Homeowners tend to focus on the interest rate on their monthly mortgage statement when assessing the cost of their loan. But your effective mortgage interest rate is actually lower, thanks to tax breaks from Uncle Sam. Because mortgage interest is tax-deductible, you recoup some of it through a lower tax bill. Your effective, or after-tax, rate accounts for these tax savings and represents the true annual cost of your loan as a percentage of your balance. However, mortgage interest is deductible only as an itemized deduction on your tax return. If you take the standard deduction, there are no savings.
In order to calculate the effective mortgage interest rate after deductions, you will need to use your annual interest rate, your taxable income and IRS Form 1040.
Review Your Documents
Look up your annual interest rate on your mortgage statement or in the documents you signed when you got the loan. For example, assume your interest rate is 6 percent.
Identify your taxable income on last year’s tax return. On Form 1040, taxable income is on or around line 43, depending on the year. Taxable income is the amount you earned after writing off mortgage interest and other deductions. It’s what the Internal Revenue Service uses to figure your tax bill. In this example, assume you’re married and file jointly and had $95,000 in taxable income last year.
Calculate Your Taxable Income
Visit the IRS website and download the latest Form 1040 instructions booklet. Locate the tax rate schedules toward the back of the booklet and identify the one that applies to your filing status, such as single. These schedules show the percentage tax rates applied to different income levels. Make sure you don’t confuse them with the “tax tables.” In this example, find these schedules on page 105 and use Schedule Y-1 for married filing jointly.
Find the two income levels that your taxable income lands between in the first two columns of the schedule. Your taxable income should be greater than the income in the first column but less than or equal to the income in the second. In this example, assume the third row of the schedule shows $70,700 in the first column and $142,700 in the second. Your $95,000 fits in between these levels.
Calculate Your Actual Interest
Identify the percentage in the third column of that row to determine your marginal tax rate. This is the rate that applies to the top portion of your income and the one used to figure the benefits of tax-deductible expenses, such as mortgage interest. In this example, assume the table shows 25 percent. This means your marginal tax rate is 25 percent.
Subtract your marginal tax rate as a decimal from 1. In this example, subtract 25 percent, or 0.25, from 1 to get 0.75. Multiply your result by your mortgage interest rate as a decimal. Multiply this result by 100 to figure your effective interest rate as a percentage. Concluding the example, Multiply 0.75 by 6 percent, or 0.06, to get 0.045. Multiply 0.045 by 100 to get a marginal tax rate of 4.5 percent. After your tax deductions, the true cost of your loan is only 4.5 percent a year, instead of 6 percent.
Items you will need
- Mortgage statement
- Last year’s tax return