The First of the "Big Three" of Itemized Deductions ― Mortgage Interest Expense

We have focused on the fact that interest expense on the mortgage indebtedness on our home is an Itemized Deduction.  It is not the entire mortgage payment that constitutes an Itemized Deduction, just the interest expense.  When we mortgage finance the purchase of our home over 15 or 30 years, the mortgage payments are broken into two component parts: the principal amount borrowed and an interest expense on that principal.

I will explain this next point in greater detail under the Home Ownership section of the book, but we will generally pay our mortgage payments on a monthly basis and the monthly payment will be exactly the same (in the case of a fixed rate mortgage) or approximately the same (in the case of an adjustable rate mortgage) over the 15 or 30-year term of the mortgage.  In the earlier years of the mortgage, because there is more unpaid principal outstanding, more of your monthly mortgage payment will be interest and less will be principal.  In the later years of the mortgage, when there is less unpaid principal outstanding, more of your monthly mortgage payment will be non-deductible principal and less of it will be deductible interest expense.

Example:  Mark and Debbie take out a 30-year mortgage to finance the purchase of their home.  The principal amount borrowed from the Bank is $100,000 and the rate of interest is fixed at 7% over the life of the mortgage.  The monthly payments will always be $665.  Although $100,000 was borrowed, approximately $239,400 ($665 times 12 months times 30 years) will be repaid to the Bank.  Thus, there will be a total of $100,000 of principal repaid to the Bank and $139,400 of interest paid to the Bank over the life of the mortgage.

In the first year of the loan, the couple would make total payments of $7,980 ($665 times 12 months).  Of those first year payments, approximately $7,000 of the $7,980 will be interest and $980 will go to pay down principal.  In the final year of the 30-year mortgage, the situation will have reversed itself. Of the final 12 monthly payments of $7,980, about $300 will be interest expense with approximately $7,680 being non-deductible principal repayment (go to my Web site at http://www.personal.kent.edu/~maltieri/web/guide/home.htm, click on Home Ownership and Financing and then Mortgage Tools to fine-tune this analysis).

Therefore, every year the amount of your deductible mortgage interest expense will vary.  The Bank from which you have obtained the mortgage will send you a Form 1098 that will specify how much of your total mortgage payment for the year constituted mortgage interest expense.  So each year the Bank will give you the exact number of your mortgage interest expense that you can deduct if you are an itemizer.

NOTE:  Additional information may be necessary for you to more fully understand the tax law and competently file your federal tax return.  Luckily there is plenty of easy to understand information enabling just that.  If you are an itemizer, you must file the regular Form 1040.  The Instructions to the Form 1040 are very helpful, providing examples, worksheets and clear directions in a simple language format.  Additionally, the Instructions frequently reference IRS Publications.  IRS Publications are small booklets dealing with specific tax topics. For example, Publication 530, Tax Information for First-Time Homeowners and Publication 936, Home Mortgage Interest Deduction, provide more detail than I will give you on the mortgage interest expense deduction.  The IRS Publications are comprehensive, well written and readily understandable.  They are not overly technical and have been written so as to make complex tax concepts understandable to non-tax savvy readers.  As an additional bonus, the Publications generally are well‑indexed and are full of helpful examples.  You can find all of the IRS Publications on-line at my Web site http://www.personal.kent.edu/~maltieri/web/guide/home.htm (click on Tax Planning and then IRS Publications).  Also, many IRS Publications are available at your local library.

Frequently you will want to print documents off the Web.  With larger documents like the IRS Publications, you may need a free computer program called Adobe Acrobat.  If you don't already have Adobe Acrobat on your computer, go to my Web site, click on Miscellaneous and then Adobe Acrobat and follow the download instructions.

Points

Another element of deductible mortgage interest expense that may be available to you is your payment of "points."  If you pay points on your mortgage, you only pay them in the first year of the mortgage.  Points are prepaid interest expense and any points you pay will be noted on the Form 1098 you get from your Bank for the first year of the mortgage.  To the extent that you pay points on the home mortgage you use to first purchase your home (or points paid on a home improvement loan), you may deduct those points as home mortgage interest expense in the year that you pay them.  One point equals one percentage point, so if the mortgage loan is for $100,000 and there are three points paid by the borrower to get that mortgage loan, the borrower pays $3,000 (3% times $100,000) once only in the first year of the loan.

Example:  Mark and Debbie purchase a home and mortgage finance $100,000 of the purchase price.  The mortgage is a three-point loan on which they pay $3,000 of points once at the inception of the loan.  Mark and Debbie are itemizers.  They may deduct the $3,000 for the tax year in which those points are paid in addition to the other mortgage interest expense they pay that year on the mortgage.

Although I will discuss this further in the Home Ownership section of the book, different mortgage loans have different levels of points paid on them.  If you look at your Saturday or Sunday newspaper, the Home Section should list mortgages available from local mortgage lenders.  The list will show a variety of things including the type of mortgage, the rate of interest charged on the mortgage and the points, if any, charged in the first year of the mortgage.

You will note that some mortgages don't charge any points. Why would you pay points at the inception of the mortgage if you don't have to?  If you study the mortgage listings, you will note that the more points you pay at the inception of the loan, the lesser the rate of interest you will be charged over the entire term of the mortgage.  Thus, you can "buy-down" the mortgage interest rate by paying more points at the inception of the mortgage.  Is this a good idea?  It depends on how long you plan on staying in the home.  The longer you plan to stay in your home, the more sense it makes to buy-down the interest rate for the entire mortgage term by paying points up-front.

Example: Mark and Debbie, from the prior Example, again are mortgage financing the purchase of their home.  The amount of the mortgage loan will be $100,000 and the rate of interest is 7% if no points are paid.  If Mark and Debbie pay three points, they can obtain the same $100,000 loan with an interest rate of 6.25%.  The couple is quite sure that they will be moving after living in the home for about three years.  Which mortgage should they take out?  The 7% mortgage would require monthly payments of $665 whereas the 6.25% mortgage would require monthly payments of $615, a savings of $50.  Over a three-year period, the $50 savings a month will save them approximately $1,800 over the 7% mortgage.  However, to get the 6.25% mortgage, remember they had to pay $3,000 of points up-front.  Thus, the zero point 7% loan makes more sense if the couple will indeed be moving after about three years.

Points Paid When Refinancing a Home Mortgage

Under the Home Ownership section of the book we will talk some more about shopping for a mortgage and the logic of refinancing an existing first mortgage on your home.  But we must also broach the subject under our tax analysis for the following reason.  We have just noted that points that you pay on a home mortgage are generally deductible.  However, read the rule again a little more slowly.  It is points on a home mortgage used to purchase or improve your home that are deductible.  If interest rates have been going down and you have already purchased and taken out a mortgage loan of the fixed rate variety (discussed in detail under the Home Ownership section of the book), you may find yourself in a situation where you have locked yourself into a rate of interest that is substantially higher than what you could now obtain on a new home mortgage.  In this situation it may be highly advisable to refinance your home mortgage.

As is the case with any home mortgage, you can "buy down" the interest rate by paying points on the refinanced home mortgage.  However, now (unlike the mortgage you incurred on the initial purchase of your home) the points you pay on the refinanced mortgage will not be currently deductible.  Any points you pay on the refinanced mortgage are deductible but only in equal increments over the entire term of the loan.

Example:  Mark and Debbie refinance their old mortgage because interest rates have gone down and they no longer want to be locked into the higher rates of interest payable on their original home mortgage.  The refinanced mortgage is $100,000 repayable over 30 years. Mark and Debbie can pay no points and obtain a 7% rate or pay three points and obtain a 6.25% rate.  However, if they select the 6.25% mortgage and pay $3,000 in points, they can only deduct $100 in the current year ($3,000 divided by 30 years) and $100 a year for each of the next 29 years.

You see in the Example that the points paid on the refinanced mortgage are deductible but it will take 30 years (in the case of a 30 year mortgage) to fully deduct them. We get so little immediate deductible bang for the buck – in addition to the fact that we will probably forget to deduct the allowable amount in the future – that it usually makes much more sense to refinance with a low or zero point loan.

Home Equity Loans and Second Mortgages

A home equity loan (sometimes called an equity line of credit) constitutes a loan from a Bank that is also secured by a mortgage on your home.  A loan that is properly labeled a home equity loan looks a lot like the principle mortgage loan on your home.  That is, there is set term to the home equity loan with amortized (equal) payments, typically made monthly, for the duration of that term.  A true equity line of credit loan (as opposed to a home equity loan) would operate more like your standard Master Card or Visa-you could draw on it as needed, would not have to repay a set monthly payment, and would pay an interest charge on any unpaid principle outstanding for each billing (typically monthly).  For purposes of this tax analysis, I will initially refer to both types as home equity loans.

Since the home equity loan is a loan made in addition to the primary mortgage on your home, it is a "second mortgage" loan (your primary mortgage being the "first" mortgage loan).  The difference between a first and second mortgage is a matter of security on the lending Bank's part—if you default on your mortgage payments and your home is sold off to satisfy the debt, the first mortgage lender would be paid-in-full before the second mortgage lender would be paid a penny.

The great thing about home equity loans from a tax‑planning standpoint is that the interest expense paid on them is generally an Itemized Deduction along with the interest expense on the primary first mortgage.  This is true no matter what the home equity loan proceeds are used for.  More precisely, the tax laws allow for the interest expense on a home equity loan to be deductible to the extent it does not exceed the lesser of 1) the fair market value of the home minus the principal amount of the first mortgage (this is the equity in the home), or 2) $100,000.  We had better look at an Example to see how this would work.

Example: Mark and Debbie own a home with a fair market value of $200,000.  The principal amount outstanding on their first mortgage is $150,000.  Therefore, the couple has equity in their home of $50,000 ($200,000 minus $150,000).  Mark takes out a home equity loan for $25,000 from the Bank and secures it with a second mortgage on their home.  The purpose of the home equity loan is to provide funds for the purchase of a family automobile, to provide for the educational expenses of their children, or for some other personal purpose.  Normally the interest expense on a loan to finance personal expenses is nondeductible consumer interest expense (as noted below).  Here, however, the interest on both the first mortgage and the home equity loan is deductible by Mark and Debbie as an Itemized Deduction on their federal income tax return.

Another advantage of the home equity loan is that the Bank will charge you a significantly lesser rate of interest than it charges on your unsecured Master Card or Visa.  This is because of the security that the second mortgage on the home provides to the lender.

What are the risks?  If you are not a very disciplined borrower and you run up your home equity loan to the point of defaulting on it, the consequences are extreme.  Because of the security embodied in the second mortgage, the Bank could compel the sale of your house to satisfy the debt.  Conversely, if you default on your unsecured Master Card or Visa you may ruin your credit rating but you won't have your home taken away. I feel that people might be more subconsciously inclined to run up a home equity loan (particularly of the revolving equity line of credit variety) because they know that the interest expense is tax deductible.  This is a very foolish example of letting the tax tail wag the dog.  Such tendencies could lead you to lose your home as I just mentioned.

What is my suggestion?  If you are in legitimate need of a large additional sum of money and you have plenty of equity in your home, I would consider refinancing the first mortgage at a higher amount so that the desired excess borrowing can be distributed to you in cash.  This is particularly advisable if it makes sense to refinance your first mortgage anyway (see the discussion under the Home Ownership section at page 62 as to when it makes sense to refinance). If refinancing the first mortgage doesn't make sense, I would next recommend a true home equity loan, with set amortized (equal) monthly payments over a reasonable term of years.  Lastly, I suggest staying away from the equity line of credit type home equity loan unless you know for a fact that you are a well disciplined borrower who will not run up a significant balance on the account.

Consumer Interest Expense

In the Miscellaneous section of the book, I more completely detail problems and solutions relating to consumer debt.  Consumer debt is indebtedness that is incurred to purchase non-business, personal-use items.  Thus, when we finance the purchase of a family automobile through GMAC, that is consumer debt.  When we finance a refrigerator or television set purchased from Sears or some other vendor, the underlying debt is consumer debt.  Last, but certainly not least, the balance we run up on our personal MasterCard, Visa or Discover cards is consumer debt.

There are many obvious problems with running up excessive amounts of consumer debt other than the tax implications (again, I discuss these issues in the Miscellaneous section of the book).  With regard to our tax analysis, adding insult to injury is the fact that the interest expense on consumer debt (which often is at a very high rate because the underlying debt is frequently unsecured) is not tax deductible.