Please explain the mortgage interest deduction to me
April 4, 2017 8:03 PM   Subscribe

First-time (potential) homebuyer here. I'm trying to figure out how the mortgage interest tax deduction affects my monthly budget. Snowflake-y details inside.

My husband and I are very fortunate to have enough money saved for a 20% down payment on a house (mostly due to a recent one-time windfall). We also have generous parents who have offered to help with closing costs if we need it.

We are trying to figure out how much house we can afford based on our monthly budget and expenses (food, childcare, etc). For the purposes of this AskMe, assume a 20% down payment is guaranteed. We were told by a friend (who is a current homeowner) that we are significantly underestimating how much we can afford month-to-month because of the mortgage interest tax deduction.

Their back-of-the-napkin math suggested that we can budget in an additional $700-$900 per month by reducing the amount that is withheld from our paychecks (which we would then not owe the gov't due to that deduction).

These are made up numbers but: we are currently renting and paying $2,500 a month. This fits our budget and lets us save for our child's college, build up emergency funds, take vacations, etc. Based on property taxes in our city and other estimates (homeowner's insurance, housing association dues, etc), we have been estimating that we can afford a $470K house.

Our friend thinks we can actually afford something closer to $650K. His calculations, roughly: $21K in interest paid in the first year, minus a standard deduction of $12.7K, divided by 12 = $6.9K more available per month.

This, for some reason, does not sound like it can be correct to me. What am I not understanding? I have always heard that the mortgage interest tax deduction only benefits millionaires, which we are far from being. So what am I missing?
posted by shotgunbooty to Work & Money (21 answers total) 1 user marked this as a favorite
His calculations, roughly: $21K in interest paid in the first year, minus a standard deduction of $12.7K, divided by 12 = $6.9K more available per month.

Yeah, that doesn't make sense but I think it's at least partly because of a typo. The thing to be clear about is that it's a deduction, not a tax credit. The money spent on mortgage interest isn't free; you just don't get taxed on it. The amount saved depends on your tax bracket.
posted by jon1270 at 8:13 PM on April 4, 2017 [4 favorites]

Not speaking specifically to your question, but for various reasons we ended up buying something that was a good bit less than we could "afford" on paper. I have been so happy about that since. It has been really nice to have a little room in the budget instead of going right up to the limit. YYMY, of course, and many may be better at budgeting than we are.
posted by AwkwardPause at 8:14 PM on April 4, 2017 [9 favorites]

The mortgage interest deduction is a deduction not a tax credit - essentially you can reduce your taxable income by 21K - 12.7k = 8.3K but this doesn't result in an extra $8,300 in your pocket. It lowers your adjusted income by that much - which would decrease your actual taxes by your top marginal tax rate (maybe 28%) multiplied by the deduction amount or ~$2,300 or $200/month.

You might also see some additional benefits because you can now deduct things you spend money on but didn't deduct because you didn't spend/donate enough to equal or exceed the standard deduction. If you donated 2500 to charity last year, that now becomes deductible if you were previously taking the standard deduction, further lowering your tax burden.
posted by jeffch at 8:14 PM on April 4, 2017 [9 favorites]

$21K in interest paid in the first year, minus a standard deduction of $12.7K, divided by 12 = $6.9K more available per month

(21000-12700)/12 = 692

And that's how much you can deduct, not your savings. Actual tax savings are more like 1/3 of that (depending on tax bracket, etc).

With some quick back-of-envelope calculations, I think 470k would put you right about the same monthly payment. See the always-useful NYT rent vs own calculator.
posted by supercres at 8:15 PM on April 4, 2017 [1 favorite]

Make sure that you are budgeting for maintenance of the house that you are buying. Even new houses can have significant maintenance issues, and old ones just eat money, especially if you expect to contract out most work. 1-3 percent of the home value per year is a common rule of thumb for budgeting.
posted by rockindata at 8:34 PM on April 4, 2017 [2 favorites]

Won't the amount you pay in interest (and therefore your deduction) decrease every year? As I understand it, the standard for mortgages is that the interest payments are front loaded. Budgeting for this tax deduction seems shortsighted to me.
posted by mcduff at 8:41 PM on April 4, 2017 [8 favorites]

I wouldn't ever calculate for this.

It's not that it doesn't benefit you, it does -- but previous experience has led this to not be a significant calculus except for the very first year that you own. (Assuming that you also have mortgage points as well that first year.)

Let this one go because there are so many other unknown variables that you can't calculate for - go price out things like ladders and paint and the Special Type of Paint and the ... basically your Mint/other financial watch thing will scream bloody murder at you for the first 6 months when you move in because there's a big difference of stuff between renting, owning and what the HOA will cover.

Your friend (says a person on the internet) sounds like he's on the back end of this equation and not the front end where you have too many other unknowns. Stick with the 470k if you're finding things you like in your price range.
posted by msamye at 8:58 PM on April 4, 2017 [3 favorites]

Also make sure you're taking property taxes into account. It's a little less stressful to have them deducted monthly, but I actually went the other way and never changed my withholding and then use the tax refund to pay the property taxes. Never owing on income taxes is less stressful to me than knowing a couple of big property tax bills are coming up.

Honestly, a lot of this is moot unless your lender approves the loan. Your lender should be able walk you through the true monthly cost breakdown at a few price points including homeowners insurance and taxes. You'll want to have some cushion for repairs and emergencies. It's always a fine balance between being house poor and not stretching enough to get the home you'll need.
posted by vunder at 8:59 PM on April 4, 2017 [2 favorites]

Don't ever take this friend's advice on anything financial! He doesn't understand the difference between a deduction (which is what you can take on mortgage interest) and a credit. I hope he's not doing his own taxes. Note also that the amount of the interest you pay usually declines through the repayment period; e.g., by year 10 the amount on which you can take the deduction (the interest paid) will have dropped by about $5000.

(You can see how the mortgage will amortize under various conditions here.)
posted by praemunire at 9:09 PM on April 4, 2017 [10 favorites]

Also, beware that if a flat income tax is passed, there will be no deductions (mortgage interest or otherwise) for anyone. Everyone will pay the same rate, so if the rate is, say, 10% flat, a person making $3M/year will pay $300K in federal income tax, while someone making $50K will pay$5K. I wouldn't plan on the deduction, as you may not be able to count on it being there in the future.
posted by dustkee at 9:10 PM on April 4, 2017

Here's a nice chart showing an amortization schedule. The amount you pay is the same every month but different amounts go towards principal and interest.
posted by llin at 9:13 PM on April 4, 2017

Small mortgage payments are good! Being house-poor is bad!

Also, this friend needs to buy a calculator. He's wrong by a factor of ten.

That said, you need a more detailed calculation if you want to figure out the impact of buying a house on your taxes. You'll have the mortgage interest deduction, but you'll also be able to deduct state income taxes and property taxes. Depending on where you live, this can make a big difference.

The idea that the mortgage interest deduction only affect "millionaires" is nuts. It's a huge, huge deal for most homeowners.

if a flat income tax is passed

If an American politician succeeds in revoking the mortgage interest deduction, he will be forcibly dragged from office, flayed, and spit-roasted.
posted by mr_roboto at 9:20 PM on April 4, 2017 [7 favorites]

Do you do your own taxes, or do you work with a tax accountant? If the latter--this is an excellent question to take to that person.

If you have been doing your own taxes, and are now starting to get into a financial situation where things get more complex, it may be time to find a person to work with in this regard. Since CPAs are in their absolutely busiest time of year right now, wait until the end of April to reach out to someone new and start a relationship. Right now they're all working around the clock trying to get returns done by tax day. But if you meet up with someone at the end of April, bring your current returns, and ask this question, they can pretty easily forecast what matters in your situation.

To give you an idea of how much this costs, I spent about $250 to have my tax returns done this year. I own a home and have some investments, so a little complicated but not too crazy. I live in the Boston area and things tend to be more expensive around here. I cite this number because what you're talking about are dollar values significantly more than this, and if you misjudge based on incomplete understanding, you stand to be inconvenienced by much, much more. Talking this over with a tax accountant is cheap insurance, well worth the money and effort.
posted by Sublimity at 3:41 AM on April 5, 2017

You should build a spreadsheet modeling out the interest component, amortization component, and property tax component. You should calculate the income deduction at the appropriate marginal tax rates. This might not be as simple as x*y% if it moves you down a bracket and determine what the equivalent rent would be. Then add a maintenance figure on to that. Compare that to what you pay now. Double check that you won't potentially get hit by the AMT and there you go. As far as how much house you can afford, only you can decide that based on what you want to spend your money on. Being house poor isn't bad if every vacation is at home, it's pretty terrible if you want to travel the world.
posted by JPD at 4:23 AM on April 5, 2017 [1 favorite]

There are talks in congress of a slow elimination of the mortgage deduction. It has been specifically mentioned by Paul Ryan. I wouldn't count on it existing forever.
posted by LoveHam at 5:08 AM on April 5, 2017

Yes, one more vote for no. Your friend is wrong in the specifics and in the general. Unless you slowly let your home begin to decay and fall apart after you buy, there are tons of extra, random expenses with owning. Like pest services! Yard tools! Things that break! All the stuff you suddenly need at Lowe's! Seriously, it's way cheaper to rent, so I would add 1/4 - 1/3 of your mortgage amount as misc new expenses to your budget every month to represent all the unknown unknowns that come with owning.
posted by mirabelle at 5:50 AM on April 5, 2017 [1 favorite]

1. I definitely would not count on the deduction staying around forever. And honestly it's something that you benefit from more the better off you are and that's really not how our tax system should work.

2. In practice for us it adds like $600 back to our tax refund annually. It's not that much. (Then again, our mortgage is pretty small--see below.)

3. If you're looking at such tiny amounts trying to figure out if you can afford a certain house--you can't. Don't nickle and dime your way to arrive at some target minimum number. Nothing has been of greater benefit to our financial life than buying houses that were well, well within our means.

4. Do not forget about property taxes. DO NOT FORGET ABOUT PROPERTY TAXES! And don't forget that property taxes can and do go up. And if what you're buying the house for greatly exceeds the value it was assessed at last, you will probably get slammed with a greatly increased tax bill than what is currently on the books.
posted by soren_lorensen at 6:09 AM on April 5, 2017 [2 favorites]

Response by poster: Everyone, this is so helpful! Thank you so much! This process has been so confusing and it helps so much to have the MeFi community as a resource.
posted by shotgunbooty at 8:07 AM on April 5, 2017

Double check that you won't potentially get hit by the AMT and there you go.

This part is potentially important. AMT really kicked in for us when we bought a house, and it substantially reduced our deductions. You might not be affected by it, but I'd be sure to look at this carefully before relying on having that money.
posted by primethyme at 8:09 AM on April 5, 2017 [2 favorites]

Make sure that you are budgeting for maintenance of the house that you are buying. Even new houses can have significant maintenance issues, and old ones just eat money, especially if you expect to contract out most work. 1-3 percent of the home value per year is a common rule of thumb for budgeting.

Where we live, landlords of rentals often pay water, sewer, garbage and landscaping costs. This adds $150-$175 per month, so budget for that as well.
posted by cnc at 10:06 AM on April 5, 2017 [1 favorite]

Have you talked to a mortgage broker? They can explain all of this stuff to you, plus some other things that you probably haven't considered, and can also take a look at your current income and expenses and help you figure out how much you can afford.

Also look into first time home buyer programs in your state. A mortgage broker can help you with that too.
posted by apricot at 10:37 AM on April 5, 2017

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