Most of the time, when I talk about the implications of various debt repayment options on The Simple Dollar, I utterly ignore tax deductions.
This is not an oversight. Usually, it just makes a situation needlessly more complicated and takes the “simple” out of The Simple Dollar.
As is often the case, astute readers email me about this. John, for instance:
Your advice about ordering debts is really way out of line. You should pay off your home mortgage last so you can take advantage of the tax deduction.
Yes, tax deductions can be useful in some situations. Most of the time, though, they’re not much of a help and if you overvalue them, they’ll end up costing you in the long run.
First of all, most people don’t do deductions at all. 70% of tax filers simply use 1040EZ or 1040A for their tax returns, which means that they’re simply taking the standard deduction on their taxes.
If you’re doing that – and 70% of you are – then you’re not claiming a tax deduction for your mortgage or for a lot of other things. The tax implications of whether to pay your mortgage off first or another debt off first means nothing at all.
Beyond that, some of the 30% who do file the full 1040 do so for self-employment reasons and still claim the standard deduction, putting them in that group that is unaffected by deductions.
In a nutshell, if you take the standard deduction, you’re not counting your home mortgage as a deduction, and most Americans are taking the standard deduction.
Second, even if you do claim the deduction, it’s not as enormous as it’s often made out to be. Let’s look at the projected income tax brackets for 2010 and also assume that we’re talking about the average American family, bringing in $66,000 this year with two adults and two children in the household.
This income level puts that family in the 15% tax bracket. This means that if the family were to file long form and itemize their deductions, they would only deduct 15% of their annual mortgage interest from their taxes. In other words, the effective interest rate on their mortgage drops by only 15% when you take this into consideration. A 6% mortgage effectively becomes a 5.1% mortgage, in other words.
But it’s even worse than that.
To actually get that full 15%, you have to actually have other itemized claims that add up to more than the standard deduction for your family. The standard deduction for that family is $11,400. So, to get the full value of that 15%, a family filing with itemized deductions has to top $11,400 in deductions before including their home mortgage at all.
Let me show you what I mean. A couple filing jointly has a standard deduction of $11,400. They have $3,000 in various deductions and $10,000 in mortgage interest, so they’re going to file long form and itemize.
In the end, though, they’re only deducting $1,600 more than they would have with the standard deduction ($13,000 vs. $11,400). Even if you’re generous and say all of that money came from the mortgage, that’s still only a small deduction. If they’re in the 15% tax bracket mentioned above, they’re only saving $240 by filing long form. That’s the equivalent of dropping their 6% mortgage rate down to only 5.856%.
Here’s the truth. For almost all families, cash flow is much more of a day-to-day concern than tax deductions. It’s much more important that you have a low monthly debt load than it is to maximize your tax saving. With a high monthly debt load, you run the risk of going into more debt because of emergencies, and even a little bit of consumer debt taken on to handle those emergencies can quickly devour your “savings” from your deductions (and a lot more).
So, unless you’re very well off and have a strong monthly income, worrying about tax deductions and their impact on your day-to-day life is a bit of a moot point. It doesn’t save you all that much even if you do everything perfectly, and if doing everything “perfectly” means having a lot of monthly debt payments, you’re introducing a lot of risk into your life for relatively little reward.
Of course, credit card and mortgage marketers prefer that you’re in the latter situation. The more debt you’re in that you can handle and keep making the payments, the better off those big banks are because they’re just sitting back and collecting the interest off of you. Thus, they’ll talk up the tax advantages of various debts as much as they can, trying to make them sound like the greatest thing in the world.
You’re far better off having a small debt load and perhaps missing a deduction or two than having a high debt load and getting those deductions. The latter situation puts your whole financial house at risk because if an emergency occurs, you’ll have a very hard time meeting the monthly bills.
If you have a strong income, and are in a situation where you’re claiming lots of deductions anyway, it does become a factor, but if you’re in that situation, you’re in a very lucky and rather small minority of the American public.