Mortgage Interest Deduction: Not the deal some say it is?

[phwadsworth]

I've bought and sold a house now, not as an investment, but simply as shelter.  We simply bought the house that fit our needs (much less than our wants) at the time.  So, I never really did the math on how I made out with interest, taxes, deductions etc.  other than to know we beat the cost of renting.

Sometime soon we'll be buying the next house, and since wife and I will soon be in the highest marginal tax bracket many people advise buying a lot of house because the tax deduction is taken from a ~45%+ marginal rate (fed + state).  When I listen to these arguments from bloggers/friends/realtors/bankers they sort of make sense, but I can't seem to get the math to work.  It sure seems that no matter what, I'd be better off not spending any more than absolutely necessary on mortgage interest, even if I get to deduct that interest from the amount of income that we're paying 45% on....since it's still only 45% not 100%.

right?

Is there any way that buying more house than necessary gets someone ahead in investments or cash flow?
Sure seems I should just buy the house I need again and put all those ridiculous earnings (taxed at 45%) into the 'stache and sit tight.  right?

thanks.

[forummm]

Yes, it's only a deduction. You are still out the money you are spending--just not the income tax that would have been due on it. If someone offered you a $2k/mo raise (or whatever your interest proportion is), you would definitely take it, even though you'd have to pay taxes on that extra income, right?

People justify spending more on houses for certain school districts ("deductible loan interest is cheaper than tuition") or because it's "an investment". But they are still out the money. Also higher property taxes and higher homeowners insurance.

And because you'll need a higher down payment, you are locking up more cash that you could otherwise have invested.

If you are getting a loan that's bigger than the standard loans (a jumbo) that comes with higher loan costs as well.

[nobodyspecial]

even if I get to deduct that interest from the amount of income that we're paying 45% on....since it's still only 45% not 100%.

Shhhh, if everyone works this out the entire system collapses.

[Arktinkerer]

Only way it really pays is if the house appreciates and you sell it.  Basically, you are getting the appreciation on borrowed money so you are gambling that the increase is more than interest payment.  Other than that, it is just an expense like any other.  Lots of people made money, until they didn't.  government bailed them out if they made decisions that were bad enough.  the Looks like the cycle is starting up again...

[SnackDog]

If you live in an area where homes are likely to appreciate, your leverage can yield you large returns when you sell. The more leveraged the better the return. The larger the investment, the larger the amount returned. If you buy a house for $100k with zero down and your buddy buys one for $1MM with zero down and both appreciate 10% per year which one would you rather own and sell after five years?

[Tabaxus]

If you live in an area where homes are likely to appreciate, your leverage can yield you large returns when you sell. The more leveraged the better the return. The larger the investment, the larger the amount returned. If you buy a house for $100k with zero down and your buddy buys one for $1MM with zero down and both appreciate 10% per year which one would you rather own and sell after five years?

Sure.  Of course the question is how this is any different than investing on margin, which very few people are comfortable doing.  Real estate, as any other investment, can appreciate, depreciate, or stay flat.  And the real estate has higher maintenance costs, property taxes, etc., than do stocks. 

[phwadsworth]

Yes, it's only a deduction. You are still out the money you are spending--

phew!  OK, I thought I was going crazy or something. 

Thanks for the help all.  With regards to appreciation, I believe more in my sweat equity than the performance of the short term real estate market, so I'll keep my money in long term stocks....after paying the tax man.  We did very well on this last house sale, without even planning on it, just by consistently working on simple value-add projects in the house.

[arebelspy]

If you live in an area where homes are likely to appreciate, your leverage can yield you large returns when you sell. The more leveraged the better the return. The larger the investment, the larger the amount returned. If you buy a house for $100k with zero down and your buddy buys one for $1MM with zero down and both appreciate 10% per year which one would you rather own and sell after five years?

Sure.  Of course the question is how this is any different than investing on margin, which very few people are comfortable doing.  Real estate, as any other investment, can appreciate, depreciate, or stay flat.  And the real estate has higher maintenance costs, property taxes, etc., than do stocks.

Except that long run real estate should appreciate with inflation. If your mortgage rate is below inflation, you come out ahead. And if you have the money to buy but invest instead, and get a return more than your mortgage, you come out ahead.

Mortgages are not great for their interest deduction, they're great for other reasons. You shouldn't get one for the deduction, and if the deduction went to 0, there's still solid arguments for paying mortgage interest even if you could buy in cash. The deduction is just an extra nice benefit helping lower your effective rate in many circumstances.

[Davids]

A few months ago I refinanced to a 15 year 3% mortgage. I was previously on a 30 year mortgage at 4.25% for my house I bought in March 2010. I had been putting extra payments towards the principal and thought about having it paid off in the next 4-5 years but decided instead to refinance to a lower rate and just make the minimum payments (well I put a little extra toward the principal just so the monthly payment is an even round number). The mortgage interest deduction is good for what it is but a 3% mortgage is what matters the most, the mortgage interest deduction is like an icing on the cake. Now instead I take all that extra I would have previously put towards principal and just add it to my Vanguard ETFs after tax brokerage account (I already max my 401K, Roth IRA and HSA and put money monthly in 529 plan for my 1 year old son).

[Tabaxus]

If you live in an area where homes are likely to appreciate, your leverage can yield you large returns when you sell. The more leveraged the better the return. The larger the investment, the larger the amount returned. If you buy a house for $100k with zero down and your buddy buys one for $1MM with zero down and both appreciate 10% per year which one would you rather own and sell after five years?

Sure.  Of course the question is how this is any different than investing on margin, which very few people are comfortable doing.  Real estate, as any other investment, can appreciate, depreciate, or stay flat.  And the real estate has higher maintenance costs, property taxes, etc., than do stocks.

Except that long run real estate should appreciate with inflation. If your mortgage rate is below inflation, you come out ahead. And if you have the money to buy but invest instead, and get a return more than your mortgage, you come out ahead.

Mortgages are not great for their interest deduction, they're great for other reasons. You shouldn't get one for the deduction, and if the deduction went to 0, there's still solid arguments for paying mortgage interest even if you could buy in cash. The deduction is just an extra nice benefit helping lower your effective rate in many circumstances.

In the long run, the markets exceed inflation, so again, I'm not sure how this is any different from investing on margin.  It's a matter of runing the numbers on effective rate of return after all taxes and so on, but for whatever reason, many many people are very comfortable running a mortgage, but far fewer people are ok investing on margin.

(As an aside, I do understand that there is something to this (1)  in states where mortgages are non-recourse; if (2) you can't get a non-recourse margin loan.  At that point you're making a risk/reward calc where your only downside is your equity, and that can make some sense, if you can't get a similar risk profile for the margin loan.)

[forummm]

If you live in an area where homes are likely to appreciate, your leverage can yield you large returns when you sell. The more leveraged the better the return. The larger the investment, the larger the amount returned. If you buy a house for $100k with zero down and your buddy buys one for $1MM with zero down and both appreciate 10% per year which one would you rather own and sell after five years?

Sure.  Of course the question is how this is any different than investing on margin, which very few people are comfortable doing.  Real estate, as any other investment, can appreciate, depreciate, or stay flat.  And the real estate has higher maintenance costs, property taxes, etc., than do stocks.

Except that long run real estate should appreciate with inflation. If your mortgage rate is below inflation, you come out ahead. And if you have the money to buy but invest instead, and get a return more than your mortgage, you come out ahead.

Mortgages are not great for their interest deduction, they're great for other reasons. You shouldn't get one for the deduction, and if the deduction went to 0, there's still solid arguments for paying mortgage interest even if you could buy in cash. The deduction is just an extra nice benefit helping lower your effective rate in many circumstances.

In the long run, the markets exceed inflation, so again, I'm not sure how this is any different from investing on margin.  It's a matter of runing the numbers on effective rate of return after all taxes and so on, but for whatever reason, many many people are very comfortable running a mortgage, but far fewer people are ok investing on margin.

(As an aside, I do understand that there is something to this (1)  in states where mortgages are non-recourse; if (2) you can't get a non-recourse margin loan.  At that point you're making a risk/reward calc where your only downside is your equity, and that can make some sense, if you can't get a similar risk profile for the margin loan.)

Every chart I've seen says that appreciation nationally happens very closely correlated with inflation over the long run, but with occasional wild swings away from inflation in the short to medium run. Which makes sense right? Otherwise houses would get so expensive that people couldn't afford to buy them. Which would lead builders to make more of them. Which would bring down the price.

[Faraday]

I've bought and sold a house now, not as an investment, but simply as shelter.  We simply bought the house that fit our needs (much less than our wants) at the time.  So, I never really did the math on how I made out with interest, taxes, deductions etc.  other than to know we beat the cost of renting.

Sometime soon we'll be buying the next house, and since wife and I will soon be in the highest marginal tax bracket many people advise buying a lot of house because the tax deduction is taken from a ~45%+ marginal rate (fed + state).  When I listen to these arguments from bloggers/friends/realtors/bankers they sort of make sense, but I can't seem to get the math to work.  It sure seems that no matter what, I'd be better off not spending any more than absolutely necessary on mortgage interest, even if I get to deduct that interest from the amount of income that we're paying 45% on....since it's still only 45% not 100%.

right?

Is there any way that buying more house than necessary gets someone ahead in investments or cash flow?
Sure seems I should just buy the house I need again and put all those ridiculous earnings (taxed at 45%) into the 'stache and sit tight.  right?

thanks.

Those are the kind of arguments you get from the crowd that says "There's good debt (typically = "mortgage") and there's bad debt (typically = unsecured, high-interest credit cards)".

Your thinking is similar to mine - trying to give the benefit of the doubt to the idea. You are trying to see if there is anything you might be missing in the "deduction point of view" and you are searching for it and just can't see it.  There's no wisdom to be had. It's simply an incentive by the government to get you to buy instead of rent.

I built a new house 8 years ago. I "qualified" for a much higher loan than I needed and much more home than I needed. Thankfully, DW and I had been working on this house design for 10 years and had it honed to a fine point of efficiency, cost-effectiveness and safety. We built for 1/3rd to 1/2 the cost of most homes in the area and at least 3x less than the low-end McMansions in the area.

My only regret? I still wish I'd been able to build for less and free up cash flow for more investment. This year, the mortgage deduction is about all we'll be left with to help us on our taxes, but I still would rather have the cash flow freed up for investment.

(I can't feel too bad: there's no way you could reproduce this house today for anywhere near what we paid. No matter what the fools over at Zillow say.)

I think you are on the right track already with what you did on the prior home: buying less/low, doing some well-thought-out upgrades and increasing the value of the property.

Badassity is recursive! The more of it you practice, the more it leverages investment returns!

[Arktinkerer]

Yes, it's only a deduction. You are still out the money you are spending--

phew!  OK, I thought I was going crazy or something. 

Thanks for the help all.  With regards to appreciation, I believe more in my sweat equity than the performance of the short term real estate market, so I'll keep my money in long term stocks....after paying the tax man.  We did very well on this last house sale, without even planning on it, just by consistently working on simple value-add projects in the house.

This is very wise.  You actually get a huge increase this way.  Your labor on the house creates gains that are not taxed (there are rules to follow for this but they have gotten much less restrictive).  Had several acquaintances who would move into a home, renovate, sell, buy another.  Was a very tax efficient way to build up their net worth.  We turned our old homes into rentals and that worked pretty well for us.  The additional benefit is you have a place to live and it is a very short commute to work!

[Faraday]

....
We turned our old homes into rentals and that worked pretty well for us.  The additional benefit is you have a place to live and it is a very short commute to work!

Arktinkerer - was this technique for "generating rentals" always a side gig to your main income-generating job, or was there a tipping point where you had enough rentals that you could pursue this strategy in place of a "normal job"? (And if it did become the main gig, how long did it take?)

[arebelspy]

If you live in an area where homes are likely to appreciate, your leverage can yield you large returns when you sell. The more leveraged the better the return. The larger the investment, the larger the amount returned. If you buy a house for $100k with zero down and your buddy buys one for $1MM with zero down and both appreciate 10% per year which one would you rather own and sell after five years?

Sure.  Of course the question is how this is any different than investing on margin, which very few people are comfortable doing.  Real estate, as any other investment, can appreciate, depreciate, or stay flat.  And the real estate has higher maintenance costs, property taxes, etc., than do stocks.

Except that long run real estate should appreciate with inflation. If your mortgage rate is below inflation, you come out ahead. And if you have the money to buy but invest instead, and get a return more than your mortgage, you come out ahead.

Mortgages are not great for their interest deduction, they're great for other reasons. You shouldn't get one for the deduction, and if the deduction went to 0, there's still solid arguments for paying mortgage interest even if you could buy in cash. The deduction is just an extra nice benefit helping lower your effective rate in many circumstances.

In the long run, the markets exceed inflation, so again, I'm not sure how this is any different from investing on margin.  It's a matter of runing the numbers on effective rate of return after all taxes and so on, but for whatever reason, many many people are very comfortable running a mortgage, but far fewer people are ok investing on margin.

(As an aside, I do understand that there is something to this (1)  in states where mortgages are non-recourse; if (2) you can't get a non-recourse margin loan.  At that point you're making a risk/reward calc where your only downside is your equity, and that can make some sense, if you can't get a similar risk profile for the margin loan.)

The biggest difference is the enormous difference in risk. The bank can't call my mortgage due if the house value is below the loan balance, as long as I'm making my payments.

A margin loan can be called.  And with the higher volatility in equities than housing, that's more likely to happen.

[tvan]

My experience buying a home for more money than we originally planned happened as follows:

We bought into the school district
We bought into the better location (cul de sac, corner lot, quiet street)

We paid 212,000 for the home at 3.25%
2 years later (almost exactly) we sold the house for 229k.  We received an offer within 24 hours of listing it.
After paying the realtor we profited 12k. 

So buying larger, in an appreciating neighborhood can pay off.  But I feel we were generally lucky as well.

[Dicey]

So many perspectives on this issue. Here's another, far less often mentioned one.

Per the IRS Tax Code, "Your sale qualifies for exclusion of $250,000 gain ($500,000 if married filing jointly) if the following is true:
You owned the home and used it as your main home during at least 2 of the last 5 years before the date of sale."

In many markets, it is possible to buy a fixer with a small down payment, live in it for at least two years while you fix it up, and then sell it for a profit. Your gain will then be tax free. If you buy the house right and make smart improvements, you can make back all the mortgage interest you paid and then some, plus pay no taxes. And yes, you can deduct the interest you pay while you're living in and improving the house. Rather a sweet deal, actually. Lather, rinse, repeat and you could be looking at FI earlier than you ever thought possible.

[forummm]

My experience buying a home for more money than we originally planned happened as follows:

We bought into the school district
We bought into the better location (cul de sac, corner lot, quiet street)

We paid 212,000 for the home at 3.25%
2 years later (almost exactly) we sold the house for 229k.  We received an offer within 24 hours of listing it.
After paying the realtor we profited 12k. 

So buying larger, in an appreciating neighborhood can pay off.  But I feel we were generally lucky as well.

So for your example, you'd want to know how much a different and less expensive house would have appreciated during the same time period. That's the appropriate comparator for whether you were better off buying that house vs another. And from your profit, you'd have to subtract the extra taxes, interest, and insurance you paid relative to that cheaper house you did not buy to compare it to the profit you would have realized from owning and selling the other house instead.

[forummm]

Sort of an aside. Another thing about the mortgage interest deduction is that it's really more beneficial to higher income earners and people who spend more on housing. For example, although we both work and each make decent (but not amazing) money, and we also took a cash-out refi on the house recently, our total mortgage interest plus our state income and property taxes, etc, are not high enough on their own to exceed the standard deduction we get! So it doesn't benefit us at all on our federal taxes unless we make very large charitable contributions. That's what we get for buying a very reasonably priced house :)

[mm1970]

Yes, it's only a deduction. You are still out the money you are spending--

phew!  OK, I thought I was going crazy or something. 

Thanks for the help all.  With regards to appreciation, I believe more in my sweat equity than the performance of the short term real estate market, so I'll keep my money in long term stocks....after paying the tax man.  We did very well on this last house sale, without even planning on it, just by consistently working on simple value-add projects in the house.

I may be wrong (it's totally possible), but your income matters.  We started getting hit with the AMT recently, which lessens our effective mortgage deduction. We live in a HCOL area, and I think our first year, our mortgage interest the first full year was something like $30,000.  It's gone down since then due to refi and paying down the mortgage.  But we go through all the tax math and then get hit with the AMT to the tune of several thousand a year.  So say that one year our taxes were reduced by $13k (that's a number that sticks in my brain).

Well now our income is such that we end up paying several thousand in AMT, so we aren't getting the full deduction.

[phwadsworth]

My experience buying a home for more money than we originally planned happened as follows:

We bought into the school district
We bought into the better location (cul de sac, corner lot, quiet street)

We paid 212,000 for the home at 3.25%
2 years later (almost exactly) we sold the house for 229k.  We received an offer within 24 hours of listing it.
After paying the realtor we profited 12k. 

So buying larger, in an appreciating neighborhood can pay off.  But I feel we were generally lucky as well.

So for your example, you'd want to know how much a different and less expensive house would have appreciated during the same time period. That's the appropriate comparator for whether you were better off buying that house vs another. And from your profit, you'd have to subtract the extra taxes, interest, and insurance you paid relative to that cheaper house you did not buy to compare it to the profit you would have realized from owning and selling the other house instead.

^^ this ^^
This is exactly the math I always try to do out with people and no one (except mustachians, it seems) gets it.
We just sold our current house for $112k more than we paid for it 5 years ago.  Wow, we "made so much money!" according to the same people who say we should buy a more expensive house next time to "get a bigger deduction".

  But, I figure we lost about $60k when we include the taxes, interest, insurance, fees, etc.  The good news is if we had rented a place not-quite-as-nice as this we would have spent about $100k in rent.  So, I consider our housing decision a good one, but certainly not profitable.  Before this forum though, I haven't found other people who do the math this way.  So, ya'll are as stupid/crazy as me I guess.

[forummm]

My experience buying a home for more money than we originally planned happened as follows:

We bought into the school district
We bought into the better location (cul de sac, corner lot, quiet street)

We paid 212,000 for the home at 3.25%
2 years later (almost exactly) we sold the house for 229k.  We received an offer within 24 hours of listing it.
After paying the realtor we profited 12k. 

So buying larger, in an appreciating neighborhood can pay off.  But I feel we were generally lucky as well.

So for your example, you'd want to know how much a different and less expensive house would have appreciated during the same time period. That's the appropriate comparator for whether you were better off buying that house vs another. And from your profit, you'd have to subtract the extra taxes, interest, and insurance you paid relative to that cheaper house you did not buy to compare it to the profit you would have realized from owning and selling the other house instead.

^^ this ^^
This is exactly the math I always try to do out with people and no one (except mustachians, it seems) gets it.
We just sold our current house for $112k more than we paid for it 5 years ago.  Wow, we "made so much money!" according to the same people who say we should buy a more expensive house next time to "get a bigger deduction".

  But, I figure we lost about $60k when we include the taxes, interest, insurance, fees, etc.  The good news is if we had rented a place not-quite-as-nice as this we would have spent about $100k in rent.  So, I consider our housing decision a good one, but certainly not profitable.  Before this forum though, I haven't found other people who do the math this way.  So, ya'll are as stupid/crazy as me I guess.

I don't know. We're all rich, or about to be rich at pretty young ages, and doing whatever we want with our lives. If that's stupid/crazy, sign me up! :)

[NaturallyHappier]

The original poster mentioned that they are in the highest tax bracket.  That means they are paying AMT which pretty much counteracts any deductions.  I know this because this has been my situation.  If you increase the deductions the AMT goes up by about the same amount you would have saved.

[waltworks]

My experience buying a home for more money than we originally planned happened as follows:

We bought into the school district
We bought into the better location (cul de sac, corner lot, quiet street)

We paid 212,000 for the home at 3.25%
2 years later (almost exactly) we sold the house for 229k.  We received an offer within 24 hours of listing it.
After paying the realtor we profited 12k. 

So buying larger, in an appreciating neighborhood can pay off.  But I feel we were generally lucky as well.

Erm, your closing costs, taxes, and realtor fees were only $5k on a $229k sale?

Wow.

To be fair, too, assuming inflation ran 2% or so in that time period, you really made nothing.

-W

[tvan]

My experience buying a home for more money than we originally planned happened as follows:

We bought into the school district
We bought into the better location (cul de sac, corner lot, quiet street)

We paid 212,000 for the home at 3.25%
2 years later (almost exactly) we sold the house for 229k.  We received an offer within 24 hours of listing it.
After paying the realtor we profited 12k. 

So buying larger, in an appreciating neighborhood can pay off.  But I feel we were generally lucky as well.

Erm, your closing costs, taxes, and realtor fees were only $5k on a $229k sale?

Wow.

To be fair, too, assuming inflation ran 2% or so in that time period, you really made nothing.

-W

We didn't pay closing. I used the word profit incorrectly. What I should have said is that we essentially paid half of what we would have in rent to live in a great place.

[Dicey]

What I should have said is that we essentially paid half of what we would have in rent to live in a great place.

Now you're on the right track!

Edit: Fixed quote.

[Arktinkerer]

....
We turned our old homes into rentals and that worked pretty well for us.  The additional benefit is you have a place to live and it is a very short commute to work!

Arktinkerer - was this technique for "generating rentals" always a side gig to your main income-generating job, or was there a tipping point where you had enough rentals that you could pursue this strategy in place of a "normal job"? (And if it did become the main gig, how long did it take?)

I am retiring this August from my "regular" job and we will be managing 8 rentals.  When we decided to do rental property we purchased one that I found for a bargain price. We then moved and turned a rural house into a rental (it was paid off).  When both I and my wife decided we were ok with handling rental properties, we then pushed ahead to quickly get a total of 5.  We did this so that should even two become vacant at the same time, the other 3 would pay the mortgages.  A year or two later we moved again and converted that home into a rental as well.  The conversions to rentals do have some complex issues with setting the basis since we did most of the work ourselves.  One of the people I mentioned was ex-military and executed his plan to use his VA mortgage rights to the hilt buying homes, improving them, and converting them to rentals as fast as the rules would let him.  Been a while but I think he was doing quite well some years back.  Don't know how or if he weathered 2008 though.

[Chris22]

The reason you consider the deduction is when doing the analysis of whether to invest or pay off debt.  If you have a mortgage at 3%, and are in the 30% tax bracket, your effective mortgage rate is ~2%.  If you are comfortable investing in something other than AAA bonds you should beat 2% pretty handily.  The tax-adjusted rate lets you know your required rate of return.