(This is the third in a series of blog posts on Personal Finance Fallacies. Stay tuned for at least two more posts in the series, released every Wednesday at 9:00 AM MDT.)
Did you ever read that poem "Smart" by Shel Silverstein? Here are the first few lines:
My dad gave me one dollar bill
'Cause I'm his smartest son,
And I swapped it for two shiny quarters
'Cause two is more than one!
Most people with any common sense can recognize the mistake this "smart" young man made. He feels like he's growing his money when in reality he's losing money.
Unfortunately, a lot of "sophisticated" people make this same mistake with their mortgages.
It's sad, but very true. Some people have the funds to pay extra on their mortgage in an effort to pay it off early and save on interest. (Which, by the way, would be a very wise thing to do!) However, they choose not to. Why? Because they'll lose the tax benefits, that's why!
Here are the tax benefits: if you itemize on your taxes instead of taking the standard deduction, you are allowed to deduct mortgage interest. This means that your taxable income decreases; therefore, the amount of taxes you pay decreases.
Sounds good on its face, right? (But then again, so does trading one item of value for two items of value, like in the poem...)
Here's where the logic breaks down: let's say that you could pay extra on your mortgage, which would save you $1,000 in interest. But instead, you choose to go ahead and pay the mortgage as usual, and pay the $1,000 in interest. At tax time, you decide to itemize, and that extra $1,000 is deducted from your taxable income. Because of that extra deduction, depending on your tax rate, you save about $300 in taxes.
Did you spot the problem? You paid $1,000 in interest to the bank, so that you could save $300 on your taxes.
Gosh, that's even worse than trading a $1 bill for two quarters!
Just wait. It gets worse.
Notice I stated that you get that deduction if (and only if) you itemize on your taxes. Most people take the standard deduction. If you are intentionally keeping your mortgage payments to save on taxes, but then turn around and take the standard deducting instead of itemizing, then you did this "sophisticated" tax-saving strategy for nothing! You paid $1,000 in interest to the bank, so that you could save $0.00 on your taxes.
Yep. See? It got worse.
Historically, most people have taken the standard deduction. But have you heard that the standard deduction increased starting in 2018? That means even fewer people will want to itemize their deductions, creating even less of an incentive for most people to unnecessarily keep their mortgage.
Here's the bottom line: you would never trade $1,000 for $300. But that's exactly what this fallacy is trying to make you do. If you have the ability to pay down your mortgage faster, go ahead and do it! Your interest savings will far outweigh any tax "benefits" you might (or might not, if you use the standard deduction) get.
(Here's a video from the National Association for the Self-Employed, explaining how we should never spend money for a tax deduction.)
(If the video doesn't work, click this YouTube link to watch it directly on YouTube.)