Understanding the True Cost of Mortgage Interest: How Tax Deductions Affect APR
One of the biggest reasons for homeownership is the potential tax benefits associated with mortgage interest deductions. However, many people are not aware of how these deductions actually impact the true cost of their home loan.
In this blog post, we will explain in detail how mortgage interest deductions can affect your APR and the overall cost of your mortgage. We will also provide examples to help you better understand this concept.
The Impact of Tax Deductions on Your Mortgage Interest
When it comes to tax deductions, homeowners have an advantage over non-homeowners. This is because they are able to deduct the interest paid on their mortgage from their taxable income. But what does this mean for the overall cost of your mortgage?
Let's look at an example. If you are married and filing taxes jointly, the standard deduction for 2024 is $29,200. Using this information and a loan amount of $600k with an interest rate of 6.5%, we can calculate that the first year's mortgage interest would be $39,000 - which is $9,800 more than the standard deduction. In this case, it would be more beneficial to itemize your deductions.
To calculate the value of this deduction, we multiply the additional amount (in this case $9,800) by our current marginal tax rate. Assuming a family income of $250,000 in 2024 and a tax bracket of 24%, the deduction would be worth $2,352 ($9,800 x 0.24 = $2,352). This amount is then subtracted from the annual interest cost of $39,000, resulting in a net interest cost of $36,648. When we divide this by the loan amount of $600,000, we get a net APR of 6.1%. This NET APR is actually lower than the stated loan APR of 6.5%, meaning that the tax benefits of having a high mortgage interest can reduce the true cost of the loan.
In the following table, we've outlined a comparative snapshot of various mortgage scenarios based on differing interest rates and loan amounts. Use this as a reference to better understand where your own mortgage might fall in comparison to our example. The yellow higlighted areas show a possible benefit for single tax filers while the green shaded area reflects the higher threshold needed to benefit married filing joint filers.
Note: Current tax law under TCJA limits this benefit to a $750,000 mortgage. If you have a mortgage balance over $750,000, use the numbers in the $750,000 column for your own hypothetical calculations.
Factoring Future Changes in Tax Laws
The purpose of this exercise is to allow us to compare paying off a mortgage with other financial options. When we consider the APR of our home loan in comparison to other debts or investments, it's important to account for the NET cost of interest after factoring in the tax impact.
To illustrate this point further, let's look at what may happen in 2026 if the Tax Cuts and Jobs Act (TCJA) expires. The standard deduction for married couples filing jointly may decrease to $12,700. Using this information and a loan amount of $600k with an interest rate of 6.5%, we can calculate that the first year's mortgage interest would be $39,000 - which is $26,300 more than the standard deduction. This means that in this scenario, itemizing deductions would still be more beneficial.
To calculate the value of this deduction, we follow the same process as before - multiplying the additional amount of $26,300 by our current marginal tax rate. Assuming a family income of $250,000 in 2026 and a tax bracket of 25%, the deduction would be worth $6,575. Subtracting this from the annual interest cost of $39,000 results in a net interest cost of $32,425. When we divide this by the loan amount of $600,000, we get a NET APR of 5.4%. This is significantly lower than the stated loan APR of 6.5%, highlighting the impact of tax deductions on the true cost of a mortgage.
Refer to the table provided to understand how varying mortgage interest rates and loan amounts can impact the annual cost of your mortgage. The highlighted portion has been changed from the previous table to convey the additional benefit to homeowners should the TCJA expire in 2026. It is important to keep in mind that tax laws are constantly changing, so it's crucial to stay informed and regularly review your mortgage and other financial options.
If TCJA expires, the mortgage interest deduction will become more beneficial for both smaller loan amounts and higher loan amounts.
Note: If TCJA is allowed to expire, the table will expand from $750,000 of allowable mortgage balance to $1,000,000.
Considerations for Homeowners
Understanding the true cost of your mortgage is crucial when making decisions about paying off debts or investing. It's important to not only consider the current NET APR, but also how changes in tax laws could affect your net interest cost in the future.
As we have seen, the potential tax benefits associated with mortgage interest can potentially reduce the true cost of a loan. This provides an incentive for taxpayers to not pay off their home loans early, unless it is the best use of their free cash flow.
In conclusion, homeowners should carefully consider the net cost of a mortgage when making financial decisions. By understanding how tax deductions impact APR, you can make more informed choices about your mortgage and other financial obligations.