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How Do You Calculate the After-Tax Interest Rate on a Mortgage?

A reader writes in, asking:

“I’m in the process of buying my first home, and I keep reading about how I need to know the after tax interest rate on my mortgage. Does that just depend on my tax bracket or is there more to know here?”

If you’re already itemizing every year before you take out a mortgage, the calculation is simple. The after-tax interest rate on the mortgage is the interest rate, multiplied by (1 – your marginal tax rate). In other words, it’s the interest you pay, minus the tax savings you get back.

Example: Celeste is unmarried, with a standard deduction of $6,300 per year. She’s in the 25% federal tax bracket and 5% state tax bracket, for a total marginal tax rate of 30%. She already has itemized deductions totaling $10,000 per year, so she chooses to itemize each year rather than use the standard deduction. If she takes out a mortgage with an interest rate of 4%, the after-tax interest rate on her mortgage will be 2.8% (calculated as 4% x 0.7, because she gets 30% of the mortgage interest back in the form of tax savings).*

But in a situation in which you don’t already itemize, a part of the deduction is essentially wasted, because all it’s doing is bringing your itemized deductions up to the level of deduction you would have already had with the standard deduction. And it’s only the amount beyond that point that’s actually saving you any money on your taxes.

Example: Martin and Johanna are married, with a standard deduction of $12,600 per year. They’re in the 25% federal tax bracket and 5% state tax bracket, for a total marginal tax rate of 30%. Prior to taking out a mortgage, their itemized deductions are just $7,000 per year, so they currently choose to use the standard deduction each year. They’re considering taking out a mortgage with an interest rate of 4%.

Despite the fact that Martin and Johanna have the same marginal tax rate as Celeste, and are considering a mortgage with the same interest rate, their after-tax interest rate on the mortgage will be higher than hers, because they will get less tax savings from the deduction than she gets. Specifically, the first $5,600 of their deduction for home mortgage interest will serve no purpose other than to bring their itemized deductions up to the level of the standard deduction. They will only achieve tax savings for any home mortgage interest they pay that is in excess of $5,600 per year.

So for Martin and Johanna to calculate their after-tax interest rate for the first year of such a mortgage, they would calculate the amount of interest they would pay over the course of the year, then subtract $5,600. The resulting amount would be multiplied by 30% (their marginal tax rate) to determine the amount of their tax savings. Then they would subtract that tax savings from the amount of interest they paid over the year to determine the after-tax amount of interest they paid. And if they divide that after-tax interest amount by the outstanding balance on their mortgage, they’ll arrive at their after-tax interest rate.

A key point here is that Martin and Johanna will have to revisit this calculation whenever they want to know the after-tax interest rate on their mortgage, because the figures involved will change over time. (For instance, the amount of interest they pay each year will decline over time as they pay down their mortgage balance. And their itemized deductions from things other than home mortgage interest will change over time as well.)

*This is a simplification. As we’ve discussed before, your marginal tax rate is not necessarily the same as your tax bracket, but I’m keeping things as simple as possible in our examples. We’re also assuming here that all of the interest on the mortgage does qualify for a deduction. (IRS Publication 936 has the details on that topic.) In addition, if you are itemizing, your state income tax can be claimed as a deduction against your federal taxable income, thereby slightly reducing your overall marginal tax rate.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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