So we all know when people buy a home, they generally put 20-40% down and get a loan from their local bank in the form of a mortgage. This mortgage takes the form of a monthly payment coming out of our wallets. We also know that we get a tax deduction for property taxes and the interest on the mortgage. One thing you may have noticed is that the interest deduction on your taxes is reduced over time. The explanation is as follows.
We can understand it more clearly if we take a deeper look at what a mortgage is and how it works in finance. I made this a short, 5 year, 4%, 500,000 loan to keep it from running too long, but what happens in the loan is exactly the same as a 30 year mortgage. The monthly payment is 9,208.26. Take a look at the numbers below. Then head over to the interest column. Notice how the number keeps dropping?
This is an amortization schedule that we use here at Lodestone Capital Solutions when we buy/sell residential and commercial properties. The tax deductible part for a residential loan is the interest. So over the life of the loan, the amount of interest deductible each year decreases as the loan balance decreases.
One item that is not as skewed is the interest vs principal payments. As this is a 5 year loan, it is paid off quite quickly so the initial principal payments are actually larger than the interest portion of the payment. In general, for most residential 15-30 year loans, the initial interest port of the total payment will be much greater than the principal portion of the payment. For example, if I were to make this 500,000 loan, into a 30 year loan vs a 5 year loan, the first few interest payments would be, 1,666.67, 1,664.27, and 1,659.44 corresponding to principal payments of 720.41, 722.81, and 725.22. You can see the longer the loan, the larger percent the interest is of the earlier payments.
This graph below shows the general trend of what happens to principal and interest over the life of the loan.
So what happens over time is the interest portion of the payment diminishes while the principal payment increases, keeping the monthly mortgage payments the same over the life of the mortgage and is why the interest deduction on your tax returns is reduced every year.