Aug. 26, 2005 - Fuzzy Math

I received an email the other day that contained a common error I see all too often.  The error has to do with the federal tax deduction for home mortgage interest.

The reasoning starts out on solid, logical footing like this:

1.  I get a tax break on the interest expense from my home mortgage.

2.  The more I borrow, the greater the amount of interest I will pay.

3.  The greater the amount of interest I pay, the more I will save on my taxes.

So far, so good.  These are all true statements.

The problem comes with the goofy conclusions some people make based on these facts.

"I should borrow as much as possible so I can get a bigger tax break."

 

"I shouldn't pay off my mortgage early because if I do, then I will lose out on the tax break."

There is just enough truth in these statements to convince many people to take the wrong action.  What is missing, however, is a simple mathematical reality.

The federal tax brackets for 2005 are 10%, 15%, 25%, 28%, 33%, and 35%. 

That means it is impossible to recoup the full cost of your mortgage interest expense with tax savings.

For example, if you are in the 25% tax bracket, then for every $1.00 you spend in deductible mortgage interest, you can save 25 cents on your taxes.  In the 35% bracket you can save 35 cents.  That is the maximum.

Therefore, taking on mortgage interest expense just for the sake of the tax deduction is never a winning proposition.

Don't see it yet?  Try looking at it this way.  For every $1.00 you give to me, I will return 25 cents to you.  Sound like a deal?  I didn't think so.  That's exactly how the tax break pans out.  Yet more than a few people miss this important point. 

Don't let the lure of tax savings lead you into a poor financial decision.