Did you know if you were a company and borrowed money that the interest you pay is a tax write-off? So imagine you borrowed $1 million to finance a new project and had to pay 5% interest. Your interest payments are considered an expense worthy of a tax deduction. Finance departments factor this tax advantage into their calculations when determining whether to borrow money or raise money from investors to finance a project.

But you’re also familiar with this if you’ve ever bought a home or taken out a student loan. The interest paid is a tax deduction for you as well. For the purposes of this post we’ll focus on the tax deduction you get from a mortgage. Is there a way to calculate how much money is saved this way? Of course.

Pretend you have mortgage worth $200k at 6% interest and your effective tax rate is 30%. (Assume you make one payment a year for simplicity). Since the interest is tax deductible your effective mortgage interest rate can be calculated as X*(1-T) where X = the interest rate on your mortgage and T is the tax rate. For this mortgage the effective interest rate is actually 4.2%. The tax deduction makes it cheaper to buy a house.

Proponents of the tax deduction say it encourages home-ownership. I find that hard to believe as only a few people would be in make it or break it mode with the tax break. In the example about the mortgage payment is $1199.10 but with the effective rate reduction your tax reduced payment is $978.03. While $221 sounds like a lot it really isn’t. And if a difference of $200 makes or breaks a house for you, you’re buying too much house. Opponents of the interest rate tax deduction say that only a select few would actually be in make it or break it mode with this tax deduction.

So who does it help? As a future home-buyer I suspect it will help me. But it also helps the wealthy. Do I need help, probably not. Do wealthy people? You tell me. So what we’ve got is a government program that puts tax revenue back into the hands of people that can afford to buy a house. I’m just not sure why this thing exists.

Don’t get me wrong, I’m cheap and will take any tax deduction that is thrown my way. But if this thing didn’t exist I wouldn’t miss it. And as much as you think you would, you wouldn’t. In most countries the deduction doesn’t exist.

There’s another problem with the mortgage tax deduction. In 1986, the tax code was altered to disallow interest rate deductions on personal loans such as credit card balances. However loans based on the equity of your home (HELOCs and HELs etc) still had tax deductibility. As we all know, people used these loans liberally to subsidize their lifestyles in the mid 2000s. So people were able to use the HELOC to buy a car at a reduced interest rate and further reduce the rate via a tax deduction. Hello loophole.

But finally there’s something else. The deductibility doesn’t even matter all that much to many people because of the standard tax deduction you can take in the US in place of itemizing. Many folks are better off using the standard deduction instead of itemizing, and come out ahead because of it. But for the wealthy who pay even more in interest due to high loan balances, their deduction is higher. This bolsters the idea that the tax cut benefits the wealthy, and many in the middle class miss out.

So why is interest tax deductible? Hell if I know.

Photo: daryl mitchell

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categories: banking, government, loans, personal finance