Tax Implications of Paying Off a Mortgage Early
Generally, a debt-free life is one to strive for -- except when the debt is a mortgage loan, especially one with a penalty for early payoff. The U.S. tax code allows for certain taxpayers who take out home loans to enjoy write-offs that lower their tax liability. An accountant can crunch the numbers for you and advise you whether you should hold onto your mortgage debt or let it go.
In addition to having to pay interest, mortgage holders are subject to points and insurance premiums. Points are fees the lender charges for processing the loan; they are sometimes called loan origination fees. Often, you can lower your loan’s interest rate by paying for more points. In addition, it is usual for financial institutions to require that the borrower buy mortgage insurance as a protection against default. The U.S. tax code lets homeowners claim mortgage interest, points and mortgage insurance premiums as deductions on their tax returns. The catch is that not every borrower qualifies for the write-offs.
You have two options to claim certain deductions that reduce your taxable income: To itemize allowed expenses and subtract them from your pay or to use the standard deduction the IRS provides. It makes the most sense to submit the higher of the two numbers, which reduces your taxable income to the lowest figure possible. However, you qualify for the mortgage write-offs only if you itemize your taxes in Schedule A. Thus, if the standard deduction is always the one you take and you do not expect that to change, paying off your mortgage early will not impact your taxes.
Gradual Payoff vs. Refinancing
In a May 2012 advice column on Forbes.com, personal finance writer Erik Carter says the tax implications of refinancing a mortgage for a lower interest rate are more advantageous than those that result from paying it off gradually. Since the lender applies extra payments to the principal balance, you pay progressively less interest over time, thus reducing the tax write-off you can claim if you itemize your deductions. You may end up with a mortgage that ceases to offer a tax benefit. On the other hand, although your principal is not reduced when you refinance the loan for a lower rate, your monthly payments go down. Besides, because the principal balance on which the bank charges interest remains sizeable, you are likely to continue to qualify for a tax deduction. An accountant can run the numbers for you to verify that refinancing is beneficial in your situation.
Mortgage loans vary from package to package and lender to lender. Some contracts include a penalty for an early payoff. Or they may hold you accountable for the original interest regardless of how quickly you pay down the principal. Read the terms of your mortgage to find out whether the original agreement offers flexibility. Tax implications aside, it may be too costly for you to pry your house out of the bank’s claws.
Emma Watkins writes on finance, fitness and gardening. Her articles and essays have appeared in "Writer's Digest," "The Writer," "From House to Home," "Big Apple Parent" and other online and print venues. Watkins holds a Master of Arts in psychology.