Many of us need to borrow money to finance various aspects of our lives, whether it's buying a home, getting a car, or even paying for things like food and electricity. Whenever you borrow a sum of money, your payments will include interest in addition to your principal loan amount. And while you can't get a tax break on credit card interest, the IRS does let you deduct interest on mortgages and business loans. Knowing what tax-deductible interest payments to claim can help put money back in your pocket.
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How tax deductions save you money
Tax deductions work by reducing the amount of your income that's subject to taxes. Some people confuse tax deductions with tax credits, but in reality, the two are very different beasts. A tax credit is a dollar-for-dollar reduction of your tax liability. When two people claim a tax credit in the same amount, that's what they both get to save on their taxes.
When you claim a tax deduction, however, your savings amount is tied directly to your tax rate, and it's possible for two people to take the same deduction but get different tax benefits out of it. For example, let's say your effective tax rate is 25%, and that you're eligible for a $2,000 deduction. That deduction will translate into $500 of tax savings. Now let's say your neighbor claims that same $2,000 deduction, but because he's a higher earner than you, his effective tax rate is 30%. In that case, a $2,000 deduction will save him $600 -- $100 more than you -- even though you're claiming the same amount.
Tax deductions for interest payments
Certain types of interest payments can serve as eligible tax deductions. The mortgage interest deduction is a popular tax break for homeowners because it can end up having a significant impact, especially during the early years of a mortgage. When you first start repaying your mortgage, the majority of your monthly payments are applied to interest on your loan as opposed to its principal. That's why you may come to notice that your principal has barely dropped despite having been making payments for a number of years. The good news, however, is that the more you pay in mortgage interest, the more you can write off on your taxes.
Similarly, you're allowed to deduct the interest you pay on a business loan. If you borrow money to buy new equipment for your business, or to market your business, the interest portion of your payments will serve as a tax break.
Calculating your tax savings
While you shouldn't borrow more money than you can afford to pay back, knowing what type of tax break you'll get on your interest payments can help you arrive at a more comfortable figure. This helpful calculator can help you determine which interest payments of yours are tax-deductible, and how much you stand to gain by claiming those deductions:
* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.
As you'll see, certain types of interest, like credit card interest, are not tax-deductible. That said, if you use a credit card to finance purchases for your business, you can deduct the interest you pay on your taxes. But if your charges stem from personal use, that interest won't result in a tax break.
Because only certain types of interest are tax-deductible, it pays to be judicious about how you borrow. Paying off a credit card balance over time, for example, means signing up to lose money to interest with no inherent benefit. While some interest payments, like your mortgage or car loan, may be inevitable, you're better off avoiding using a credit card unless you're confident you can pay it off on time and in full.