Mortgage deduction savings exaggerated

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Dear Dr. Don,
I still owe $100,000 on my house at an interest rate of 5.88 percent. I would like to pay off the mortgage, but people keep insisting that I shouldn’t because I’ll lose the mortgage interest deduction.

Do I really save money in the end? I’m in the 25-percent bracket. I feel I could save more by just paying it off and then saving the mortgage payment. The loan is for 15 years. How long can I take advantage of this tax break, if I am getting a tax break at all?
— Lilian Loan

Dear Lilian,
Yours is a classic question in personal finance. Are taxes the tail that wags the dog or are they just one of many variables to consider when deciding on a financial course of action? I lean toward the latter. You want to consider the tax impact of your financial decisions but not to the exclusion of all else.

The mortgage interest deduction does reduce taxes paid, at least to the extent your deductions exceed the standard deduction. But there’s still the after-tax cost of your debt to consider. Ignoring state and local income taxes, the effective (after-tax) rate on your mortgage, at the 25-percent income tax bracket, is approximately 4.41 percent. I say approximate because I don’t know all the details of your mortgage. You can get a better read yourself by using Bankrate’s “Mortgage tax deduction calculator.”

My rule of thumb in deciding whether you should prepay your mortgage is to compare the effective cost of your mortgage debt with what you expect to earn on an after-tax basis on your investment. In general, the more conservative the investor, the more willing he or she is to take the certain savings of prepaying the mortgage.

As your mortgage loan gets closer to being paid off, the mortgage interest deduction goes down. You can estimate your annual interest expense by reviewing an amortization schedule of your loan. Using the “View Report” function on Bankrate’s Mortgage tax deduction calculator will show you the approximate interest expense by year on your mortgage.

A tax professional will be able to tell you how much the mortgage interest deduction benefits you on taxes. For many homeowners, it doesn’t contribute all that much to reducing their income taxes because the homeowners’ itemized deductions — including the mortgage interest deduction — don’t add up to substantially more than the standard deduction. For the 2009 tax year, the standard deduction amounts are: $11,400 for joint filers, $5,700 for singles and $8,350 for heads of households.