You need a mortgage. Sounds crazy right? Isn’t sound financial planning and wealth building strategies all about saving and investing? Not necessarily. It is about saving and invest and keeping more of what you earn. That means keeping a careful eye on taxes. One of the biggest tax deductions (other than your retirement plans like a 401K) you can take is the mortgage interest deduction. When you take out a mortgage most of your payment is interest and all of that interest is deductable. If you have a mortgage, take a look at your Schedule A Itemized deductions federal tax form. Under interest deductions, you will see how much you wrote off of the total amount of yearly mortgage payments. Why so much? Because almost all mortgages are fully amortized, this means that each payment is part interest and part principal. In the early years you will see that almost all of your payments are interest. You can get a mortgage amortization schedule of your mortgage on an online calculator if you really want to get exact.
Most people focus on the payments that they make on their mortgage. There wealth building strategy is to get a lower payment. That can be a really bad strategy in some situations. Let’s look at two in particular:
- John is getting ready to retire. His wealth building strategy is to pay off his mortgage so he has less debt. He will live on his social security, income from his 401K, and some part-time job income. What John doesn’t realize is that by paying off his mortgage, he may be paying more taxes than when he was working. Why? The income from his 401K and his part-time job is taxable. He doesn’t have any mortgage interest deductions to reduce that taxable income so his taxes are higher and part of his social security is taxed too. John is not happy about the choices he made.
- Sue bought a house 15 years ago. She has just come into an inheritance. She wants to refinance and use her inheritance to pay off most of the mortgage. She figures she will be able to work part-time if she doesn’t have a big mortgage. Sue refinances at a lower rate and uses all of her inheritance to pay off most of the mortgage. Sue now finds that she can’t live on her part-time income even with a lower mortgage. Her taxes on the lesser income are much higher and her take home pay is a lot lower than she expected. She will have to go back to full time work. She is not happy about the choices she made.
In both examples, there was good intention to do the right thing but not a holistic approach to the problem. You need to carefully consider tax planning with your Financial Advisor or Wealth Coach in any wealth building strategy that you choose but in particular with a mortgage or a refinance.