at 6% interest kept for the full 30 years, and for a shorter term if an additional $200 is paid towards the mortgage each month. The homeowner is in a 40% tax bracket.
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You can see that the interest payment dwarfs the tax savings in every case.
Now let’s take the same graphs and combine the results. The yellow area in the graph below represents the positive cost difference between early repayment (ER) and paying to full term (FT).
As you can see, paying the mortgage down early will save you more money that you can save in taxes. This is the simple truth, no games or hidden tricks.
Another perk of early repayment of a mortgage is that you have saved time for investment. In the case of the $300,000 mortgage, a $200 extra monthly payment would chop about 7 years off the repayment time. That is 7 years that you get to enjoy your home payment free. That is also 7 years in which your income is freed up for investment. This is when you do your heavy hitting investing. With the mortgage gone, it is not unreasonable to invest the entire mortgage payment (a total of over $20,000/year). Investments like that add up fast!
It can’t be so simple, can it?
Well, when you boil it down to just the taxes and interest, it is that simple. However, many people endorse a philosophy of investing your extra money instead of paying down your mortgage. This philosophy has its merits, but is beyond the scope of this particular post.
Posted on 22 Mar 2008