If you have a mortgage loan, you are well aware of the tax deduction you get each year for the interest. Once per year, all that interest you pay to your bank gives you a benefit as well. By strategizing your monthly payment schedule, you can further benefit from the tax savings available from the mortgage interest deduction.
After the first of the year, your bank will send you a 1098 form itemizing the total interest you paid in the current year. It is measured by the calendar year, not the amortization schedule. What this means is that if you make your January payment now—being sure it posts to your mortgage before Dec. 31—the interest from that extra mortgage payment will count toward this year’s deduction.
Why Pay Early
Technically, the January payment covers interest that accrued during the month of December, making it eligible for this year’s tax accounting. Paying any further in advance would be considered “pre-paid” interest, making it ineligible for this year’s tax deduction. If your loan payment includes monthly mortgage insurance, then your savings will be even greater because mortgage insurance is also tax deductible.
Of course, if you do this strategy now, you will have less of a deduction for the next year. Conventional wisdom, considering the time value of money, says to take savings now rather than later, if all other factors are equal. But consider the possibility both ways. If you had or expect a large change in your income from one year to the next, that would be a reason to choose to pull the savings into this year, or to defer it to next year.
How to Make an Extra Mortgage Payment
If you plan to make an extra mortgage payment before the end of the year, make sure you communicate your intentions clearly with your bank. Sometimes banks assume that an extra mortgage payment, made ahead of schedule, is intended as a principal reduction. While there are advantages to making extra principal payments as well, it does not benefit you on your tax bill.
If you have a coupon book for your mortgage, you should be able to send in a future payment with the appropriate coupon and a note asking for it to be applied to your mortgage immediately. If you receive a monthly bill for your mortgage, then you will have to mail your payment even if you haven’t gotten the bill yet. Include very clear instructions with your check, or better yet, go into a local branch if your mortgage lender has one. If your mortgage is set up on an automatic payment withdrawal, you will need to clarify that your check supersedes the next month’s auto-draft.
Not Always an Advantage
Before you make an extra mortgage payment, keep in mind that not all mortgages have tax deductible interest. Typically, mortgage interest on an owner occupied home is deductible, while the interest on a rental property can be counted as an expense against rental income. Interest on a second home or vacation property is typically ineligible.
There may be a cap to the maximum amount that can be deducted based on the specifics of your loan and the state you live in. If you are unsure, it is always a good idea to talk with your tax advisor to see if you face any restrictions in mortgage interest deductibility.
Update: Consider seeking the advice of a financial advisor before you make this or any other significant financial decision. So many people reached out to us saying they wanted help with financial planning, that we built a tool to match you with a financial advisor who can meet your needs. First you answer a series of questions about your situation and your goals. Then the program narrows down thousands of advisors to three fiduciaries who meet your needs. You can 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 doing much of the hard work for you.
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