Tax deductions are not free money

So you deducted your loan interest in your taxes. That means the interest was essentially free right? I could not quite figure out the answer to this question in my head recently, so I thought I would do a simple example and share it here, in case it could be useful for someone else.

First, the conclusion: Just because an expense is deductible does not make it free. It would have been better to not have the expense in the first place. However, if you cannot avoid the expense, then deductibles are of course great!

Let’s say we pay $10 interest on a loan, our income is $100 and we pay 50% tax. The table below shows the scenario where our interest is not deductible, compared to the scenario where our interest is 100% deductible1.

DescriptionAmount w/o deductible Amount w/ deductible
Income$100$100
Taxable income$100$90
Tax-$50-$45
Net income$50$55
Interest-$10-$10
Final income$40$45

In case we can deduct all of the interest, we would have $5 extra disposable income. Thus, about half of the interest in this example were “free” ($5). However, If we did not have to pay interest at all, we would of course have $50 in final income.

In other words, if we can completely avoid an expense, even if it is tax deductible, that is always the best financial outcome. In practice, this is not always possible, but I think it is a good principle to keep in mind.