How To Calculate Your True Mortgage Interest Rate

The mortgage interest tax deduction is one of the major selling points realtors love to highlight when trying to get you to pull the trigger on a new home.  “Sure, the mortgage interest rate is 6.5%,” they’ll say, “but it’s tax-deductible, so your true after-tax interest rate is only 4.55% since you’re combined federal and state marginal tax rate is 30%!  You’d be a fool not to buy the largest house you can afford with a rate that low!”

A 4.55% after-tax rate on your mortgage sounds great, right?  It is.  Too bad you’ll never get it in real life.

Remember The Standard Deduction?

Remember the Standard Deduction?  It’s a deduction everybody who doesn’t itemize their deductions gets for free, and it’s

• $5,700 for single filers
• $8,350 for head-of-household filers
• $11,400 for married joint filers

What does that mean for you?  In practice, it means you only get to take deductions that exceed the standard deduction.  That means for a single filer, you won’t see any tax benefit at all for the first $75,000 of home you buy, since a $75,000 will throw off just under $5700 in mortgage interest over the course of a year at 6.5%.  The threshold is even higher if you have a lower nominal rate.  That means for a single person, you’re only getting a tax benefit on about half your mortgage interest on a $150,000 home at 6.5%!  Instead of 4.55%, your after-tax mortgage rate works out to about 5.525%.  Not quite as rosy, is it?  But this is a trick real-estate “experts” love to use.

It Gets Worse For Married Filers

Okay, so going from 6.5% to 5.525% is still a pretty decent discount.  But for married filers, it gets much worse because the standard deduction is twice as high.  Thus, you’d have to pay twice as much interest as a single filer to see even a cent of your tax benefits.  At 6.5%, that threshold is about $150,000.  At 6.0%, the threshold is even higher at about $160,000.  If the median American home value in 2009 was $215,000 (U.S. Census data, open as PDF in another tab), that means the median American family is only really able to deduct the interest on somewhere between $50,000-$70,000 worth of home, or only about 23% of the total.  Think about that, the median American family is only able to deduct about 23% of the value of their mortgage in the first year.  And to make matters worse, the percentage of your payment going to interest decreases dramatically over the years, meaning many families will get no tax benefit at all after being in their homes for a decade or so.  Of course, the picture gets brighter when you ad up all the tax deductions related to children, education expenses, student loan interest, etc but I’d be willing to bet most Americans are lucky to be able to deduct more than 50% of their mortgage interest.

So next time you hear mortgage interest is tax-deductible, don’t forget to adjust for the standard deduction.  It makes no sense to count a deduction you would have gotten anyway no matter what as an “advantage” of paying mortgage interest.