Have you ever heard someone say they couldn’t afford to pay off their loan because they would lose the interest deduction on their tax return?
Although it’s true that the taxpayer will be able to deduct their loan interest at tax time, there’s a lot more to consider – read on to learn more about the tax treatment of loans and interest to identify a repayment strategy that works best for you.
It Is Worth It To Be In Debt?
Let’s assume that you are in the 25 percent tax bracket, which means that for every dollar you pay the bank in interest, the government will give you 25 cents back in tax savings. BUT – you have to remember that you are still out of pocket 75 cents of every dollar you pay the bank in interest. From an overall cash flow standpoint, that doesn’t really sound like a winning strategy to me.
Even though it would be nice to have a tax break to look forward to in the spring, you will ultimately end up paying more over the duration of your repayment period if you choose not to pay your loan off. That being said, if you have the funds available to pay off the principal loan balance you will save yourself the cost of the interest you are being charged by the bank.
Without the tax deduction, you will pay a little more in income taxes but you will be left with more money in your bank account at the end of the day.
Possible Reasons to Hold On To Your Loan
- Investment Opportunities
Let’s say your loan balance is $50,000. If you have $50,000 of excess funds available to pay off your loan, you may also want to consider what your investment options are if you didn’t pay that loan off. Could you earn a rate of return greater than the interest rate you are paying on your loan? If so, then you may be better off keeping the loan and investing your excess funds.
Another consideration is the liquidity. You may have the funds to pay off the loan but you may want to keep a reserve of funds for an emergency or unknown need that may arise. Everyone has their own comfort level when it comes to maintaining an excess supply of cash reserves and your decision may vary whether you are holding on to a home mortgage loan or a business loan. As a business owner, for example, you might find it to be more beneficial to keep the borrowed money readily available to cover any fluctuations pertaining to your company’s equipment or inventory needs. Or you may want to keep a reserve of funds to get through your slow season.
Depending on where you are with your business or personal finances, you’ll want to consider various factors when deciding if you should pay off your mortgage or business loan. If you are only looking at the tax savings, then paying off the loan is likely your best option. However, it may also be important to consider other factors such as alternative investment options and liquidity. If you have questions about paying off your loan, email your Rea advisor.