What are the tax advantages of a mortgage on rental property?
The math is pretty simple when deciding whether it is better to pay off a loan or keep it or for tax purposes. Start with what the actual tax savings you receive when you have a mortgage on a rental property. The entire mortgage payment is not tax-deductible, only the interest portion of a mortgage payment is deductible. If your payment is $500 a month, then $400 of it may be interest and $100 of it may be principal pay down. Only the $400 in interest is tax-deductible on the mortgage, not the principal. Here is a great article on the other tax advantages of a rental property.
As your mortgage matures in age, the amount of the payment going towards principal increases and the amount going to interest decreases. This means the tax advantages decrease the longer you have a mortgage. Towards the end of a mortgage the interest portion of a $500 a month payment may only be $100, which is the only tax-deductible portion of the payment. The longer you have a mortgage the less tax advantages you will get from the mortgage. If you refinance a mortgage, then the amortization schedule would start over and you would have more tax deductions.
How much money does deducting your mortgage payment save you?
The tax rate used for rental income depends on what tax bracket you are in. The savings will vary from person to person based on how much income you make as well as a number of other factors. If you happen to be in the highest tax rate you could pay almost 40 percent of your income to taxes. If you have a $500 a month mortgage payment on your rental property and $400 of that is interest, your tax savings would be $160. So having a $500 a month mortgage payment will save $160 a month in taxes assuming you are the very highest tax bracket and the mortgage is brand new.
Does it make sense to spend $500 on mortgage payments to save $160 on taxes?
In my opinion it makes no sense to pay $500 to save $160. Technically $100 of that payment is going to principle pay down so you are only spending $400 to save $160 a month. Sure it is nice to have tax deductions, but if you make more money than the tax deductions save you, it doesn’t make sense to keep the payment. If I pay off the loan I have $500 more a month in cash flow. I have to pay $160 more in taxes, but I am still making $240 more a month than I did paying $400 in interest a month in mortgage payments.
Should you always pay off your mortgage?
The math shows it doesn’t make sense to keep a mortgage just for tax purposes. That doesn’t mean a mortgage doesn’t make sense for other reasons. I get mortgages on all my new rental property purchases, because it allows me to buy more properties and make more money. I then pay off one of those mortgages at a time using the snowball method. This allows me to reduce the amount of mortgages in my name and offset some of the risks of adjustable rate mortgages. In a perfect world where I could get 30 year fixed rate loans on as many rentals as I wanted, I would not pay off the loans, because I would make more money investing in new properties with a higher return than the mortgage rates.