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Is Prepaying January Mortgage Bill for Tax Gain a Good Idea? Myth Busted.

Contributed by mm | December 12, 2007 6:38 AM PST

taxman.jpgAs we are approaching the year end, many personal finance journalists are busy throwing out last minute tax advices. One of the most discussed year-end tax saving strategy is to prepay your January's mortgage bill in late December so one may deduct 13 months' interest on mortgage payments instead of 12 months'.

Is this really worth your time? Let's run a quick calculation:

If your January 2008 mortgage bill is $500 in principal and $2,000 in mortgage interest, by prepaying the January 1, 2008 bill on December 20, 2007, you only pay the opportunity cost of 10 days' worth of interest on the $2,500, yet you can claim $2,000 more in deductions in the 2007 tax return, and that's worth $500 if you are in the 25% tax bracket.

Now you are not actually $500 better off by applying this strategy; the strategy in most cases only helps you to move $500 worth of tax liability from 2007 to 2008 (remember you cannot always pay 13 months' mortgage year in year out), so the real monetary benefit is one year's interest on $500, or about $25 if you deposit the money in a high-yield savings account like WT Direct (currently yielding 4.9%). Also remember you will surrender 10 days' interest on $2,500, and that's $5. All in all, you will make $20 by adopting this tip, and that's before Uncle Sam takes his legitimate bite on your hard-earned $20.

Small change? To be fair, let's admit everyone's tax situation is different, and this strategy may mean substantial savings for someone or will backfire for another in special circumstances.

Scenario #1. You may reap substantial benefit if this year you file as itemized deduction and you knows for sure that next year you will file with standard deduction.

In this situation, if you pay your January mortgage bill in January, the $250 is your net benefit out of the strategy. Considering you only pay less than $1 in opportunity cost of interest, the return is massive.

Scenario #2. The strategy may backfire if you just bought your house. This scenario actually applies to me back in 2003: I bought the house in August 2003 and I'll never have enough mortgage interest and property tax bill for 2003 to qualify for itemized deduction (that is, have more than $9,500 household deduction) no matter I prepay the January 2004 bill or not.

In this scenario, should I have prepaid my January 2004 bill without considering the consequences, I would have actually lost $1,000 worth of mortgage interest deduction in the next tax year, which means the strategy will cost me $250.

All in all, I seriously doubt more than 10% homeowners will benefit more than $20 from mortgage prepayment. It is scary that our media is pushing these tax "tips" to people in an authoritative manner, and when you have a Vice President of the 2nd largest tax preparation firm claiming the same in a press release without reminding people of circumstances like whether they qualify for itemized deduction or are subject to AMT, we have a problem.

This Post Has Received 42 Comments. Share Your Opinions Too.

pfodyssey Commented on December 15, 2007

The only time I really considered this approach was when I had received a significant bonus that was pushing me over various income limits that were both restricting my ability to make certain contributions (ex: IRAs) and also getting nipped by AMT.

Essentially, I was looking for every angle to reduce my tax bill in what was an extraordinary tax year. Otherwise, it's still something, but certainly not the boon that it is made out to be.

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