Using Mortgage Interest as an Itemized Deduction

What is mortgage interest? It is any interest you pay on a secured loan when you bought your first or second home. The loans include the mortgage to buy your home, a second mortgage, a line of credit or a home equity loan. The loan must be secured debt or it will be considered a personal loan and the interest is not deductible.

For the average consumer who has managed to acquire credit card debt, car loans, and various other small debts, is the mortgage interest, especially with an interest only loan an answer to mortgage interest deductions and the elimination of non-deductible interest?

What options does the average consumer have in accommodating the tax need in relation to the housing need? What about the interest only loan option on a new house mortgage? Today’s housing and mortgage market has seen a tremendous growth in mortgage packages, variety and amount. The mortgage interest deductible on the interest only loan option, once thought to have gone the way of the Edsel automobile, is back today and in use by the masses. The mortgage market has seen an unbelievable increase in the interest only loans from just a mere sliver of the market a few years ago, to around 25% of the market share today. That’s huge growth, especially when you talk less than five years to experience that growth.

What benefit does the mortgage interest (especially the interest only loan) bring to the table, and does this benefit the homeowner as a taxpayer? This is one question the mortgage lender probably won’t be able to answer for you, and one you probably won’t think to ask. But you should, because it’s one question that can make a difference to you and to your federal tax return and the amount of the mortgage interest that will actually provide you with a federal income tax deduction. A mortgage interest deduction is one of the best financial reasons to purchase a home. Who gets the deduction? You do, if you are the primary borrower, legally obligated to pay the debt and actually make the payments. If you are married and both of you signed the loan then both of you are the primary borrowers.

The interest only loan and the amount of interest you can deduct on your income tax return are one and the same if your income levels are low enough; the concern for the average consumer is the total dollar value they get to take off their tax return. Quite often, the deductions for the consumer aren’t enough to contribute to the bottom line, because the income level the percentage of deductible interest is calculated on is simply too high. Higher dollar amounts in interest will usually mean a greater possibility of a greater deduction. There can be limits to the tax deduction. Your tax deduction is limited if all mortgages on your home are either more than the fair market value of your home or more than one million dollars ($500,000 if married and filing separately)

The greater deduction would be the only advantage to the interest only loan as far as the taxpayer is concerned, unless of course, they use the money saved from the interest only loan to fund a 401k, an IRA, or an MSA (that’s a topic for a completely different paper). The mortgage interest and especially the interest only loan is sold to the consumer as a way to afford more house, pay off credit card debt, or provide a means to fund a savings of some kind, and if that’s true, it can be used for that purpose. And if you’re considering paying off those high interest credit cards, the mortgage interest you’re charged on the interest only loan is fully tax deductible, while the credit cards are not; a word of caution, however, make sure you don’t turn around and use those credit cards again, putting yourself right back where you started from, just with a bigger interest payment and less house equity.

Why has the market experienced such growth? It’s not totally related to the income tax benefit; the home mortgages of today satisfy a common desire for the consumer: instant gratification of bigger and better. Such is the case when it’s time to make those needed repairs, or house expansion. A second mortgage makes it possible to retain the same monthly mortgage payment, and still pull a lot of equity out of your home. This may sound like the ultimate solution, but is it really? It also adds to the amount of interest an individual can deduct at the end of the year; and if income levels are growing, the interest expense must grow in order to keep up. Now, this is a somewhat skewed way of looking at the benefit of a mortgage, but it figures right into the same scheme as the elimination of credit card debt and saving for 401(k) s as a valid reason to borrow money against your home.
Remember that your home mortgage must be a secured loan from your main home or second home. No deduction can be made for a mortgage from a third home, fourth home and so on. The mortgage and the resulting interest are great tools, when used by the right people, in the right situation. For the average consumer and long-term homeowner, unless you think a better deduction on your tax return is worth the forfeiture of equity in your home, you’d better think twice before re-financing with a second mortgage that generates more interest, but less equity.