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All About the Mortgage Interest Deduction

Update: The Trump tax plan impacts the mortgage interest deduction. It will limit the deduction to mortgages under $750,000. The plan is not retroactive and so only affects loans going forward.

Unless you can afford to buy a home with cash, you’ll be paying some interest on a mortgage if you decide to go from being a renter to being a homeowner. Paying interest to a bank is no one’s idea of a good time. The good news, though, is that with the mortgage interest deduction the IRS lets you deduct that mortgage interest from your taxable income when you file your tax returns.

How the Mortgage Interest Deduction Helps

The mortgage interest deduction takes some of the sting out of owning a home and having to make monthly mortgage payments. Just as landlords can deduct mortgage interest on rental properties they own, so can regular folks deduct mortgage interest on the home or homes they buy. Taxpayers who itemize their deductions can deduct their mortgage interest on up to $1 million of debt from a home purchase, plus up to $100,000 of debt from a home equity loan. The deduction doesn’t have to be for your first home or primary residence. It can be for your ski lodge or beach cottage, too.

The mortgage interest deduction was designed to encourage homeownership. Although American homeownership rates are no higher than comparable countries that don’t offer a mortgage interest deduction, our tax break has achieved hallowed status. Many think that eliminating or reforming the mortgage interest tax deduction would be politically impossible. That’s a shame, say critics of the deduction.

What the Critics Say

Critics have a lot to say about the mortgage interest tax deduction. For one thing, they say the deduction favors the rich. Actually, any itemized tax deduction is more valuable the higher your tax bracket. Unlike a tax credit, a tax deduction is more advantageous the higher up the income ladder you go. If your top tax rate is 37.5%, a $1,000 reduction in your taxable income is more valuable to you than to someone who tax rate is 15%.

Plus, because wealthier people buy more expensive homes and because the mortgage interest tax deduction is available on second homes and vacation homes, rich people can reap some serious benefits from it. Research shows that most of the benefits of the mortgage interest deduction go to wealthy families. Those who think the tax structure should do more to help money flow to less advantaged Americans take issue with this.

Another criticism of the mortgage interest deduction is that it doesn’t achieve its stated goal of increasing home ownership among middle-income Americans. Most low- and middle-income Americans don’t itemize their deductions, so they don’t take advantage of the mortgage interest deduction. For most of these folks, the Standard Deduction provides a bigger tax break than itemizing and taking the mortgage interest tax deduction would. Critics say the deduction doesn’t encourage responsible, affordable homeownership among the middle class. If anything, it encourages middle-class and working-class families to go for “reach” houses and take out bigger mortgages. The financial crisis showed us why that can be dangerous. And because most of America’s lowest-income citizens are renters, not buyers, the mortgage interest deduction doesn’t provide them any benefits.

Why It Matters

All About the Mortgage Interest Deduction

Aside from being an interesting tax policy debate (if you like that kind of thing), the controversy around the mortgage interest tax deduction could have big practical implications. If it is reformed, for example to limit the deduction to a filer’s primary residence, some people will face a bigger tax bill. The current mortgage interest deduction costs the US government over $70 billion in lost tax revenue. Reforming the deduction or replacing it with some kind of affordable housing tax credit could help address budget deficits.

The Congressional Budget Office (CBO) has recommended gradually replacing the current deduction with a 15% nonrefundable tax credit. Under the CBO proposal, the maximum amount of mortgage debt that would be eligible for inclusion in the credit calculation would be $500,000. The credit could be applied only to interest on debt used to buy, build, or improve a first home. No more tax breaks for mortgages on beach getaways. Still, reforming the mortgage interest tax deduction isn’t exactly a high political priority. If you’re buying a new home and you’re looking forward to the deduction, rest easy.

The Takeaway

All About the Mortgage Interest Deduction

When pondering the rent vs. buy decision, consider the whole picture, not just the mortgage interest tax break. Think about what your monthly payments will be, about closing costs, transportation costs and maintenance costs. The bigger your mortgage and the higher your income, the more valuable the mortgage interest tax deduction will be to you. That’s not to say that you should buy the most lavish house you can possibly finance. Learn from the past and stick to the comfortable affordability limit when you’re making the jump to homeownership.

Tips for Buying a Home

  • Make sure your credit score is in good shape. With a high credit score, you can get lower mortgage rates, which translates to lower monthly mortgage payments.
  • Talk to a financial advisor about how buying a home will factor into your larger financial plan. You want to ensure you can purchase a home without sacrificing your other financial goals. A matching tool like SmartAsset’s SmartAdvisor can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three fiduciaries who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.

Photo credit: © iStock/GetUpStudio, © iStock/Catherine Lane, © iStock/emmgunn

Amelia Josephson Amelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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