Windows 7 - Computer audio is being picked up by mic input.

Hi, this is my first time posting in this forum!

It all started when my friend told me that he could hear all of my computer audio through Skype, even though my mic (on my headset) is hard-muted (muted by switch on the headset itself).

All of my computer audio (system sounds, iTunes, YouTube) is being picked up by the mic under "Recording Devices". I've tried just about everything I can think of. Stereo Mix is disabled and the ONLY way I've found for the audio not to be picked up by mic is if I mute the mic in sound settings. I have set my microphone to default device and Playback is muted.

I've done lots of testing with different audio settings and using Windows "Sound Recorder" to record while iTunes is playing music whilst my mic is hard-muted, yet EVERY TIME it picks up the music!

Thanks for reading! And if you have any suggestions I thank you in advance!

MoBo : Asus Sabertooth P67 using ONBOARD sound.
Realtek High Definition Audio

*** I forgot to mention this problem only persists while I use my headset, if I unplug my headset and use speakers the mic doesn't pick up audio ***

P.S. I keep using the word hard-mute because I cannot mute the mic via the sound settings otherwise it would render it pointless...

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The screenshot I took is an example of how the mic picks up iTunes audio even though the mic is hard-muted.

this is driving me insane!