Deductible: Home Mortgage from a Tax Perspective
You've heard your parents mention it a hundred times: The Mortgage. If they're average Americans, it's likely their biggest expense, other than... you. What is it? It's the loan they took out to buy the roof over your head. A home might have cost 300 grand—but mom and dad had to borrow 200 grand to pay for it.
A home is "just" another investment—but in America, there is one key special feature about the way home loans are viewed by the government: The interest cost on that loan, if it is specifically to buy a home, is... deductible.
Okay, another vocab word: Deductible. The concept means that mom and dad can deduct the cost of the interest on the loan (not paying back the principal—just the interest) from their taxes... as if they had simply earned less.
To wit (and using very simple math that's in the zip code of realistic, these daze): Together mom and dad make $120,000 a year: she's a school teacher; he's a coach, and they do a little work on the side. Overly simply, their marginal tax rate is 25%. That is, on the last dollar they make, they only keep 75 cents and 25 cents goes to Uncle Sam and gang. Said differently, of the 120,000th dollar they earn, they keep only 25 cents.
But wait. They have a mortgage. The mortgage is for $200,000 and they pay 6% interest on it or $12,000 a year. (Fancy math... 200,000 x 0.06 = 12,000.) The monthly payments are likely more than a grand a month because they also have to pay down the principal they borrowed on the loan. But that part isn't deductible. The grand of interest, however...is.
So as far as the IRS is concerned, Mom and Dad don't really make $120,000 a year. At least for tax purposes. Rather, they make $108,000 a year. See how we... deducted that 12 grand from the 120? Clever.
So let's say that their average tax rate was 20% over the entire amount of their earnings (and remember we live in a graduated tax world where they pay zero on the first 10 grand or so of earnings, then 10ish% from 10 grand to 20 grand, and 15% from 20 grand to 35 grand.... and so on—the numbers change every few years but you get the basic idea here).
So the average is 20% on $120,000, forgetting the mortgage part. In that case, they would pay $24,000 a year in taxes. One slightly used Prius per year.
But instead, because the interest of $12,000 is deductible, they pay taxes on $108,000 a year (and the true average will be a bit less because of the graduated tax system we live in, but that complicates things a bit much for this example). So let's apply that 20% figure to the $108,000 and their taxes are .2 x 10800 = $21,600.
So wait. What happened here? They "saved" a difference of $2,400 in taxes by having that mortgage—on an after tax basis, the mortgage didn't really cost them interest of $12,000. Instead, with the deductible mortgage interest credit, it cost them $9,600 instead. That's the magic of tax deductibility. And the richer you are (i.e., higher marginal tax rate you pay), the more attractive it is to find those tax deductions.